10-K

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED	DECEMBER 31, 2005
COMMISSION FILE NUMBER	0-11113

PACIFIC CAPITAL BANCORP

(Exact Name of Registrant as Specified in its Charter)

California	95-3673456
(State or other jurisdiction of	(I.R.S. Employer
incorporation or organization)	Identification No.)
1021 Anacapa St.
Santa Barbara, California	93101
(Address of principal executive offices)	(Zip Code)

(805) 564-6405

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act: NONE

Securities registered pursuant to Section 12(g) of the Act:

Title of Class

Common Stock, no par value

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes X     No     

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes         No X

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes X     No     

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act). (Check one):

Large accelerated filer X Accelerated filer      Non-accelerated filer     

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes         No X

The aggregate market value of the voting stock held by non-affiliates computed June 30, 2005, based on the sales prices on that date of $37.00 per share: Common Stock—$ 1,581,149,231. This amount is based on reported beneficial ownership by all directors and executive officers and the registrant’s Employee Stock Ownership Plan; however, this determination does not constitute an admission of affiliate status for any of these stockholders.

As of February 28, 2006, there were 46,683,513 shares of the issuer’s common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE: Portions of registrant’s Proxy Statement for the Annual Meeting of Shareholders on May 25, 2006 are incorporated by reference into Part III.

INDEX			Page
PART I
Item 1.	Business
	(a)	General Development of the Business	3
	(b)	Financial Information about Industry Segments	4
	(c)	Narrative Description of Business	4
	(d)	Financial Information about Foreign and Domestic Operations and Export Sales	5
	(e)	Available Information	5
Item 1A.	Risk Factors		6
Item 1B.	Unresolved Comments		6
Item 2.	Properties		6
Item 3.	Legal Proceedings		7
Item 4.	Submission of Matters to a Vote of Security Holders		7
PART II
Item 5.	Market for the Registrant’s Common Stock and Related Stockholder Matters		8
	(a)	Market Information	8
	(b)	Holders	8
	(c)	Dividends	8
	(d)	Securities Authorized for Issuance Under Equity Compensation Plans	8
Item 6.	Selected Financial Data		9
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		10
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk		72
Item 8.	Financial Statements and Supplementary Data		72
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosures		131
Item 9A.	Controls and Procedures		132
PART III
Item 10.	Directors and Executive Officers of the Registrant		134
Item 11.	Executive Compensation		134
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters		134
Item 13.	Certain Business Relationships		134
Item 14.	Principal Accountant Fees and Services		134
PART IV
Item 15.	Exhibits, Financial Statements, and Reports on Form 8-K		135
SIGNATURES			136
EXHIBIT INDEX			137
CERTIFICATIONS			140

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PART I

ITEM 1. BUSINESS

(a)  General Development of the Business

Operations commenced as Santa Barbara National Bank (“the Bank”) in 1960. In 1979, the Bank switched from a national charter to a state charter and changed its name to Santa Barbara Bank & Trust (“SBB&T”). Santa Barbara Bancorp (“SBBancorp”) was formed as a holding company in 1982. In 1998, SBBancorp merged with Pacific Capital Bancorp (“PCB”), a bank holding company that was the parent of First National Bank of Central California (“FNB”). SBBancorp was the surviving company, but took the name Pacific Capital Bancorp to recognize the wider market area. In March 2002, the Company consolidated the two subsidiary banks, SBB&T and FNB, into one national bank charter (“the Bank Merger”), Pacific Capital Bank, N.A. (“PCBNA”). Unless otherwise stated, “Company” refers to this consolidated entity and to its subsidiary bank when the context indicates. “Bancorp” refers to the parent company only.

At the time of the Bank Merger, SBB&T had grown to 29 banking offices with loan, trust and escrow subsidiary offices. Through 1988, banking activities were primarily centered in the southern coastal region of Santa Barbara County. Two banking offices were added in the merger with Community Bank of Santa Ynez Valley on March 31, 1989. Five offices in northern Santa Barbara County were added with the acquisition of First Valley Bank on March 31, 1997, and three offices in the Santa Clara River Valley region of Ventura County were added with the acquisition of Citizens State Bank on September 30, 1997. From 1995 through 1998, six new banking offices were opened in western Ventura County and one in northern Santa Barbara County. The Company acquired Los Robles Bank (“LRB”) at the end of June 2000, when the Company purchased all of the outstanding shares of Los Robles Bancorp, parent of LRB. LRB was merged with SBB&T in the second quarter of 2001. LRB had three offices. Two of these became offices of SBB&T and the third was closed because of its close proximity to one of the existing offices of SBB&T.

At the time of the Bank Merger, FNB had 11 banking offices in Monterey, Santa Cruz, Santa Clara, and San Benito counties. The offices in Santa Clara County use the name South Valley National Bank, which was a separate subsidiary of PCB until it was consolidated with FNB shortly before PCB merged with SBBancorp. The offices in San Benito County use the name San Benito Bank (“SBB”). SBB was a separate bank prior to its merger with FNB at the end of July 2000. FNB also provided trust and investment services to its customers.

Subsequent to the Bank Merger, the Company opened an additional banking office in the Simi Valley area of Ventura County. Pacific Crest Capital Inc. (“PCCI”) was acquired in March 2004. Its subsidiary, Pacific Crest Bank with its deposit offices and lending activities was merged into PCBNA. The deposit offices are located in Encino and Beverly Hills in Los Angeles County, and in San Diego in San Diego County. The lending activities of the former Pacific Crest Bank are conducted in a number of western states. Primarily these loans are for income producing properties and loans to small businesses guaranteed by the Small Business Administration. PCCI was merged into the Bancorp. First Bancshares, Inc. (“FBSLO”) was acquired in August 2005. Its subsidiary, First Bank of San Luis Obispo, with its deposit offices and lending activities in San Luis Obispo County, was merged into PCBNA. FBSLO was merged into the Bancorp. PCBNA now has 48 banking offices from San Diego in the South to Morgan Hill in the North. The Company continues to use the brand names of Santa Barbara Bank & Trust, First National Bank of Central California, South Valley National Bank, First Bank of San Luis Obispo and San Benito Bank in their respective market areas, and Pacific Capital Bank for the three former offices of Pacific Crest Bank.

The Company has several other subsidiaries. PCB Services Corporation was formed in 1988. This subsidiary, which was primarily involved in mortgage brokering services and the servicing of brokered loans, ceased those activities in 2001 and now has only insignificant activities. A second, Pacific Capital Services Corporation, is inactive. There are two additional subsidiaries, SBB&T Automobile Loan Securitization Corporation and SBB&T RAL Funding Corporation, that are or were used in the securitizations mentioned in Note 11 to the Consolidated Financial Statements on page 104.

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(b)  Financial Information about Industry Segments

Information about industry segments is provided in Note 25 to the Consolidated Financial Statements in Item 8 which begins on page 123 of this report. In addition, the following information is provided to assist the reader in understanding the Company’s business segments:

(i) Geographical areas—As explained in (a) above, the Company’s deposit businesses are conducted in nine California counties. Approximately 29% of this business is conducted in a northern region consisting of the four counties of Monterey, Santa Cruz, San Benito, and Santa Clara. Approximately 66% of this business is conducted in a region consisting of the three counties of Santa Barbara, Ventura and San Luis Obispo. The three banking offices in Encino, Beverly Hills (Los Angeles County) and San Diego County account for about 5% of the deposits. The use of the separate brand names is for community recognition only, all offices are legally branches of PCBNA, and all of these banking offices are administered under one management structure.

In addition to the retail and business deposits managed by the above banking offices, the Company makes use of brokered deposits and deposits received from the State of California, both of which are administered by the Company’s Treasury department.

The Company’s lending businesses are organized broadly by product line, not region. There is one manager for commercial lending, another for consumer lending, and one for Wealth Management lending to high net worth customers.

Several of the Company’s businesses are conducted over a wider geographic area than the nine counties listed above. The income tax refund businesses described in Management’s Discussion and Analysis in Item 7 of this Annual Report (“MD&A”) on pages 59 through 66 and which comprise a separate reportable segment in Note 25 to the Financial Statements, are conducted in all 50 states. The commercial equipment leasing business is also conducted nation-wide, but primarily throughout the Western United States. The indirect auto lending business is also conducted in several counties in California other than the counties listed above. Neither the commercial equipment leasing nor the indirect automobile lending businesses comprise an individual segment reportable in Note 25. As described above, the lending businesses acquired with PCCI are conducted in California, Arizona, Texas, and Oregon.

(ii) Foreign operations—The Company has no foreign operations of its own. The Company does lend to and provide letters of credit and other trade-related services to a number of commercial enterprises that do business abroad. None of these customer relationships generate a significant portion of the Company’s revenues.

(iii) There are no facts that, in the opinion of Management, would indicate that the three-year segment information provided in Note 25 may not be indicative of current or future operations of the segments reported aside from (a) the impact of changes on interest income and interest expense from changes in prevailing market rates that may occur in 2006 and subsequent years (which primarily impact the Consumer Banking and Commercial Segments), (b) expenses incurred in connection with the Company’s technology investments described on page 52 of the MD&A, (c) changes in reporting relationships that could cause realignment of the reportable segments, and (d) a change in the national, state or local economy that could cause an adverse impact on the ability of borrowers to repay their loans.

(c)  Narrative Description of Business

Holding Company:  Bancorp is a bank holding company. As of December 31, 2005, as described above, it had one bank subsidiary, PCBNA. Bancorp provides support services to its subsidiary bank. These services include executive management, legal, accounting and treasury, and investor relations.

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Bank Products and Services:  PCBNA offers a full range of commercial banking services to households, professionals, and small- to medium-sized businesses. These include various commercial, real estate and consumer loan, leasing and deposit products. PCBNA offers other services such as electronic funds transfers and safe deposit boxes to both individuals and businesses. In addition, services such as lockbox payment servicing, foreign currency exchange, letters of credit, and cash management are offered to business customers. PCBNA also offers trust and investment services to individuals and businesses. These include acting as trustee or agent for living and testamentary trusts, charitable remainder trusts, employee benefit trusts, and profit sharing plans, as well as executor or probate agent for estates. Investment management and advisory services are also provided.

PCBNA also offers two products related to income tax returns filed electronically. The Company is one of three financial institutions, which together provide over 90% of these products on a national basis. The Company provides these products to taxpayers who file their returns electronically. For both products, the taxpayer instructs the Internal Revenue Service to remit his/her refund to the Company. In the case of a Refund Anticipation Loan (RAL), the Company will have lent the taxpayer some portion of the amount of his/her refund and will apply the refund when received from the IRS to repayment of the loan. In the case of a Refund Transfer (RT), the Company will forward the refund to the taxpayer once it has been received from the IRS. As a loan product, there is credit risk associated with a RAL. There is no credit risk associated with an RT. Because they are associated with income tax returns, there is a high degree of seasonality to the income from these programs. These programs are more fully described in the MD&A on pages 59 through 66.

Additional information about the products of the various business segments of PCBNA is provided in Note 25 of the Financial Statements.

Customer concentration:  No customer individually accounts for 10% or more of consolidated revenues.

Competition:  For most of its banking products, the Company faces competition in its market area from branches of most of the major California money center banks, some of the statewide savings and loan associations, and other local community banks, savings and loans, and credit unions. For some of its products, the Company faces competition from other non-bank financial service companies, especially securities firms and asset or investment managers. Some of these competitors emphasize price and others technology. The Company strives to compete primarily on the basis of customer service.

Employees:  The Company currently employs the equivalent of 1,505 full time employees. Additional employees would be added if new opportunities for geographic expansion or other business activities should occur.

(d) Financial Information about Foreign and Domestic Operations and Export Sales

The Company does not have any foreign business operations or export sales of its own. However, it does provide financial services including wire transfers, foreign currency exchange, letters of credit, and loans to other businesses involved in foreign trade.

(e)  Available Information

The Company maintains an Internet website at http://www.pcbancorp.com. The Company makes available its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to such reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities and Exchange Act of 1934, as amended, and other information related to the Company, free of charge, through this site as soon as reasonably practicable after it electronically files those documents with, or otherwise furnishes them to, the SEC. The Company’s Internet website and the information contained therein or connected thereto are not intended to be incorporated into this annual report on Form 10-K.

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ITEM 1A. RISK FACTORS

Various risk factors to which the Company is exposed are discussed in specific sections of Management’s Discussion and Analysis in Item 7 of this Annual Report.

That events may not occur as anticipated by the Company is discussed in the Introduction in the section titled “Forward-Looking Statements.”

That estimates made in the accounting process by Management may prove inaccurate is discussed in the section titled “Critical Accounting Policies.”

The risk from external events including economic conditions, regulatory considerations, and competition are discussed in the section titled “External Factors Impacting the Company.”

Risk factors related to changes in interest rates are discussed in two sections, “The Impact of Changes in Assets and Liabilities to Net Interest Income and Net Interest Margin” and “Interest Rate Risk.”

Credit risk factors are also discussed in two sections, “Allowance for Credit Losses” and “Credit Losses.”

Liquidity risk is discussed in “Liquidity.”

Risks specific to the tax refund programs are discussed in the section titled “Tax Refund Anticipation Loan and Refund Transfer Programs.”

In addition to these risks discussed in sections of Item 7, the nature of and the risk from the litigation in which the Company is involved is disclosed in Note 18 to the financial statements.

ITEM 1B. UNRESOLVED COMMENTS

There are no comments received from Securities Exchange Commission staff regarding its periodic or current reports that are unresolved. No comments have been received from the staff in the last three years.

ITEM 2. PROPERTIES

The Company maintains its executive offices in leased premises at 1021 Anacapa St., Santa Barbara, California. The Trust & Investment Services Division is also located in this building. The Company leases other premises in the Santa Barbara area for Information Technology, Operations Support and other administrative functions and other premises in Ventura County for its Delinquency Management Unit and for the relationship managers in that county. Of the 48 branch banking offices, 34 are leased in whole or part. The 48 branch offices are located in the nine California counties mentioned above in Item 1(a). The Company owns the building used by its Residential Real Estate, Business Services, and International Banking units.

The Company has obtained the master lease on the shopping center where one of its branch offices is located. As explained in Note 14 to the Consolidated Financial Statements in Item 8 of this Annual Report on page 106, the portion of the lease related to the building is classified as a capital lease.

Premises are utilized based on needed space and the geography of the customer served. There is no necessary correspondence between use of the buildings and business segments. For example, in addition to employees providing deposit related services, portions of the branch offices frequently house Consumer and Commercial Banking segment employees involved in lending activities. Similarly, of the Residential Real Estate, Business Services, and International Banking units housed in the building mentioned above, the first is in the Consumer Banking segment and the second two are in the Commercial Banking segment. Rather than attempt an allocation of ownership of these assets, for segment reporting in Note 25, all buildings are recognized as assets of the “All Other”

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segment, but rental expenses are generally charged to the business segments using the properties when allocation is practicable.

The buildings are of various ages and consequently require varying levels of maintenance. All are suitable and adequate for their intended use.

ITEM 3. LEGAL PROCEEDINGS

The Company has been named in several lawsuits filed by customers and others. The significant suits are described in Note 18 to the Consolidated Financial Statements in Item 8 on page 114 of this report. The Company does not expect that these suits will have any material impact on its financial condition or operating results.

The Company is involved in various other litigation of a routine nature that is being handled and defended in the ordinary course of the Company’s business. In the opinion of Management, based in part on consultation with legal counsel, the resolution of these litigation matters will not have a material impact on the Company’s financial condition or operating results.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

There were no matters submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report.

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PART II

ITEM 5. MARKET FOR THE REGISTRANT’S COMMON STOCK AND RELATED STOCKHOLDER MATTERS

(a)  Market Information

The Company’s common stock trades on The Nasdaq Stock Market under the symbol “PCBC”. The following table presents the high and low closing sales prices of the Company’s common stock for each quarterly period for the last two years as reported by The Nasdaq Stock Market:

		2005 Quarters								2004 Quarters
	4th		3rd		2nd		1st		4th		3rd		2nd		1st
Range of stock prices:
High	$	38.23	$	39.36	$	37.00	$	33.46	$	34.54	$	30.18	$	30.41	$	30.19
Low	$	32.39	$	29.86	$	26.64	$	27.89	$	29.34	$	26.30	$	25.87	$	26.75

(b)  Holders

There were approximately 10,500 shareholders as of December 31, 2005. This number includes an estimate of the number of shareholders whose shares are held in the name of brokerage firms or other financial institutions. The Company is not provided with the exact number or identities of these shareholders, but has estimated the number of such shareholders from the number of shareholder documents requested by these firms for distribution to their customers.

Based on filings with the SEC by institutional investors, approximately 33% of the Company’s shares are owned by these institutions. These institutions may be investing for their own accounts or acting as investment managers for other investors.

(c)  Dividends

The Company declares cash dividends to its shareholders each quarter. Its policy is to declare and pay dividends of between 35% and 40% of its net income to shareholders. The following table presents cash dividends declared per share for the last two years:

		2005 Quarters								2004 Quarters
	4th		3rd		2nd		1st		4th		3rd		2nd		1st
Cash dividends declared	$	0.20	$	0.20	$	0.20	$	0.18	$	0.18	$	0.18	$	0.17	$	0.17

The above per share figures are adjusted for the 4 for 3 stock split that was distributed in June 2004. The pre-split amounts for the first two quarters of 2004 were $0.22 per share. Adjusted for the split, the quarterly figures were $0.165. These amounts have been rounded to $0.17 per share for presentation.

The Company funds the dividends paid to shareholders primarily from dividends received from the subsidiary bank, PCBNA.

(d)  Securities Authorized for Issuance Under Equity Compensation Plans

The required table for this section of Item 5 is included in Note 19 to the Consolidated Financial Statements in Item 8 on page 116 of this report and is hereby incorporated by reference.

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ITEM 6. SELECTED FINANCIAL DATA

The following table compares selected financial data for 2005 with the same data for the four prior years. The Company’s Consolidated Financial Statements and the accompanying notes presented in Item 8 and Management’s Discussion and Analysis in Item 7 on the next page explain reasons for the year-to-year changes. The following data has been derived from the Consolidated Financial Statements of the Company and should be read in conjunction with those statements, which are included in this report.

(amounts in thousands except per share amounts)	2005			Increase (Decrease)			2004			2003			2002			2001
RESULTS OF OPERATIONS:
Interest income	$	426,157		$	99,976		$	326,181		$	272,189		$	266,746		$	291,108
Interest expense		111,505			42,294			69,211			53,933			62,799			97,226
Net interest income		314,652			57,682			256,970			218,256			203,947			193,882
Provision for credit losses		53,873			41,064			12,809			18,286			19,727			26,671
Other operating income		111,923			36,288			75,635			80,281			73,784			65,726
Non-interest expense:
Staff expense		108,023			13,326			94,697			83,902			74,420			69,788
Other operating expense		106,382			21,173			85,209			78,336			68,868			73,362
Income before income taxes		158,297			18,407			139,890			118,013			114,716			89,787
Provision for income taxes		59,012			7,066			51,946			42,342			39,865			33,676
Net Income	$	99,285		$	11,341		$	87,944		$	75,671		$	74,851		$	56,111
DILUTED PER SHARE DATA:
Average shares outstanding		46,358			447			45,911			46,083			46,653			47,359
Net Income	$	2.14		$	0.22		$	1.92		$	1.64		$	1.60		$	1.18
Cash dividends declared	$	0.78		$	0.09		$	0.69		$	0.60		$	0.53		$	0.38
Cash dividends paid	$	0.78		$	0.09		$	0.69		$	0.60		$	0.53		$	0.50
FINANCIAL CONDITION:
Total loans	$	4,897,286		$	834,992		$	4,062,294		$	3,180,879		$	3,019,820		$	2,799,092
Total assets		6,876,159			851,374			6,024,785			4,859,630			4,219,213			3,960,929
Total deposits		5,017,866			505,576			4,512,290			3,854,717			3,516,077			3,365,575
Long-term debt*		803,212			(29,040	)		832,252			491,100			252,000			175,000
Total shareholders’ equity		545,256			85,574			459,682			399,048			371,075			325,876
OPERATING AND CAPITAL RATIOS:
Average total shareholders’ equity to average total assets		8.08	%		0.49	%		7.59	%		8.38	%		8.40	%		8.33	%
Rate of return on average:
Total assets		1.55	%		0.01	%		1.54	%		1.63	%		1.80	%		1.45	%
Total shareholders’ equity		19.18	%		-1.12	%		20.30	%		19.44	%		21.46	%		17.46	%
Tier 1 leverage ratio		6.57	%		0.24	%		6.33	%		7.46	%		7.94	%		7.70	%
Tier 1 risk-based capital ratio		8.02	%		-0.16	%		8.18	%		10.06	%		9.77	%		9.78	%
Total risk-based capital ratio		11.33	%		-0.77	%		12.10	%		13.33	%		12.10	%		12.23	%
Dividend payout ratio		36.4	%		0.5	%		35.9	%		36.5	%		32.7	%		32.1	%

*Includes obligations under capital lease.

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ITEM 7.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Pacific Capital Bancorp and Subsidiaries

INTRODUCTION

Purpose and Definition of Terms

The following provides Management’s comments on the financial condition and results of operations of Pacific Capital Bancorp and its subsidiaries. Unless otherwise stated, “the Company” refers to this consolidated entity and “we” refers to the Company’s Management. You should read this discussion in conjunction with the Company’s Consolidated Financial Statements and the notes to the Consolidated Financial Statements. These statements and notes are presented on pages 72 through 131 of this Annual Report on Form 10-K. “Bancorp” will be used when referring to the parent company only. Terms with which you may not be familiar are printed in bold and defined the first time they occur or are defined in a note on pages 68 through 71. These notes are designated by a letter. References to notes designated by a number refer to notes to the Consolidated Financial Statements that are found on pages 82 through 131 of this document. The impact of recent accounting pronouncements is disclosed in Note 1.

Subsidiaries

The Company has one subsidiary bank, Pacific Capital Bank, N.A. (“PCBNA”). PCBNA continues to use brand names of banks from which it was formed or which the Company acquired and merged into PCBNA. PCB Services Corporation is a non-bank subsidiary of Bancorp which was primarily involved in mortgage brokering and the servicing of brokered loans. It ceased this business and became essentially inactive in 2001. The Company has a second inactive subsidiary, Pacific Capital Services Corporation. The Company has two subsidiaries that are special purpose entities which are used in the securitizations mentioned in Note 11 on page 104. One of these, SBB&T Automobile Loan Securitization Corporation, is now inactive, as the securitization it was used for has been closed. The three subsidiaries used for the trust preferred securities described in Note 14 on page 106 are not consolidated with the Company and the rest of its subsidiaries. The reason they are not consolidated is explained in the “Consolidation of Variable Interest Entities” section of Note 1 on page 90.

Forward-Looking Statements

This discussion and analysis provides insight into Management’s assessment of the operating trends over the last several years and its expectations for 2006. Such expressions of expectations are not historical in nature and are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are subject to risks and uncertainties that may cause actual future results to differ materially from those expressed in any forward-looking statement. Such risks and uncertainties with respect to the Company include:

· increased competitive pressure among financial services companies;

· changes in the interest rate environment reducing interest margins or increasing interest rate risk;

· deterioration in general economic conditions, internationally, nationally or in the State of California;

· the occurrence of events such as the terrorist acts of September 11, 2001;

· economic or other disruptions caused by military actions in Iraq or other areas;

· the availability of sources of liquidity at a reasonable cost;

· difficulties in opening additional branches, integrating acquisitions, or introducing new products and services;

· reduced demand for, or earnings derived from, the Company’s income tax refund loan and refund transfer programs; and

· legislative or regulatory changes adversely affecting the businesses in which the Company engages.

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This discussion also provides information on the strategies adopted by the Company to address these risks, and the results of these strategies.

GAAP AND NON-GAAP MEASURES

In various sections of this discussion and analysis, we have called attention to the significant impacts on the Company’s balance sheet and year to date income statement caused by its tax refund anticipation loans (“RAL”) and refund transfer (“RT”) programs. These programs account for approximately one-third of the Company’s pretax income. We have discussed the results of operations and actions taken by the Company to manage these programs in the section below titled “Tax Refund Anticipation Loan and Refund Transfer Programs” on page 59 through 66. Included in the discussion is a summary statement of the results of operations for the programs. These programs comprise one of the Company’s operating segments for purposes of segment reporting in Note 25, “Segment Disclosure,” to the Consolidated Financial Statements. As such, Management believes that separately reporting operating results for the programs is consistent with accounting principles generally accepted in the United States (“GAAP”).

Because there are only two other financial institutions with nationwide refund programs of similar size to those of the Company, Management computes a number of amounts and ratios exclusive of the balances and operating results of these programs. We do this so that we may compare the results of the Company’s traditional banking operations with the results of other financial institutions. For the last several years, we have conducted conference calls with analysts and investors in connection with our quarterly earnings releases. During these calls, investors and analysts have expressed through their questions an interest in knowing certain balances and the usual performance ratios for the Company exclusive of the RAL and RT programs. We believe analysts and investors request this information for the same reason that Management uses it internally, namely, to provide more comparability with virtually all of the rest of the Company’s peers that do not operate such programs. For example, Management compares the Company’s net interest margin without RAL interest income or expense to the net interest margin of other banks to determine the efficiency with which it prices loans and deposits. Consequently, we have provided these amounts and ratios both with and without the balances and results of the RAL and RT programs in our press releases and in our periodic quarterly and annual reports on Forms 10-Q and 10-K, respectively. All such amounts and ratios that exclude the balances and results of the RAL and RT programs are clearly labeled as “without” or “excluding RAL/RT.”

While we provide these amounts and ratios both with and without the balances and results of the RAL and RT programs, we would stress that both shareholders and potential investors should pay attention primarily to the GAAP results that include the operating results of the RAL and RT programs.

In the section of this discussion that explains the RAL and RT programs, “Tax Refund Anticipation Loan and Refund Transfer Programs” that begins on page 59, we include several tables that reconcile all numbers and ratios reported in this discussion exclusive of the RAL/RT balances or results to the same numbers and ratios for the Company as a whole reported in the Consolidated Financial Statements. The reconciliations for amounts and ratios related to credit quality are included in Table 9B on page 43. The tables provide the consolidated numbers or ratios, the RAL/RT adjustment, and the numbers or ratios exclusive of the RAL/RT adjustment.

In addition to the non-GAAP measures computed related to the Company’s balances and results exclusive of its RAL and RT programs, we have included in this analysis and discussion other financial information determined by methods other than in accordance with GAAP. We use these non-GAAP measures in our analysis of the business and its performance. In particular, net interest income, net interest margin and operating efficiency are calculated on a fully tax-equivalent basis (“FTE”).

The use of FTE measurement is a common practice in banking and Management finds that calculating these measures on an FTE basis provides a useful picture of net interest income, net interest margin and operating efficiency for comparative purposes. The efficiency ratio also uses net interest income on an FTE basis. The calculation of net interest income on this basis is explained in Note A. Table 2 contains a reconciliation of the amounts and ratios with and without the FTE adjustment. Net interest income as reported on the Company’s Consolidated Income Statement in Item 8 of this Annual Report on Form 10-K is not reported on an FTE basis.

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OVERVIEW OF EARNINGS PERFORMANCE

In 2005, the Company earned net income of $99.3 million, or $2.14 per diluted share. This represents a 13% increase over the $87.9 million net income, or $1.92 per diluted share reported for 2004.

The significant factors impacting net income for 2005 compared to 2004 were:

· the Federal Open Market Committee (“FOMC”) of the Federal Reserve Board raised its target Federal funds rate eight times totaling 2% during 2005;

· we saw an increase of approximately 11.9% in transaction volumes in our income tax refund loan and transfer programs; interest income on the loans and fees on the transfers increased accordingly; interest income and provision expense also increased because of a change in our contract with one of the companies with whom these are provided;

· loan balances increased approximately $618 million exclusive of the loans purchased with FBSLO;

· we introduced a “no-fee” checking product in late 2003 that continued to grow in 2005, providing relatively low cost funds;

· non-performing assets declined by just under $5 million permitting a smaller increase in the allowance for credit losses to the increase in loans;

· we had losses of $730,000 in 2005 in the securities portfolio compared to losses of $2.0 million in 2004; and

· noninterest expenses increased primarily due to a full year of salaries for the staff added from the PCCI purchase, five months of salary expense for the staff added from the purchase of the FBSLO and consulting expense and depreciation/amortization expense related to the installation of new core accounting and customer relationship management software.

Each of these items will be addressed in more detail in various sections of this discussion.

In 2004, the Company earned net income of $87.9 million, or $1.92 per diluted share. This represents a 16% increase over the $75.7 million net income or $1.64 per diluted share reported for 2003.

The significant factors impacting net income for 2004 compared to 2003 were:

· the FOMC raised its target Federal funds rate five times during 2004;

· we saw an increase of approximately 10% in transaction volumes in our income tax refund loan and transfer programs; interest income on the loans and fees on the transfers increased accordingly;

· the purchase of PCCI added new loans and deposits to increase net interest income;

· loan balances increased approximately $462 million exclusive of the loans purchased with PCCI;

· we introduced a “no-fee” checking product in late 2003 that continued to grow in 2004, providing relatively low cost funds;

· we received significant payments on loans that had been charged-off in prior years permitting a very low provision expense for credit losses;

· we had losses of $2.0 million in 2004 in the securities portfolio compared to gains of $2.0 million in 2003 as we sold low-yielding securities in 2004 at a loss to reposition the proceeds in higher yielding securities; and

· noninterest expenses increased primarily due to the new staff added from the PCCI purchase and consulting expense for implementing the Sarbanes-Oxley Act.

From a longer range perspective, for the five years of 2001 through 2005, the Company’s net income increased at a compound annual rate of 14.0%. Among the reasons for this favorable trend of increase in net income have been:

· the integration of six new branch offices through acquisitions;

· growth in the tax refund anticipation loan (“RAL”) and refund transfer (“RT”) programs;

· strong loan demand—compound annual growth of 14.2% exclusive of acquisitions;

· continued growth in service charges and fee income; and

· cost savings related to its mergers.

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Measures and ratios of profitability, specifically return on assets, return on equity, the operating efficiency ratio and net interest margin with and without the RAL and RT program, may be found in Table 16G.

CRITICAL ACCOUNTING POLICIES

The Company’s accounting policies for significant balance sheet and income statement accounts are disclosed in Note 1 to the consolidated financial statements beginning on page 82. Management believes that a number of these are critical to the understanding of the Company’s financial condition and results of operation because they involve estimates, judgment, or are otherwise less subject to precise measurement and because the quality of the estimates materially impact those results. This section is intended (1) to identify those critical accounting policies used in the preparation of the Consolidated Financial Statements; (2) to help the reader understand the methodology used in determining these estimates; (3) to identify assumptions used in determining these estimates; and (4) to give readers an understanding of the impact those estimates have on the presentation of a company’s financial condition, changes in financial condition or results of operations.

The preparation of Consolidated Financial Statements in accordance with GAAP requires Management to make certain estimates and assumptions that affect the amounts of reported assets and liabilities as well as contingent assets and liabilities as of the date of these financial statements. Some of these critical estimates concern past events that are uncertain or otherwise not subject to direct measurement. Others involve predictions regarding future events. As events occur and these estimates and assumptions are confirmed or are shown to require adjustment, they affect the reported amounts of revenues and expenses during the reporting period(s). Although Management believes these estimates and assumptions to be reasonably accurate, actual results may differ.

The principal areas in which significant estimates and management judgment are used are as follows:

Collectibility of Loans and the Allowance for Credit Losses:  With respect to delinquent loans, we are required to estimate whether the principal and interest due on the loans will be collected. If a loan is deemed uncollectible, it must be charged-off. If we estimate that a loan will be collected but it is later determined that it will not be collected, then the Company’s loan assets will have been overstated because only collectible amounts are to be reported. If we estimate that a loan is not collectible and therefore charge it off, but subsequently payments are received, then the loan balances were understated and provision expense was overstated.

With respect to loans that are not deemed to be wholly uncollectible, an estimate of the amount of the probable losses incurred in the Company’s loan portfolio must still be made. This estimate is used to determine the amount of the allowance for credit losses and therefore the periodic charge to income for the provision for credit losses expense. A description of the method of developing the estimate is described in the section below titled “Allowance for Credit Losses” on page 40 and in Note 1 on page 85. If the actual losses incurred in future periods materially exceed the estimate of probable losses developed by Management, then the Allowance for Credit Losses will have been understated and the Company will have to record additional provision expense as the actual amount of losses are recognized. If the losses currently in the portfolio are materially less than the estimate, then the Company will reverse the excess allowance through provision expense in future periods.

Events or circumstances that can cause losses that eventually occur to be substantially different than the current estimate are primarily a lack of sufficient information about borrowers’ financial condition or changes in their financial condition over time. A lack of sufficient information occurs because the borrower does not provide the information on a timely basis or because it is incomplete or inaccurate.

As discussed in the section below titled “Credit Losses” beginning on page 43, it is normal for there to be differences, sometimes significant, between the estimate of credit losses and the eventual actual losses. The Company experienced such differences in 2005 and 2004 for loans other than RALs. In earlier years, we had estimated that certain loans were uncollectible and that we would be

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paid less than the outstanding amount for certain other loans. Consequently we had charged-off the first group of loans and allocated allowance for credit loss to the second group equal to our estimate of what we would not be paid. In 2004, a significant amount of payments were received on some of these loans. These collections or recoveries were added back to the allowance for credit loss. This resulted in a lower provision expense than would have otherwise been the case because this added allowance was then available to cover estimated losses on other loans in 2005 a lesser, but still significant, amount was collected. In essence, a portion of the allowance was provided by the recoveries rather than by provision expense.

Realizing the benefit of Deferred Tax Assets:  The Company’s deferred tax assets are explained in the section below titled “Income Tax Expense” on page 58 and in Note 16 on page 111. The Company uses an estimate of future earnings to support its position that the benefit of its deferred tax assets will be realized. If future income should prove non-existent or not sufficient to recover the amount of the deferred tax assets within the tax years to which they may be applied, the assets will not be realized and the Company’s net income will be reduced.

The Company’s pretax income for 2005 was $158 million, more than eight times the net deferred tax asset of $18 million. Consequently, the Company considers that realization of the deferred tax asset involves very little risk.

Actuarial estimates used in Retiree Health Plan:  The Company uses certain estimates to determine its liability for Post Retirement Health Benefits. These estimates include the life expectancy and, length of time before retirement for employees, the long-term rate of return on assets, and future rates of growth of medical costs. Should these estimates prove materially wrong such that the liability is understated, the Company will either incur more expense to provide the benefits or it will need to amend the plan to limit benefits. The primary estimate involved in the determination of this liability is the rate of future increases in health costs. The sensitivity of the liability to a 1% change in the assumed rates of growth is disclosed in Note 15.

Prepayment assumptions used in determining the amortization of premium and discount for securities:  Mortgage-backed or asset-backed securities make up 58% of the Company’s investment securities. These securities are subject to the prepayment of principal of the underlying loans. The rate at which prepayments are expected to occur in future periods impacts the amount of premium to be amortized in the current period. This is because holders of securities are required to recognize an amortization amount each period that would result in the same effective interest rate for the security if prepayments in fact occur as estimated. If prepayments in a future period are higher than estimated, then the Company must amortize a larger amount of premium in that future period. In that way, the total premium amortized to date as of the end of that future period will equal the amount that would have been amortized had the higher prepayment rate been experienced during all past periods over which the security was held. If future prepayments are less than estimated, then less premium will be amortized in the future period to similarly result in an amount of premium amortization life-to-date as if the lower rate of prepayments had been experienced from the purchase of the security. The Company estimates prepayment rates based on the current interest rate environment because interest rates change from period to period, prepayment rates will change and there will be over and under estimates. The result then of an over or under estimate is to introduce volatility to interest income.

During the last three years, amortization of premium on these securities has varied from $0.5 million to $2.0 million per quarter depending on the prepayment assumptions used. The Company is able to compare its prepayment assumptions with published market estimates to avoid using unrealistic assumptions. With the declining balance in the portfolio and the available market confirmation, the Company expects that the result of using an overestimate or underestimate would not be material to any quarter’s results.

Estimates of the fair value of assets:  Certain assets of the Company are recorded at fair value, or the lower of cost or fair value. In some cases, the fair value used is an estimate. Included among these assets are securities that are classified as available-for-sale, goodwill and other intangible assets, and other real estate owned and impaired loans. These estimates may change from period to period as they are impacted by changes in interest rates and other market conditions. Losses not anticipated

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or greater than anticipated could result if the Company were forced to sell one of these assets and discovered that its estimate of fair value had been too high. Gains not anticipated or greater than anticipated could result if the Company were to sell one of these assets and discovered that its estimate of fair value had been too low. Estimates of fair value are arrived at as follows:

Available-for-sale securities:  The fair values of most securities classified as available-for-sale are based on quoted market prices. These quoted market prices are derived from two independent sources and compared for consistency. If the two sources differ significantly, or if quoted market prices are not available, alternative methods are used including seeking bids from brokers on a representative security or extrapolating the value from the quoted prices of similar instruments. The Company also uses estimates of the future rate of prepayments on the loans underlying the various mortgage-backed securities to determine the expected life of that security. That estimated life then determines the rate of amortization or accretion to recognize against the premium or discount of those instruments.

Business Combinations:  Assets and liabilities acquired in business combinations are recorded at fair value. The Company uses a variety of methodologies to estimate these fair values. In general the methodologies are the same as those used in determining the fair value of assets and liabilities as described in Note 24 beginning on page 121. The fair value of most financial assets and liabilities are determined by discounting the anticipated cash flows from or for the instrument using current market rates applicable to each category of instrument. Where market quotes may be available as in the case of securities, these are used in preference to estimates determined by discounting cash flows. Because the excess of consideration paid in the business combination over the fair value of the net assets is recorded as goodwill, errors in the estimation process of the fair value of acquired assets and liabilities will result in an overstatement or understatement of goodwill. This in turn will result in overstatements or understatement of income and expenses and, in the case of an overstatement of goodwill, could make the Company more subject to an impairment charge when the overstatement is discovered in its annual assessment for impairment.

Goodwill and other intangible assets:  The Company has recorded $150 million in goodwill and other intangible assets arising from business combinations. As discussed in Note 9 on page 103, the Company must assess goodwill and other intangible assets each year for impairment. This assessment involves estimating cash flows for future periods, preparing analyses of market multiples for similar operations, and estimating the fair value of the reporting unit to which the goodwill is allocated. If the future cash flows were materially less than the estimates, the Company would be required to take a charge against earnings to write down the asset to the lower fair value.

Other real estate owned and impaired loans:  The fair value of other real estate owned or collateral supporting impaired loans is generally determined from appraisals obtained from independent appraisers. The Company also must estimate the costs to dispose of the property. This is generally done based on experience with similar properties. When determining the valuation allowance for impaired loans, the Company may use the discounted cash flow method which may include estimates of borrower revenue, expenses, capital expenditures and disposals of capital assets, along with estimates of future economic conditions including forecasts of interest rates and other economic factors that management believes would impact estimated future customer cash flows.

EXTERNAL FACTORS IMPACTING THE COMPANY

The major external factors impacting the Company include economic conditions, regulatory considerations, and trends in the banking and financial services industries.

Economic Conditions

From a national perspective, the most significant economic factors impacting the Company in the last three years have been a slow growth in the economy during 2003 and the actions of the FOMC to increase the pace of that growth followed by faster growth in 2004 and 2005 accompanied by FOMC increases in short-term interest rates to limit potential inflationary impacts from that growth. The FOMC had lowered its target short-term rate once in 2003 by 0.25% to its lowest rate in 45 years. This series of changes especially the extreme rate of decline in 2001 when the Fed lowered

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rates by 4.25%, impacted the Company as market rates for loans, investments and deposits responded to the Fed’s actions. These impacts are discussed in detail in the sections below titled “The Impact of Changes in Asset and Liability Balances to Net Interest Income and Net Interest Margin” and “Interest Rate Risk.” In 2004, the FOMC raised short-term interest rates by 1.25%. These increases did not have a significant impact on the Company in 2004. Continued increases totaling 2.00% in 2005 had a more substantial impact as discussed in those same sections.

Selected customers in the hospitality and tourist industries continued to be impacted in 2002 and 2003 by the consequences of the events of September 11, 2001. Agriculture faced price pressures during 2002, but there was price firming in the row crops segment during 2003 and 2004. The wine industry remained unsettled during 2003 and 2004 with inventory high and new vines coming into production but stabilized in 2005, with excess inventory mostly absorbed. The high tech segment continued to show uncertain and varying results. Housing markets showed some slowdown in sales and refinancings in 2004, but generally prices continued to increase with the high-end residential properties showing some volatility. Sales and price increases slowed in 2005. During 2003, loan demand for commercial real estate markets slowed compared to 2002, but picked up again in 2004 and was strong in 2005. Loan demand from small businesses continued to grow at a moderate rate, except for leasing, for which outstanding balances grew 55% in 2004 and 23% in 2005. Consumer loan demand aside from residential real estate also picked up in 2004.

Regulatory Considerations

Bank Regulation:  Changes in regulations and/or the regulatory environment impact the Company. The OCC is the primary regulator for PCBNA because it is a nationally chartered bank. The Federal Reserve Bank (“FRB”) of San Francisco is the regulator for the Bancorp because it is a bank holding company.

Regulation impacts the Company in several ways:

· the Federal Reserve Board may change the amount of cash that banks must hold with the reserve bank in their district to manage the money supply;

· the OCC may impose restrictions on the type and features of products or services offered to customers;

· it is necessary to obtain approval for business combinations from regulatory agencies;

· the regulatory agencies conduct periodic examinations;

· there are legal and regulatory restrictions on the amount of dividends that a subsidiary bank can pay to its parent;

· the Company must ensure it is in compliance with fair lending, anti-money laundering, bank secrecy, and community reinvestment legislation; and

· regulation sets minimum capital requirements.

The actions which the various banking agencies can take with respect to financial institutions which fail to maintain adequate capital and comply with the other requirements are discussed below in the section titled “Legislation and Regulation” on page 55.

Non-banking regulation:  As a public company, the Company is also subject to many laws and regulations related to securities issuance. Especially important in 2003, 2004, and 2005, is the Sarbanes-Oxley Act of 2002. Passed in response to corporate accounting and reporting failures, the act requires all large public companies as of December 31, 2004 to document their internal controls over financial reporting, evaluate the design and effectiveness of those controls, periodically test all significant controls to ensure they are functioning, and provide a certification by the Chief Executive Officer and Chief Financial Officer of the documentation, evaluation, and testing. The act further requires companies’ independent registered public accounting firm to evaluate this assertion.

The required certification is included in this Annual Report on Form 10-K on page 140 and the conclusion of the Company’s independent registered public accounting firm regarding this assertion is included in its opinion on page 74.

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Competition

The Company faces competition from other financial institutions and from businesses in other industries that have developed financial products. Banks once had an almost exclusive franchise for deposit products and provided the majority of business financing. With deregulation in the 1980’s, other kinds of financial institutions began to offer competing products. Also, increased competition in consumer financial products has come from companies not typically associated with the banking and financial services industry. Similar competition is faced for commercial financial products from insurance companies and investment bankers. Competition from companies that are not banks is also developing for payments processing. Often this activity is associated with Internet auction sites and other e-commerce. Community banks, including the Company, attempt to offset these trends by developing new products that capitalize on the service quality that a local institution can offer. Among these are new loan, deposit, and investment products. The Company’s primary competitors are different for each specific product and market area. While this offers special challenges for the Company in marketing of products, it offers protection from one competitor dominating the Company in its market areas.

For deposit products, the primary competition is from other local independent banks and the local branches of larger national and regional banks. The primary competition for consumer loans is from larger banks that can offer very fast decisions and low prices because of their investments in automation. For commercial loans, the primary competition is again from both local banks and regional/national banks based on local contacts for the former and price for the latter. Competition for residential real estate comes from both larger banks with their automation and from independent loan brokers that capitalize on relationships with realtors and title insurance firms. For fiduciary services, competition comes from local offices of larger financial institutions that capitalize on brand familiarity and from small independent money managers that suggest banks are too conservative in their money management style.

RISK MANAGEMENT

We see the process of addressing the potential impacts of the external factors listed above as part of our management of risk. In addition to common business risks such as disasters, theft, and loss of market share, the Company is subject to special types of risk due to the nature of its business. New and sophisticated financial products are continually appearing with different types of risk which need to be defined and managed if we choose to offer them to our customers. Also, the risks associated with existing products must be reassessed periodically. The Company cannot operate risk-free and make a profit. Instead, the process of risk definition and assessment allows the Company to select the appropriate level of risk for the anticipated level of reward and then decide on the steps necessary to manage this risk. The Company’s Chief Risk Officer and the other members of its Senior Leadership Council under the direction and oversight of the Board of Directors lead the risk management process.

Some of the risks faced by the Company are those faced by most enterprises—reputational risk, operational risk, and legal risk. The special risks related to the financial products offered by the Company are credit risk and interest rate risk. Credit risk relates to the possibility that a debtor will not repay according to the terms of the debt contract. Credit risk is discussed in the sections related to loans and the allowance for credit loss. Interest rate risk relates to the adverse impacts of changes in interest rates on financial instruments. The types of interest rate risk will be explained in the next two sections. The effective management of these and the other risks mentioned above is the backbone of the Company’s business strategy.

THE IMPACT OF CHANGES IN ASSETS AND LIABILITIES TO NET INTEREST INCOME AND NET INTEREST MARGIN

The Company earns its income primarily from two sources. The first of these sources is from the management of its financial assets and liabilities and the second is from charging fees for services provided. The first source involves functioning as a financial intermediary; that is, the Company accepts funds from depositors or obtains funds from other creditors and then either lends the funds

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to borrowers or invests those funds in securities or other financial instruments. Income is earned as a spread between the interest earned from the loans or investments and the interest paid on the deposits and other borrowings. The second source, fee income, is discussed in other sections of this analysis, specifically in “Noninterest Revenue” on page 49 and “Tax Refund Anticipation Loan and Refund Transfer Programs” on page 59.

We monitor asset and deposit levels, developments and trends in interest rates, liquidity, capital adequacy and marketplace opportunities. We respond to all of these to protect and increase income while managing risks within acceptable levels as set by the Company’s policies. In addition, alternative business plans and contemplated transactions are analyzed for their impact on the level of risk assumed by the Company. This process, known as asset/liability management, is carried out by changing the maturities and relative proportions of the various types of loans, investments, deposits and other borrowings in ways described below. The management staff responsible for asset/liability management operates under the oversight of the Asset/Liability Committee and provides regular reports to the Board of Directors. Board approval is obtained for major actions or the occasional exception to policy.

Changes in Net Interest Income and Net Interest Margin

Net interest income is the difference or spread between the interest and fees earned on loans and investments (the Company’s earning assets) and the interest expense paid on deposits and other liabilities. Net interest income or the amount by which interest income exceeds interest expense depends on two factors: (1) the volume or balance of earning assets compared to the volume or balance of interest-bearing deposits and liabilities, and (2) the interest rate earned on those interest earning assets compared with the interest rate paid on those interest-bearing deposits and liabilities.

The Company’s earning assets generally exceed its interest-bearing liabilities by 25%—33%. This occurs as the Company is able to fund a significant proportion of its earning assets with noninterest demand accounts.

The comparison of rates earned and rates paid is usually done with an analysis of the Company’s net interest margin. Net interest margin is net interest income expressed as a percentage of average earning assets. It is used to measure the difference between the average rate of interest earned on assets and the average rate of interest that must be paid on liabilities used to fund those assets. Net interest income is expressed using a tax equivalent adjustment (Note A) to reflect the fact that the interest income on some municipal securities and loans is exempt from Federal income tax.

Table 1 compares the changes in tax equivalent net interest income and tax-equivalent net interest margin from 2003 to 2004 and from 2004 to 2005.

TABLE 1—Changes in Tax Equivalent Net Interest Income and Net Interest Margin

(dollars in thousands)	Tax-equivalent net interest income			Average earning assets			Average interest- bearing liabilities			Tax-equivalent net interest margin
2003	$	224,835		$	4,326,896		$	3,267,652		5.20	%
Amount of change	$	38,482		$	973,018		$	921,116		-0.23	%
% change		17.1	%		22.5	%		28.2	%	-4.42	%
2004	$	263,317		$	5,299,914		$	4,188,768		4.97	%
Amount of change	$	57,337		$	586,287		$	555,362		0.48	%
% change		21.8	%		11.1	%		13.3	%	9.66	%
2005	$	320,654		$	5,886,201		$	4,744,130		5.45	%

Tax equivalent net interest income increased each year, 17.1% from 2003 to 2004 and 21.8% from 2004 to 2005 as would be expected given the growth in earning assets—22.5% from 2003 to 2004 and 11.1% from 2004 to 2005. The Company’s net interest margin decreased from 5.20% in 2003 to 4.97% in 2004, and increased to 5.45% for 2005. Management uses the information in Tables 2 and 3 to analyze these changes in net interest income and net interest margin.

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Table 2, “Distribution of Average Assets, Liabilities, and Shareholders’ Equity and Related Interest Income, Expense and Rates,” sets forth the average daily balances (Note B) for the major asset and liability categories, the related income or expense where applicable, and the resultant yield or cost attributable to the average earning assets and interest-bearing liabilities. Changes in the average balances and the rates received or paid depend on market opportunities, how well the Company has managed interest rate risks, product pricing policy, product mix, and external trends and developments.

Table 3, “Volume and Rate Variance Analysis of Net Interest Income,” analyzes the changes in net interest income from 2003 to 2004 and from 2004 to 2005 that are reported in Table 2. The analysis shows the impact of volume and rate changes on the major categories of assets and liabilities from one year to the next. The table explains what portion of the difference or variance in interest income or expense from one year to the next for each major category of assets or liabilities is due to changes in the balances (volume) or to changes in rates.

For example, Table 2 shows that interest income from nontaxable securities increased by $188,000 from $16.2 million for 2004 to $16.4 million for 2005. The average balance increased from $184 million to $198 million and the average tax equivalent rate earned decreased from 8.80% to 8.28%. Table 3 shows that the $188,000 increase in interest income was actually the sum of a $1.182 million increase in interest income from the larger balance of securities held in 2005 compared to 2004 and a decrease of $994,000 due to a decrease in the average rate received.

A shift in the relative size of the major balance sheet categories has an impact on net interest income and net interest margin. For example, to the extent that funds received from maturing or sold securities can be repositioned into loans instead of re-invested securities, earnings increase because of the higher rates paid on loans. However, changing the asset mix in this way comes at the price of additional risks that must be successfully managed. Additional credit risk is incurred with loans compared to the very low risk of default loss on securities, and the Company must carefully monitor the underwriting process to ensure that the benefit of the additional interest earned is not offset by additional credit losses. Also, because loans cannot be sold as easily as securities, the Company incurs more liquidity risk. Another example relates to the liability side of the balance sheet. In general, depositors are willing to accept a lower rate on their funds than are other providers of funds because of the Federal Deposit Insurance Corporation (“FDIC”) insurance coverage. To the extent that the Company can fund asset growth by deposits, especially the lower cost transaction accounts, rather than borrowing funds from other financial institutions, the average rates paid on funds will be less, and net interest income more. The lower cost transaction accounts, however, are demand accounts. While they generally are the result of stable relationships, these funds may be withdrawn by depositors at any time, whereas higher costs forms of borrowing generally have set maturities around which the Company can plan.

The Impact of Overall Trends in the Balances and Rates of Assets and Liabilities—2003 to 2004

As noted above, the Company’s tax equivalent net interest income increased from 2003 to 2004, but the net interest margin declined. The net interest margin also decreased from 5.20% in 2003 to 4.97% in 2004 while net interest income increased. The FOMC raised short-term interest rates by 1.25% during 2004. However, this all occurred in the second half of the year, meaning that the factors that contributed to a lower net interest margin in 2003 than in 2002 continued during the first half of 2004.

Of these factors, two were primary. The first was inability to decrease the average rate paid on interest-bearing liabilities proportionately to the decreases in the average rate on earning assets because deposit rates had already been decreased as low as possible in 2003. This caused a reduction of net interest income without a reduction of earning assets. In other words, a decrease in the numerator of the net interest margin computation with no corresponding decrease in the denominator.

The second factor brought forward from 2003 was the leveraging strategy already mentioned. In essence this involves adding earning assets at a relatively low yield or spread to generate net interest income. However, because of the low yield, it increases net interest income less than it increases earning assets, thus lowering the net interest margin. The strategy, initiated in 2003, had a full year’s impact on 2004.

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In addition to these two factors, a third factor in 2004 causing the decrease in net interest margin was the acquisition of PCCI. The business model chosen by PCCI was very profitable, but had a lower net interest margin than the Company’s. PCCI elected to take less credit risk than the Company and therefore had less provision for loan loss at the cost of lower loan yields. On the liability side, it funded its activities not through retail deposit products, but through a mixture of certificates of deposit and borrowings that paid a higher average rate than the Company paid on its funding. These two choices—accepting lower interest income for lower provision expense and trading higher cost funding for lower operational costs of nonretail deposits—simply moved its profitability out of net interest income. Consequently, the addition to the Company’s balance sheet of these lower yielding assets and higher cost liabilities resulted in an increase to net interest income, but a lowering of the net interest margin in 2004 compared to 2003.

The Impact of Overall Trends in the Balances and Rates of Assets and Liabilities—2004 to 2005

As noted above, the Company’s tax equivalent net interest income increased from 2004 to 2005, and the net interest margin also increased. The net interest margin increased from 4.97% in 2004 to 5.45% in 2005. The FOMC raised short-term interest rates by 2.0% throughout 2005.

In contrast to 2004, the increase in the net interest income was more the result of better rates earned on assets than on the increase in the volume of assets. In 2004, as shown in Table 3, 88% of the increase in interest income was due to more assets on which the Company earned interest. In 2004, 97% of the increase in interest expense was due to more liabilities on which the Company paid interest. In 2005, 48% of the increase in interest income came from increasing rates, while 75% of the increase in interest expense came from higher rates. This shift in the relative importance of rate changes compared to volume changes would be expected given the impact in 2004 of the leveraging strategy and the eight FOMC rate increases in 2005 compared to five in 2004.

INTEREST RATE RISK

As shown in Table 3, changes in interest rates impact the Company’s results of operations. With such a large proportion of the Company’s income derived from net interest income, it is important to understand how the Company addresses risks that are related to changes in interest rates by changing balances and the relative proportion of assets and liabilities.

Market Risk Relating to Fixed-Rate Instruments

Market risk results from the fact that the market values of assets or liabilities on which the interest rate is fixed will increase or decrease with changes in market interest rates. If the Company invests funds in a fixed-rate long-term security and then interest rates rise, the security is worth less than a comparable security just issued. This occurs because the older security pays less interest than the newly issued security. If the older security were then to be sold before maturity, the Company would have to recognize a loss. Conversely, if interest rates decline after a fixed-rate security is purchased, its value increases, because it is paying a higher coupon rate than newly issued securities.

The fixed-rate liabilities of the Company, like certificates of deposit and borrowings from the Federal Home Loan Bank (“FHLB”), also change in value with changes in interest rates. As rates drop, they become more valuable to the depositor or creditor because they continue to pay interest at a rate now higher than is current in financial markets. Conversely, they become more costly to the Company. If rates rise, these liabilities become more valuable to the Company, because the Company is then paying less than the current market rate. Therefore, while the value changes regardless of which direction interest rates move, the adverse impacts of market risk to the Company’s fixed-rate assets are due to rising interest rates and for the Company’s fixed-rate liabilities they are due to falling rates.

In general, for a given change in interest rates, the amount of the change in value up or down is larger for instruments with longer remaining maturities (Note E). Therefore, the exposure to market risk from assets is lessened by managing the amount of fixed-rate assets and by keeping maturities relatively short. However, these steps must be balanced against the need for adequate interest income because variable rate and shorter term fixed-rate securities generally earn less interest than fixed-rate and longer term securities.

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TABLE 2—Distribution of Average Assets, Liabilities, and Shareholders’ Equity and Related Interest Income, Expense, and Rates (Notes A and C)

	Twelve months ended December 31, 2005
(dollars in thousands)	Balance		Income		Rate
Assets:
Money market instruments:
Commercial paper	$	—	$	—	0.00	%
Federal funds sold		25,765		792	3.07	%
Total money market instruments		25,765		792	3.07	%
Securities: (2)
Taxable		1,224,425		48,565	3.97	%
Non-taxable		198,166		16,402	8.28	%
Total securities		1,422,591		64,967	4.57	%
Loans: (3)
Commercial (including leasing)		1,271,327		100,059	7.87	%
Real estate-multi family & nonresidential		1,461,259		101,352	6.94	%
Real estate-residential 1-4 family		1,004,738		56,754	5.65	%
Consumer		697,673		108,167	15.50	%
Other		2,848		68	2.39	%
Total loans		4,437,845		366,400	8.26	%
Total earning assets		5,886,201		432,159	7.34	%
FAS 115 Market Value Adjustment		10,138
Non-earning assets		509,208
Total assets	$	6,405,547
Liabilities and shareholders’ equity:
Interest-bearing deposits:
Savings and interest-bearing transaction accounts	$	2,107,079		25,206	1.20	%
Time certificates of deposit		1,615,945		47,749	2.95	%
Total interest-bearing deposits		3,723,024		72,955	1.96	%
Borrowed funds:
Repos and Federal funds purchased		186,707		5,781	3.10	%
Other borrowings		834,399		32,769	3.93	%
Total borrowed funds		1,021,106		38,550	3.78	%
Total interest-bearing liabilities		4,744,130		111,505	2.35	%
Noninterest-bearing demand deposits		1,134,952
Other liabilities		8,882
Shareholders’ equity		517,583
Total liabilities and shareholders’ equity	$	6,405,547
Interest income/earning assets					7.34	%
Interest expense/earning assets					1.89	%
Tax equivalent net interest income/margin				320,654	5.45	%
Provision for credit losses charged to operations/earning assets				53,873	0.92	%
Net interest margin after provision for credit losses on tax equivalent basis				266,781	4.53	%
Less: tax equivalent income included in interest income from non-taxable securities and loans				6,002	0.10	%
Net interest income after provision for credit loss			$	260,779	4.43	%
Loans other than RALs	$	4,363,905	$	301,628	6.91	%
Consumer loans other than RALs	$	623,733	$	43,395	6.96	%

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Twelve months ended December 31, 2004						Twelve months ended December 31, 2003
	Balance		Income	Rate			Balance		Income	Rate
$	—	$	—	0.00	%	$	1,109	$	13	1.17	%
	63,802		748	1.17	%		86,365		1,050	1.22	%
	63,802		748	1.17	%		87,474		1,063	1.22	%
	1,247,026		50,191	4.02	%		912,624		34,476	3.78	%
	184,217		16,214	8.80	%		175,470		16,152	9.20	%
	1,431,243		66,405	4.64	%		1,088,094		50,628	4.65	%
	930,554		59,950	6.44	%		796,044		48,779	6.13	%
	1,454,539		90,170	6.20	%		1,094,569		71,819	6.56	%
	847,954		47,009	5.54	%		735,055		44,643	6.07	%
	565,142		68,165	12.06	%		523,033		61,749	11.81	%
	6,680		81	1.21	%		2,627		87	3.31	%
	3,804,869		265,375	6.97	%		3,151,328		227,077	7.21	%
	5,299,914		332,528	6.27	%		4,326,896		278,768	6.44	%
	18,049						23,175
	390,008						295,583
$	5,707,971					$	4,645,654
$	1,900,627		12,429	0.65	%	$	1,591,043		10,299	0.65	%
	1,447,208		29,713	2.05	%		1,240,315		25,862	2.09	%
	3,347,835		42,142	1.26	%		2,831,358		36,161	1.28	%
	120,417		1,589	1.32	%		66,999		743	1.11	%
	720,516		25,480	3.54	%		369,295		17,029	4.61	%
	840,933		27,069	3.22	%		436,294		17,772	4.07	%
	4,188,768		69,211	1.65	%		3,267,652		53,933	1.65	%
	1,046,870						909,915
	39,065						78,818
	433,268						389,269
$	5,707,971					$	4,645,654
				6.27	%					6.44	%
				1.30	%					1.24	%
			263,317	4.97	%				224,835	5.20	%
			12,809	0.24	%				18,286	0.43	%
			250,508	4.73	%				206,549	4.77	%
			6,347	0.12	%				6,579	0.15	%
		$	244,161	4.61	%			$	199,970	4.62	%
$	3,702,100	$	228,702	6.18	%	$	3,029,669	$	195,093	6.44	%
$	462,373	$	31,492	6.81	%	$	401,374	$	29,765	7.42	%

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TABLE 3—Volume and Rate Variance Analysis of Net Interest Income

(Taxable equivalent basis—Notes A and D)

(in thousands)	2005 over 2004									2004 over 2003
	Rate			Volume			Total			Rate			Volume			Total
Increase (decrease) in:
Assets:
Money market instruments:
Commercial paper	$	—		$	—		$	—		$	(7	)	$	(6	)	$	(13	)
Federal funds sold		683			(639	)		44			(42	)		(260	)		(302	)
Total money market investment		683			(639	)		44			(49	)		(266	)		(315	)
Securities:
Taxable		(662	)		(964	)		(1,626	)		2,323			13,392			15,715
Non-taxable		(994	)		1,182			188			(159	)		221			62
Total securities		(1,656	)		218			(1,438	)		2,164			13,613			15,777
Loans:
Commercial (including leasing)		15,140			24,969			40,109			2,572			8,599			11,171
Real estate—multi family & nonresidential		10,765			417			11,182			926			17,425			18,351
Real estate—residential 1-4 family		945			8,800			9,745			(391	)		2,757			2,366
Consumer loans		21,953			18,049			40,002			1,337			5,079			6,416
Other loans		50			(63	)		(13	)		(22	)		16			(6	)
Total loans		48,853			52,172			101,025			4,422			33,876			38,298
Total earning assets		47,880			51,751			99,631			6,537			47,223			53,760
Liabilities:
Interest-bearing deposits:
Savings and interest-bearing transaction accounts		11,323			1,454			12,777			—			2,130			2,130
Time certificates of deposit		14,251			3,785			18,036			173			3,678			3,851
Total interest-bearing deposits		25,574			5,239			30,813			173			5,808			5,981
Borrowed funds:
Repos and Federal funds purchased		2,977			1,215			4,192			161			685			846
Other borrowings		2,994			4,295			7,289			61			8,390			8,451
Total borrowed funds		5,971			5,510			11,481			222			9,075			9,297
Total interest-bearing liabilities		31,545			10,749			42,294			395			14,883			15,278
Tax equivalent net interest income	$	16,335		$	41,002		$	57,337		$	6,142		$	32,340		$	38,482

The table in Note 24 on page 121 discloses the carrying amounts and fair values of the Company’s financial assets and liabilities as of the end of 2005 and 2004. Concerns about credit quality can cause the fair value of an asset to be less than the amount at which the asset is recorded or carried. However, this difference is relatively small. The primary difference between the carrying amount and the fair value of the Company’s financial assets is essentially a measure of the impact on the value of the financial assets and liabilities from changes in interest rates that have occurred since the assets were acquired or the liabilities incurred. The excess of the carrying amounts of the net financial assets over their fair values at the end of 2005 was $49.1 million compared with an excess of fair value over carrying amount $24.6 million at the end of 2004.

Loans are the only category of assets disclosed in the table that have carrying amounts different than their fair value. The change in the relationship between the carrying amount and the fair value for loans from December 31, 2004 to December 31, 2005 was due to increases in interest rates. As

24

interest rates rise fixed-rate loans decline in value just as do securities because they are no longer earning the market rate of interest.

Theoretically, variable-rate assets do not have this market risk associated with them because their coupon rate—the stated rate of the loan or security—varies or reprices with changes in market rates. However, few loans or securities are completely variable. That is, almost all have some kind of a delay before they reprice or a limitation on the extent or frequency with which they reprice. For example, a number of the Company’s loans are originated at one rate which is fixed for a specified period of time, and then they convert to variable instruments. However, even after their conversion date, they will usually reprice to the then current market rate only monthly, quarterly, annually, or less frequently.

Because the amount of the Company’s fixed-rate liabilities is significantly less than its fixed-rate assets, and because the average maturity of the fixed-rate liabilities is substantially less than for the fixed-rate assets, the market risk relating to liabilities is not as great as for assets. That is, the fair value of the Company’s fixed-rate liabilities are generally not as sensitive to changes in interest rates as are the assets. The difference between the carrying amount and the fair value in the table in Note 24 shows the impact of changing rates on the Company’s liabilities that have fixed-rates. They are worth $29.2 million less to customers or lenders to the Company at December 31, 2005, than they were when issued, because on a weighted average basis, they are paying rates that are lower than current market rates. At December 31, 2004, the fair value was less than the carrying amount by $14.4 million. With interest rates rising, it would be expected that any term deposits are now paying less interest than the current market rates and are therefore worth less to the depositor or lender.

While many of the deposits may be repriced at any time at the Company’s option, it does not typically hold term liabilities that may reprice prior to maturity. Two of the issues of subordinated debt and the structured repurchase agreements described in Note 13 on page 105 are exceptions to this general rule.

Mismatch Risk

The second interest-related risk, mismatch risk, arises from the fact that when interest rates change, the changes do not occur equally in the rates of interest earned on assets and paid on liabilities. This occurs because of differences in the contractual maturity terms of the assets and liabilities held. A difference in the maturities, a mismatch, can cause adverse impacts on net interest income.

An example of such an adverse impact could arise because the Company has a portion of its commercial loan portfolio tied to the national prime rate. If these rates are lowered because of general market conditions, e.g., the prime rate decreases in response to a rate decrease by the FOMC as happened in 2002 and 2003, these loans will be re-priced. If the Company were at the same time to have a large proportion of its deposits in longer-term fixed-rate certificates, interest earned on loans would decline while interest expense would remain at higher levels for a period of time until the certificates matured. Therefore, net interest income would decrease immediately. A decrease in net interest income could also occur with rising interest rates if the Company had a large portfolio of fixed-rate loans and securities that was funded by deposit accounts on which the rate is steadily rising.

If the assets of a holder of financial instruments mature or reprice sooner than its liabilities, then the assets will respond more quickly than liabilities to changes in interest rates. In this case, the holder is said to be asset sensitive. If liabilities respond sooner to changes in rates than assets, it is said to be liability sensitive. If the amounts of assets and liabilities maturing or repricing in the short-term are approximately the same, it is said to be neutral.

In general, community banks or regional banks tend to be asset sensitive because they primarily depend on retail or commercial deposits for their funding. These deposits are generally administered rate deposits, i.e. they may be changed at the Company’s option in response to changes in market rates, competitive pressures, and need for funding. Administered rate deposit accounts like negotiable order of withdrawal (“NOW”) accounts, money market deposit accounts (“MMDA”), and savings, are the accounts that do not have a contractually set rate for their term as

25

do certificates of deposit. Money center banks tend to have a higher proportion of other borrowings—wholesale funding—in their funding mix. Wholesale funding is comprised of borrowings from other financial institutions and deposits received from sources other than through customer relationships. These sources of funding tend to be short-term and priced by reference to indices outside of the control of the Company. Deposits provide the advantage of a lower cost of funding compared to using wholesale funding, and their interest rates are less sensitive to changes in market rates. This second characteristic is an advantage when rates are rising, but a disadvantage when rates are falling. Customer expectations do not permit banks to decrease their deposit rates as frequently as market rates may decline and, because they bear generally lower rates than other borrowings, when the interest rate environment is already low, they can’t be reduced as much as wholesale rates will move. However, when interest rates are rising, they generally do not rise as quickly as the indices to which borrowing prices are referenced.

This exposure to mismatch risk is managed by attempting to match the maturities and repricing opportunities of assets and liabilities. This may be done by varying the terms and conditions of the products that are offered to depositors and borrowers. For example, if many depositors want shorter-term certificates while most borrowers are requesting longer-term fixed rate loans, the Company may try to adjust the interest rates on the certificates and loans to try to match up demand for similar maturities. However, there are practical limitations on the extent to which the Company can encourage customers to select terms desired by the Company to attain a better matching. Generally, the Company purchases securities or incurs other borrowings with the appropriate maturity to manage a mismatch rather than trying to force customers into selecting different maturities by pricing. This is because such special pricing may raise customers’ expectations causing them disappointment when the mismatch is no longer present and the Company has no need to offer the special pricing.

The following table shows the Company’s assets and liabilities sorted into reprice/maturity ranges. While the Company does not manage its interest rate risk by means of this gap analysis—a table in which the difference between assets and liabilities maturing or repricing in each period is shown is referred to as a “gap” analysis—the following table is provided for the reader. It summarizes the time periods in which maturities and or repricing opportunities occur for the major categories of assets and liabilities for December 31, 2005. The cumulative gap and the cumulative gap as a percentage of total assets are also reported. A positive number indicates that assets maturing or repricing in that specific period exceed maturing or repricing liabilities. A negative number indicates the opposite. As of December 31, 2005, the Company had an excess of assets repricing or maturing overnight because of the prime rate loans. There is a large excess of liabilities over assets repricing in the next maturity period. Ordinarily, this would suggest that the Company is liability sensitive rather than asset sensitive as was stated in the preceding paragraph. However, this excess of liabilities over assets is a byproduct of the assumption that all non-term deposit accounts could be repriced at any time. In fact these deposit accounts are not immediately repriced with each change in market interest rates, nor do they change to the same degree as market rates when they are repriced.

Rather than drawing the larger conclusion of “asset sensitive” or “liability sensitive” from the table, a better use for it is to note that the Company has a wide distribution of maturities or repricing opportunities in both its assets and liabilities. The period gaps, cumulative gaps, and cumulative gaps relative to assets are also shown as of December 31, 2004. There were no appreciable changes in this condition from December 31, 2004 to December 31, 2005.

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TABLE 4—Repricing Opportunities by Major Category of Assets and Liabilities

(dollars in thousands)		Immedi- ate or one day			2 day to 6 months			6 months to 12 months			1 year to 3 years			3 years to 5 years			More than 5 years			Total rate sensitive			Total non-rate sensitive			Total
As of December 31, 2005
Assets:
Cash and due from banks	$	—		$	—		$	—		$	—		$	—		$	—		$	—		$	158,880		$	158,880
Federal funds sold		—			—			—			—			—			—			—			—			—
Securities		—			148,034			137,476			546,840			238,431			297,073			1,367,854			1,695			1,369,549
Loans		1,360,669			1,272,771			559,505			1,286,373			335,861			82,107			4,897,286			—			4,897,286
Allowance for loan and lease losses		—			—			—			—			—			—			—			(55,598	)		(55,598	)
Other assets		—			—			—			—			—			—			—			506,042			506,042
Total assets	$	1,360,669		$	1,420,805		$	696,981		$	1,833,213		$	574,292		$	379,180		$	6,265,140		$	611,019		$	6,876,159
Liabilities and Equity:
Deposits	$	—		$	3,160,736		$	452,266		$	282,331		$	81,226		$	383		$	3,976,942		$	1,040,924		$	5,017,866
Borrowings		305,456			329,461			129,425			231,000			124,491			120,159			1,239,992			9,862			1,249,854
Other liabilities		—			—			—			—			—			—			—			63,183			63,183
Shareholders’ equity		—			—			—			—			—			—			—			545,256			545,256
Total liabilities and equity	$	305,456		$	3,490,197		$	581,691		$	513,331		$	205,717		$	120,542		$	5,216,934		$	1,659,225		$	6,876,159
Gap	$	1,055,213		$	(2,069,392	)	$	115,290		$	1,319,882		$	368,575		$	258,638		$	1,048,206		$	(1,048,206	)	$	—
Cumulative gap	$	1,055,213		$	(1,014,179	)	$	(898,889	)	$	420,993		$	789,568		$	1,048,206		$	1,048,206		$	—		$	—
Cumulative gap/total assets		15.35	%		-14.75	%		-13.07	%		6.12	%		11.48	%		15.24	%		15.24	%		0.00	%		0.00	%

Amounts in the table above are placed in a time period based on estimates for prepayments and early withdrawals. Therefore, amounts in any particular time period may not agree with amounts in other tables in this discussion based on contractual maturity.

Basis Risk

The above gap table addresses mismatch risk, but does not address the fact that interest rates rarely change in a parallel or equal manner. This phenomenon is the cause of basis risk—that interest rates associated with the various assets and liabilities differ in how often they change, the extent to which they change, and whether they change sooner or later than other interest rates. For example, while the repricing of a specific asset and a specific liability may occur at roughly the same time, the interest rate on the liability may rise one percent in response to rising market rates while the asset increases only one-half percent. While the Company would appear to be evenly matched with respect to the maturities of the specific asset and liability, it would suffer a decrease in net interest income.

Nonparallel responses occur because various contractual limits and non-contractual factors come into play. An example of a contractual limit is the “interest rate cap” on some residential real estate loans. These caps may limit the amount that the rates customers pay may increase. An example of a non-contractual factor is the assumption on how low rates could be lowered on deposit accounts. While priced at the Company’s option, there are limits to how low they can be priced and yet retain the customers.

This exposure to basis risk is the type of interest risk least able to be managed, but is also the least dramatic. Avoiding concentration in only a few types of assets or liabilities is the best means of increasing the chance that the average interest received and paid will move in tandem. The wider diversification means that the movements in many different rates, each with their own volatility characteristics, will tend to offset each other.

The Impact of Interest Rate Risk on the Company

Each of these risks—market risk, mismatch risk, and basis risk—came into play in the last three years as the interest rate environment changed dramatically.

27

Market Risk:  In 2003 we saw the partial reversal of a trend that had started in 2001—the fair value of financial assets increasing relative to their carrying amount. This reversal was caused by the further decreases in market rates that occurred during 2001-2003. While the fair value had exceeded the carrying value by $145.9 million by the end of 2002, this excess had decreased to $54.5 million by the end of 2003. This change in the excess of fair value over carrying value occurred primarily for three reasons. The first is that while short-term interest rates were lower at the end of 2003 than a year earlier, as the FOMC decreased rates another 25 basis points in June 2003, mid- and longer-term rates increased especially during the second half of the year. For example, rates on 5-year Treasury securities were about 50 basis points higher than they had been at the beginning of 2003. The second is the reclassification of held-to-maturity securities to available-for-sale. At the end of 2002 they were carried at their amortized cost which was almost $9 million less than their fair value. With the reclassification in 2003, they were carried at their fair value at the end of 2003 reducing the overall excess of the fair value of financial assets over their carrying cost. The third is the large amount of loan refinancing and new origination activity in 2003 had the effect of narrowing the spread between fair value and carrying amounts by increasing the proportion of loans that are relatively new, i.e., for which there had been little time for their fair value to have been impacted by changes in interest rates since origination.

The increases in interest rates during 2004 and 2005 impacted financial assets, specifically loans, by reducing the excess of carrying amount over fair value. At the end of 2004, the excess of the carrying amount for loans over the fair value was $39.1 million. At the end of 2005, the excess of carrying amount for loans over the fair value was $12.2 million. It was primarily short term interest rates that increased during 2005 and prime-based or LIBOR-based loans repriced relatively quickly to these increases. Longer-term rates did not rise as much. Consequently, there was not as much of a difference between the current rates and the coupon rates for the loans. This smaller difference in rates meant less of a difference in carrying amount and fair value.

The difference between the fair value and carrying amount of liabilities was less impacted by these changes in interest rates, because the proportion of fixed rate liabilities is less than the proportion of fixed rate assets, and because of those that are fixed rate, the maturities are shorter than the maturities of fixed rate loans. Nonetheless, the Company benefited by paying less on the fixed rate liabilities than the current market rate as shown in the increase of the excess of carrying amount over fair value from $14.4 million at the end of 2004, to a $29.2 million at December 31, 2005.

Mismatch Risk:  Over the last several years, with respect to mismatch risk, the Company has generally been neutral or slightly asset sensitive. This was a detriment in 2001 as a large proportion of the Company’s assets kept repricing lower with each FOMC action lowering rates while a large proportion of its liabilities lagged in their repricing. During the first three quarters of 2002, both assets and liabilities repriced as they matured or as repricing dates occurred, but more liabilities than assets repriced and the Company’s net interest margin improved. However, the asset sensitivity negatively impacted net interest income in 2003 with the two FOMC decreases in interest rates in late 2002 and June 2003.

Basis Risk:  A good example of the nonparallel shifts in interest rate changes that cause basis risk occurred in the second half of 2004 and all of 2005. In 2004 the FOMC increased short-term interest rates five times by 25 basis points each, but mid-term and long-term rates were lower at the end of 2004 than they were at the end of 2003. In 2005 the FOMC continued to increase short-term rates eight times by 25 basis points while mid-term and long term rates remained relatively unchanged. This had the advantage of increasing rates earned on assets with very short maturities or repricing dates while not decreasing the value of the longer term assets, but it also meant that there were no opportunities to increase interest income by investing the proceeds from new deposits or maturing loans or securities at a longer maturity.

Net Interest Income and Net Economic Value Simulations

To quantify the extent of all of these risks both in its current position and in transactions it might do in the future, management uses computer modeling to simulate the impact of different interest rate scenarios on net interest income and on net economic value. Net economic value, or the market value of portfolio equity, is defined as the difference between the market value of financial assets

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and liabilities. These hypothetical scenarios include both sudden and gradual interest rate changes, and interest rate changes in both directions. This modeling is the primary source of information the Company uses in making interest rate risk management decisions.

Each month, the Company models how sudden, hypothetical changes in interest rate, called shocks, if applied to its asset and liability balances, would impact net interest income and net economic value. The results of this modeling indicate how much of the Company’s net interest income and net economic value are “at risk” (deviation from the base level) from various sudden rate changes (Note F). This exercise is valuable in identifying risk exposures and in comparing the Company’s interest rate risk profile with those of other financial institutions.

The results for the Company’s December 31, 2005, balances indicate that the Company’s net interest income at risk over a one-year period and net economic value at risk from 2% shocks are within normal expectations for such sudden changes.

TABLE 5A—Rate Sensitivity

	Shocked by –2%		Shocked by +2%
As of December 31, 2005
Net interest income	(4.44	%)	+1.64	%
Net economic value	(9.42	%)	(6.85	%)
As of December 31, 2004
Net interest income	(4.75	%)	+1.48	%
Net economic value	+3.15	%	(13.28	%)

As indicated above, with respect to net interest income over the next year, the Company’s interest rate sensitivity at December 31, 2005 is similar to that at December 31, 2004, being just slightly more asset sensitive. This is shown by the small increase in the percentage change in the net interest income at December 31, 2005 were there to be a sudden 2% parallel increase in interest rates compared to the projected change at the end of the prior year.

While no model is a perfect description of the complexity of a bank’s balance sheet, and actual results are certain to differ from any model’s predicted results, Management is unaware of any material limitations such that the above results would not reflect fully the net interest rate risk exposures of the Company. For example, there are no material positions, instruments or transactions that are not included in the modeling or included instruments that have special features that are not included.

Assumptions used in modeling:  Among the assumptions that must be included in the model are those that address optionality. Optionality is a characteristic of many financial instruments. Various examples include (1) the option customers have to prepay their loans or request early withdrawal of their term deposits; (2) the option issuers of some of the securities held by the Company to prepay or call their debt; and (3) the option of the Company to reprice its administered deposits. The Company addresses optionality in the model through estimates or assumptions. For example, Management estimates the rate at which customers of residential real estate loans will prepay their obligations under various interest rate scenarios, estimates the target rate at which security issuers are likely to call their debt, and estimates the frequency and extent to which the Company would reprice deposit rates under different interest rate scenarios.

As indicated in Notes 23 and 24, the Company does not have a significant amount of derivative instruments. Also as explained in Note 23, almost all of those instruments the Company does have are offsetting instruments where increases in income, expenses, or value from some of the swaps are offset by expenses, income, or loss from the rest. Consequently, these instruments do not need to be specifically addressed in the model.

Management also makes certain other significant assumptions for these measurements that significantly impact the results. The two most significant of these assumptions are (1) the use of a “static” balance sheet—Management does not project changes in the size or mix of the various assets and liabilities—and (2) estimates regarding the Company’s non-maturity deposits. The use of

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a static balance sheet is done to limit the variables in the model. The only exception to this is the inclusion of the RAL income in the net interest income over the next 12 months. While not sensitive to interest rates—see the section on RALs below for an explanation of interest income for this product—the amount is simply too large to ignore even though it is a seasonal product and there were no RALs on the balance sheet at year-end. The purpose of the comparison is not to project net interest income over the next year, but to measure the current sensitivity to changes in interest rates and compare that measurement to similar measurements done in the past. It is also done to determine the impact of hypothetical individual transactions on the sensitivity. Because of the assumption of a static balance sheet, readers of this discussion should not look at the above table as a projection of net interest income. The assumptions for non-maturity deposits are significant, because they have no contractual maturity and because their rates are not determined with respect to any external index. Therefore, Management must estimate how long the deposits will remain with the Company in order to determine their economic value, and must estimate how soon, how frequently, and to what degree changes in short-term interest rates will be reflected in the rates of these administered deposits to determine the impact of those changes on net interest income.

As interest rates change, the assumptions regarding responsiveness to further change must be reviewed, and any changes will affect the computed results. These assumptions are reviewed each quarter and are changed as deemed appropriate to reflect the best information available to Management. Assumptions used for the measurement at December 31, 2005 are not necessarily the same as those used for the measurement at December 31, 2004.

The same changes to the balance sheet and assumptions mentioned above in connection with net interest income also account for the changes in net economic value. However, the computation of net economic value discounts all cash flows over the life of the instrument, not only the next twelve months. For example, in estimating the impact on net interest income of a two-percent rise in rates on a security maturing in three years, only the negative impact during the first year is captured in net interest income. In estimating the impact on net economic value, the negative impact for all three years is captured. Therefore, the results tend to be more pronounced.

That the net economic value of the Company’s financial instruments would be less with a 200 basis point change in either direction is caused by the optionality in the consumer and residential real estate loan portfolios. When rates drop by these rates, the customer is more likely to prepay the loan. The positive impact to the net economic value from loans paying higher than market rates disappears with the prepayment and no longer offsets the negative impact to the net economic value from fixed rate liabilities that would be costing 200 basis points higher than then current market rates.

Asymmetry of results:  As noted above in discussing basis risk, financial instruments do not respond in parallel fashion to rising or falling interest rates. This causes an asymmetry in the magnitude of changes in net interest income and net economic value resulting from the hypothetical increases and decreases in rates. In other words, the same percentage of increase and decrease in the hypothetical interest rate will not cause the same percentage change in net interest income or net economic value.

In addition, the degree of asymmetry changes as the base rate changes from period to period and as there are changes in the Company’s product mix. For example, if savings accounts are paying 4% when one measures the impact of a 2% decrease in market rates, the measured responsiveness of the rate paid on these accounts to that decrease will be greater than the responsiveness if the current rate is 3% when the measurement is done. This is because the Company cannot assume that it will be able to lower the rates paid on these deposits as much from a 3% base as from a 4% base.

Another example of a factor that would cause asymmetric results would be the extent consumer variable rate loans are a larger proportion of the portfolio than in a previous period. The caps on loan rates, which generally are present only in consumer loans, would have more of an adverse impact on the overall result if rates were to rise.

Non-shock simulations:  In addition to applying scenarios with sudden interest rate shocks, net interest income simulations are prepared at least quarterly using various interest rate projections.

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Reflecting what appears to be a general consensus that the FOMC will raise short-term rates several more times in 2006, Management’s projection for the most likely scenario includes two increases of 25 basis point each during the first half the year. As the year progresses, the models are revised to make use of the latest available projections. In addition to a “most-likely” scenario, the Company also projects the impact on net interest income from higher and lower rate scenarios.

In addition to the assumptions used in the shock analysis mentioned above, the interest rate simulation reports are dependent on additional assumptions relating to the shape of the interest rate curves and the volatility of the interest rate scenarios selected. In addition, Management expects relatively flat yield curves (Note G).

Under these “more realistic” scenarios, as in the case of the sudden rate shock model, the Company’s net interest income at risk in 2006 is still well within normal expectations. The change in the average expected Fed funds rate is also shown to give perspective as to the extent of the interest rate changes assumed by the two scenarios.

TABLE 5B—Results of Alternative Simulations

	Rates Lower Than Most Likely		Rates Higher Than Most Likely
Percentage change in net interest income	(2.34	%)	1.74	%
compared to most likely scenario
Change in average Fed funds rate	(0.69	%)	0.29	%

Managing Interest Rate Risk with Derivative Instruments

The steps that the Company takes to mitigate interest rate risk were mentioned above as each type of interest rate risk was explained. They primarily involve pricing products to achieve diversification or offsetting risk characteristics and purchasing securities or issuing debt with maturities that offset undesired risk characteristics. The Company has also occasionally used derivative instruments, specifically interest rate swaps, to protect large loans or pools of loans. However, there are limitations and costs associated with these instruments.

In general, absent the ability to correctly predict the future direction and extent of changes in interest rates, there is a trade-off between assuming additional cost and assuming additional risk. For example, the Company could enter into an interest rate swap whereby it receives a variable rate on a notional amount to another financial institution in exchange for paying a fixed rate. This will protect the Company’s interest income if rates rise, because it will receive more as the variable rate adjusts with each increase in rates while it continues to pay the same fixed amount over the term of the contract. This will offset the fact that the Company’s fixed rate assets will be earning less than the market rate after the rise. However, the Company would lose interest income if rates decline instead of rise as its variable receipt decreases (Note P).

Alternatively, the Company could purchase an option contract under which it would receive cash from the other party if rates rose or fell by a specified amount, depending on which direction the Company anticipated rates to move. This contract avoids incurring risk should rates move against its expectations, but the option fee, a not insignificant amount, is forfeited if rates do not move as anticipated.

Despite the trade-offs inherent in using derivative instruments, Management anticipates making more use of them in the future. As its RAL program continues to grow, the Company must increasingly structure its balance sheet to provide the large amount of liquidity needed in the first quarter of each year. This limits the Company’s ability to take some of the natural or on-balance sheet hedge positions (Note H) of which it could otherwise make use. Derivative instruments may provide the additional flexibility needed both to maintain the liquidity and protect net interest income.

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SECURITIES

The major components of the Company’s earning asset base are the securities portfolio, the loan portfolio and its holdings of money market instruments. At the direction of the Board, the Company’s Asset Liability Management Committee (“ALCO”) has overall responsibility for the management of the securities portfolios, the money market instruments, and the Company’s borrowings. The structure and detail within these portfolios are very significant to an analysis of the financial condition of the Company. The loan and money market instrument portfolios and the borrowings will be covered in later sections of this discussion.

Securities Portfolios

The Company groups its securities into three portfolios: the “Liquidity Portfolio,” the “Discretionary Portfolio,” and the “Earnings Portfolio.” Each of these portfolios is comprised only of securities classified in the financial statements as available-for-sale.

The Liquidity Portfolio’s primary purpose is to provide liquidity to meet cash flow needs. The portfolio consists of U.S. Treasury and agency securities. These securities are purchased with maturities of up to three years with an average maturity of between one and two years.

The Discretionary Portfolio’s primary purposes are to provide income from available funds and to hold earning assets that can be purchased or sold as part of overall asset/liability management. The Discretionary Portfolio consists of U.S. Treasury and agency securities, collateralized mortgage obligations (“CMOs”), asset-backed securities, mortgage-backed securities (Note I), and municipal securities.

The Earnings Portfolio’s primary purpose is to provide income from securities purchased with funds not expected to be needed for making loans or repaying depositors. The Earnings Portfolio consists of long-term tax-exempt obligations.

As explained in Note 1, securities that are classified as available-for-sale are carried at their fair value. This means that the carrying amount of some securities will increase or decrease based on changes in interest rates and very rarely to changes in their credit quality. In December 2003, the Company recognized that the flexibility to sell any of its securities prior to maturity in order to manage interest rate risk or to provide liquidity was more desirable than the avoidance of the balance sheet volatility and consequently reclassified all of its securities as available-for-sale.

Maintaining adequate liquidity is one of the highest priorities for the Company. Therefore, available funds are first used to purchase securities for the Liquidity Portfolio. So long as there are sufficient securities in that portfolio to meet its purposes, available funds are then used to purchase securities for the Discretionary Portfolio and the Earnings Portfolio.

The average yields on the taxable securities are significantly lower than the average rates earned from loans as shown in Table 2. Because of this, while taxable securities provide liquidity and act as collateral for deposits and borrowings, they are purchased for earnings only when loan demand is weak or when the company can fund the purchase with specific debt that locks in an acceptable spread.

Additional Purposes Served by the Securities Portfolios

The securities portfolios of the Company serve additional purposes: (1) to act as collateral for the deposits of public agencies and trust customers that must be secured by certain securities owned by the Company; (2) to be used as collateral for borrowings that the Company occasionally utilizes for liquidity purposes; (3) to support the development needs of the communities within its marketplace; and (4) to assist in managing interest rate risk.

Collateral for deposits:  The legal requirements for securing specific deposits may only be satisfied by pledging certain types of the Company’s securities. A large proportion of these deposits may be secured by state and municipal securities, but some can only be secured by U.S. Treasury securities, so, despite their lower yield, holding a minimum amount of these securities will always be necessary.

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Collateral for borrowing:  As covered in other sections of this discussion, the Company borrows funds from other financial institutions to manage its liquidity position. Certain amounts may be borrowed unsecured, i.e. without collateral, but by pledging some of its securities as collateral, the Company may borrow more and/or at lower rates.

Community Development:  The Company searches actively for investments that support the development needs of communities within its marketplace. Such investments would include mortgage-backed securities consisting of real estate loans to lower income borrowers in its market areas. The Company also holds several bonds of school districts within its market areas.

Interest Rate Risk Management:  The Company also uses purchases for and sales from its securities portfolios to manage interest rate risk as explained above in the section titled “Interest Rate Risk”.

Amounts and Maturities of Securities

As a ready source of liquidity, the size of the securities portfolios tends to vary with the relative increase in loan and deposit balances.

The ideal manner for a financial institution to grow or to increase its net interest income is through adding deposits and investing the received funds in loans. This is ideal because the spread between the interest earned and paid is then maximized. However, in 2003, with interest rates low, loan demand improving, but still moderate, and customers unwilling to place their funds in the longer-term CDs that would help the Company avoid incurring mismatch risk, the opportunities to grow in this manner were limited. The Company decided that the purchase of securities funded by the borrowings would provide some additional net interest income, even though the relatively thin spread between the earnings rate on the securities and the cost of the borrowings would negatively impact the net interest margin. The Company began to implement this “leveraging” strategy in a small way in late 2002, and then substantially increased the Discretionary Portfolio by the purchase of $500 million of securities from April through September 2003 after the end of the 2003 RAL/RT season. It is termed “leveraging” because the purchaser is increasing its assets without a corresponding increase in capital, hence leveraging its capital. The net result was to increase the end of year balance of securities by $449 million from 2002 to 2003.

Almost all of the securities purchased were hybrid ARM MBS supplemented by a few CMOs. Hybrid ARM MBSs are mortgage-backed securities that have the initial coupon rate of the underlying mortgages fixed for 3, 5, or 7 years and then reprice to an external index. The majority of the securities purchased were funded by term borrowings from the Federal Home Loan Bank (“FHLB”). The use of term debt to fund the purchases reduces the interest rate risk incurred by the purchase of the securities because the spread between the assets and liabilities would be “locked in” for at least the term of the debt. The Company did not try to exactly “match fund” the purchases—exactly match the term of the securities purchased and the debt incurred—because the spreads would then be too narrow. The Company had been asset sensitive as explained in the section titled “Interest Rate Sensitivity,” and it could afford some mismatching of the maturities to obtain a wider spread in the interest income and expense. Some of the purchases were funded by deposits as they increased by $339 million compared to the increase in loans of $161 million.

In 2004, loans increased more ($881 million) than deposits ($657 million), and securities increased by $207 million. The acquisition of PCCI caused much of the increases in these balances, but without the effect of the purchase, loans still increased $462 million, deposits $367 million, and securities $86 million.

The Company purchased another $200 million in hybrid ARM MBS securities during 2004, this time using only the 3 and 5 year initial fixed rates. Again, these were funded with FHLB advances. That the securities portfolios increased only $76 million despite these purchases is due to the payments received on the earlier purchases. As disclosed in the Consolidated Statement of Cash flows for 2004, the Company received $306 million in proceeds on sale or maturity of securities.

The 2005 end of year balance of securities declined by $155 million despite the addition of $51 million in securities in the FBSLO acquisition. Some of the decrease is accounted for by sales during 2005 of approximately $48 million, but as in 2004, there was a large amount of payments received

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on the MBS securities. With interest rates rising making the spread between securities and borrowings very narrow, there was little reason to do any further leveraging. In addition, more loan demand and a decreased rate of deposit growth meant that payments on securities would be more profitably invested in lending activities than new securities.

Table 6 sets forth the amounts and maturity ranges of the securities at December 31, 2005. Because many of the securities included in the Earnings Portfolio are state or municipal bonds, much of the income from this portfolio has the additional advantage of being tax-exempt. Therefore, the tax equivalent weighted average yields of the securities are shown in Table 2.

Other Securities Disclosures

Turnover and Maturity Profile:  The Company generally purchases municipal securities with maturities of 18-25 years because, in Management’s judgment, they have the best ratio of rate earned to the market risk incurred in purchasing these fixed rate securities. However, to mitigate this higher interest rate risk, the Company purchases taxable securities with relatively short maturities. This in turn causes frequent maturities and what may appear to be a relatively high turnover rate. In addition, MBS securities represent a large proportion of the securities portfolios. There is a monthly paydown for these securities as mortgage payments are received on the underlying mortgages. Therefore it would be expected that proceeds from maturities would be higher relative to these securities than they would be for single maturity securities, and consequently, the Consolidated Statement of Cash Flows shows a relatively large amount of cash received from calls, maturities, and partial paydowns for securities.

TABLE 6—Maturity Distribution and Yield Analysis of the Securities Portfolios

As of December 31, 2005 (dollars in thousands)	One year or less			After one year to five years			After five years to ten years			Over ten years			Total
Maturity distribution:
Available-for-sale:
U.S. Treasury obligations	$	35,024		$	64,028		$	—		$	—		$	99,052
U.S. agency obligations		82,664			176,020			—			—			258,684
Mortgage-backed securities and
Collateralized mortgage obligations		15,384			600,130			114,650			35,869			766,033
Asset-backed securities		6,188			906			—			—			7,094
State and municipal securities		822			13,491			43,875			180,498			238,686
Total	$	140,082		$	854,575		$	158,525		$	216,367		$	1,369,549
Weighted average yield (Tax equivalent—Note A):
Available-for-sale:
U.S. Treasury obligations		2.73	%		3.48	%		—			—			3.21	%
U.S. agency obligations		3.81	%		3.81	%		—			—			3.81	%
Mortgage-backed securities and
Collateralized mortgage obligations		3.06	%		4.23	%		4.51	%		4.81	%		4.27	%
Asset-backed securities		3.62	%		4.92	%		—			—			3.79	%
State and municipal securities		5.55	%		10.60	%		8.25	%		9.62	%		9.39	%
Overall weighted average		3.46	%		4.18	%		5.48	%		8.71	%		4.90	%

Security Sales, Calls and Purchases:  The Consolidated Statement of Cash Flows for 2005 shows $47.4 million in proceeds on the sale of securities. For 2004, proceeds from the sales were $87 million.

These sales are not due to trading activity. The Company does not have a trading portfolio. That is, it does not purchase securities on the speculation that interest rates will decrease and thereby allow subsequent sale at a gain. Proceeds from sales represented only 3% of the average balance in the

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securities portfolio in 2005 and 6% in 2004. The losses from sales of securities were minimal, representing 0.34% of pretax income in 2005 and 1.44% in 2004.

In 2005 and 2004, most of the sales were made in consideration of the likelihood of additional rising interest rates. Selling some of the lowest yielding securities allowed the Company to reinvest the proceeds from these sales at higher rates either in new securities in 2004 or in loans in 2005. Taking a loss and the resulting tax deduction in the current year with reinvestment in higher yielding securities or loans improves total return on the portfolio compared with leaving the funds earning the lower rate.

Proceeds from called securities in 2005 were $1.6 million compared to $1.9 million in 2004.

Even though the balance of securities declined during 2005, if the various purposes for the portfolios mentioned above are to be met, especially maintaining sufficient collateral for public deposits and for borrowing, some purchases must be made each year. For liquidity purposes, it is advantageous to purchase those securities throughout interest rate cycles. Rather than anticipate the direction of changes in interest rates, the Company’s investment practice with respect to securities in the Liquidity and Discretionary Portfolios is to purchase securities so that the maturities are approximately equally spaced by quarter within the portfolios. The periodic spacing of maturities provides the Company with a steady source of cash. If the cash is not needed, this pattern of frequent maturities nonetheless minimizes reinvestment risk—having too much cash available all at once that must be invested perhaps when rates are low.

Securities gains and losses:  As occurred in 2004, the Company will occasionally sell securities prior to maturity to reposition the funds into a better yielding asset. This usually results in a loss. The Company generally does not follow a practice of selling securities to realize gains. This is because future income is reduced after a sale by the difference between the higher rates that were being earned on the sold securities and the lower rates that can be earned on new securities purchased with the proceeds. In addition, the Company pays taxes on the gains sooner than it would if paying taxes only as interest is received, thereby losing the use of those funds. However, gains are occasionally recognized when interest rates have decreased and:

· the issuer calls the securities to refinance them at the lower market rates;

· the Company needs to reposition the maturities of securities to manage mismatch risk;

· the Company needs to change the risk-weighting profile of its assets to manage its capital position (see the section below titled “Capital Resources”); or

· the Company is selling small remaining portions of amortizing securities to reduce administrative burden.

Hedges, Derivatives, and Other Disclosures

The Company has policies and procedures that permit limited types and amounts of derivatives to help manage interest rate risk. As with securities, the Company’s ALCO has overall responsibility for the use and management of derivatives, interest rate swaps, and hedging activities.

As mentioned above, the Company has occasionally purchased interest rate swaps from other financial institutions to hedge large, fixed-rate loans or to mitigate the interest rate risk in pools of fixed-rate loans. The Company’s use of derivative instruments is discussed in Note 23 to the Consolidated Financial Statements.

The Company has not purchased any securities arising out of a highly leveraged transaction and its investment policy prohibits the purchase of any securities of less than investment grade or so-called “junk bonds.”

MONEY MARKET INSTRUMENTS—FEDERAL FUNDS SOLD, SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL, AND COMMERCIAL PAPER

Cash in excess of amounts projected to be needed for operations over the next several months is generally placed in securities. Cash in excess of amounts immediately needed for operations is

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generally lent to other financial institutions as Federal funds sold or as securities purchased under agreements to resell (for brevity termed “reverse repos”). Both transactions are overnight loans. Federal funds sold are unsecured; reverse repos are secured. The one-day term of the Federal funds sold and reverse repos means (1) that they are highly liquid as the funds are returned to the Company the next day and (2) that they are not subject to market risk because they immediately reflect changes in short-term interest rates. The highly liquid nature of these money market instruments results in a relatively low earnings rate. The average rate earned in 2005 was 3.07%. For 2004 and 2003, the average rates earned were 1.17% and 1.22%, respectively. The increase in 2005 is strictly due to the eight increases in overnight rates by the FOMC.

As discussed below in “Liquidity,” the Company has developed and maintains numerous other sources of liquidity than these overnight and short-term funds. With loans growing more than deposits in 2005, the Company has had less excess funds than in prior years and the average balance of funds held in these instruments is therefore lower than in prior years.

LOAN PORTFOLIO

The Company offers a wide variety of loan types and terms to customers along with very competitive pricing and quick delivery of the credit decision. Table 7 sets forth the distribution of the Company’s loans at the end of each of the last five years.

The amounts shown in the table for each category are net of the deferred or unamortized loan origination, extension, and commitment fees and the deferred origination costs for loans in that category. These net deferred fees and costs included in the loan totals are shown for information at the bottom of the table. These deferred amounts are amortized over the lives of the loans to which they relate.

Growth in Portfolio and Loan Sales

The year-end balance for all loans has continued to increase over the last five years with increases of $221 million, $161 million, $881 million and $835 million for the years of 2002 through 2005 over the preceding year. Approximately $419 million of the growth during 2004 was due to the acquisition of PCCI and approximately $217 million of the growth during 2005 was due to the acquisition of FBSLO. All of the categories reported in Table 7 on page 38 showed growth during 2004 and 2005. Most of the categories also showed growth in 2002 and 2003.

From time to time the Company sells loans. The balances would be higher were it not for these sales. The sales are transacted for several reasons which are discussed below as they relate to each loan category.

Loan Categories

The Company makes both adjustable rate and fixed rate 1-4 family mortgage loans. The Company originated $226 million of these loans in 2003 and sold $73 million. In 2004 and 2005, loan originations slowed as rising interest rates slowed refinance activity, so fewer loans were sold. The Company uses sales (1) to manage the growth in the portfolio—more loans are sold when originations are high so that the portfolio size is kept to a reasonable amount while fewer loans are sold when originations are low to maintain the interest income; (2) to generate gains and fees on the sales; and (3) to manage interest rate risk—when fixed rate loans are in more demand than adjustable, the Company is likely to sell more. Loan balances in this category grew $93 million and $227 million during 2004 and 2005, respectively. Approximately $37 million of the increase in 2005 was from the acquisition of FBSLO. PCCI did not have any residential real estate loans.

Construction and development loans increased $88 million in 2005 to $375 million. The portfolio is primarily comprised of owner-developed residential and commercial properties with the outstanding lending commitment averaging less than $1 million. This loan category is probably the most volatile because developer activity is most subject to changes in the economic cycle. The balances at December 31, 2004 and 2003 were $286 million and $250 million, respectively, the growth indicative of the strong demand for housing in the Company’s market areas. Approximately $18 million of the increase in 2005 was from the acquisition of FBSLO.

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In 2004 and 2005, economic recovery appeared more obvious and consumer confidence increased, allowing consumer loans to increase $91 million from 2004 to 2005. None of this growth was the result of the PCCI or FBSLO acquisitions.

This category includes the Company’s program of indirect auto loans—the purchase of loans originated by dealers. The Company has entered into indirect financing agreements with a number of automobile dealers whereby the Company purchases loans dealers have made to customers. While automobile dealers frequently provide financing to customers through manufacturers’ finance subsidiaries, some customers prefer loan terms that are not included in the standard dealer packages. Other customers are purchasing used cars not covered by the manufacturers’ programs. Based on parameters agreed to by the Company, the dealer makes the loan to the customer and then sells the loan to the Company.

This program is neither a factoring nor a flooring arrangement. The individual customers, not the dealers, are the borrowers and thus there is no large concentration of credit risk. In addition, there is a review of underwriting practices of a dealer prior to acceptance into the program. This is done to ensure process integrity, to protect the Company’s reputation, and to monitor compliance with consumer loan laws and regulations.

Growth in this line was slow in 2003 because, with the economy slow, auto sales were sluggish and auto manufacturers reintroduced 0% financing to increase sales. This made the Company’s auto loan programs temporarily less competitive. In addition, the Company did not add as many dealers to the program as it had in previous years. There were approximately $207 million of such loans included in the consumer loan total below for December 31, 2003, as compared with $192 million at December 31, 2002. In 2004, auto sales picked up and the balance of these loans was $236 million at the end of the year. In 2005, the manufacturers again ran special “employee rate” promotions that resulted in a lower volume of originations and the balance of these loans decreased to $196 million.

Home equity loans and small business commercial equipment leasing both experienced significant percentage increases in 2004, 53% for the former, and 55% for the latter. In 2005, home equity loans increased 51% and equipment leasing by 25%. Aggressive marketing efforts and the improving economy accounted for the growth. None of the PCCI loans and only about 15%, or $15.5 million, of the increase in the home equity category, came from FBSLO.

Commercial loans increased by $147 million during 2005, compared to an increase of $106 million in 2004. The economy continues its recovery and businesses are gaining confidence to increase their activity. Approximately $37 million of the growth in 2004 was acquired with PCCI and $17 million of the growth in 2005 was acquired with FBSLO.

Most of PCCI’s loans were in the commercial or non residential real estate loan category, and the acquisition added $376 million to these categories. The Company added another $108 million in this category during 2004. In this category as well, the recovering economy was evident as the Company had added only $35 million in 2003. In 2005, the Company added $121 million in this category, with two thirds of the growth coming with FBSLO.

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TABLE 7—Loan Portfolio Analysis by Category

	December 31,
(dollars in thousands)		2005		2004		2003		2002		2001
Real estate:
Residential	$	1,128,318	$	901,679	$	809,031	$	715,430	$	733,748
Multi-family residential		256,857		182,936		121,750		83,787		90,438
Nonresidential		1,160,864		1,028,278		732,231		733,187		503,237
Construction and development		374,500		286,387		249,976		289,017		185,264
Commercial, industrial, and agricultural		934,840		826,684		681,722		645,696		875,253
Home equity lines		319,195		212,064		138,422		116,704		85,025
Consumer		431,542		387,257		296,286		288,040		187,949
Leases		287,504		234,189		149,642		138,927		128,106
Other		3,666		2,820		1,819		9,032		10,072
Total loans	$	4,897,286	$	4,062,294	$	3,180,879	$	3,019,820	$	2,799,092
Net deferred fees	$	6,195	$	7,107	$	5,380	$	5,313	$	4,908

The terms of approximately two-thirds of the balance of loans held by the Company involve some repricing characteristic that reflect changes in interest rates—either they immediately reprice as some external index such as prime rate changes or they reprice periodically based on the then current value of an index. Nonetheless, fixed rate loans still make up about 28% of the portfolio, and to the extent that even the variable rate loans do not reprice immediately, the same interest rate and liquidity risks that apply to securities are also applicable to lending activity. Fixed-rate loans and loans that only periodically reprice are subject to market risk—they decline in value as interest rates rise and rise in value as interest rates decrease with the exception of the residential real estate loans, the Company’s loans that have fixed rates generally have relatively short maturities, which effectively lessens the sensitivity to changes in value from market risk. With the exception of some of the residential real estate loans that have an extended period before their first repricing, the loans that reprice periodically usually do so frequently, i.e. at least annually. The fixed rate residential real estate loans have longer maturities and less frequent repricings, but do have monthly principal amortization that at least permits the repricing of those principal payments.

The table in Note 24 on page 123 shows that there was very little change in the relationship between the carrying value and fair value of loans at December 31, 2005 compared to December 31, 2004. At the end of 2004, the excess of the carrying value of net loans over the fair value was $39.1 million or 1.0%. At December 31, 2005, there was an excess of carrying value over fair value of $12.2 million. This excess represents 0.25% of the carrying value.

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Table 8 shows the scheduled maturity of selected loan types outstanding as of December 31, 2005, and shows the proportion of fixed and floating rate loans for each type. Net deferred loan origination, extension, and commitment fees are also not shown in the table. There is no maturity or interest sensitivity associated with the fees because they have been collected in advance.

TABLE 8—Maturities and Sensitivities of Selected

Loan Types to Changes in Interest Rates

(in thousands)	Due in one year or less		Due after one year to five years		Due after five years
Commercial, industrial, and agricultural
Floating rate	$	795,542	$	26,383	$	550
Fixed rate		47,485		61,348		3,532
Real estate—construction and development
Floating rate		362,719		1,698		227
Fixed rate		4,963		4,317		576
Real estate—residential
Floating rate		348,381		225,630		740
Fixed rate		178,233		299,563		75,771
Total	$	1,737,323	$	618,939	$	81,396

The amortization and short maturities generally present in the Company’s fixed rate loans also help to maintain the liquidity of the portfolio and reduce credit risk. However, they result in lower interest income if rates are falling because the cash received from monthly principal payments is reinvested at lower rates. At present, except for the specific market risk incurred by the decision to hold some of the fixed-rate residential and non-residential real estate mortgages, Management prefers to incur market risk from longer maturities in the securities portfolios, and avoid such risk in the loan portfolio. The reason for this preference is that, aside from residential mortgages, the secondary markets for longer-term loans are more limited than for longer-term securities. In the event that the Company should want to sell such loans for either liquidity or capital management reasons when interest rates are above the original issue rates, the loss taken would be greater than for the sale of securities with comparable maturities (Note O).

Potential Problem Loans:  From time to time, Management has reason to believe that certain borrowers may not be able to repay their loans within the parameters of the present repayment terms, even though, in some cases, the loans are current at the time. These loans are regarded as potential problem loans, and a portion of the allowance is assigned and/or allocated, as discussed below, to cover the Company’s exposure to loss should the borrowers indeed fail to perform according to the terms of the notes. This class of loans does not include loans in a nonaccrual status or 90 days or more delinquent but still accruing, which are shown in Table 11.

At year-end 2005, potential problem loans amounted to $132.6 million or 2.7% of the portfolio. The corresponding amounts for 2004 and 2003 were $90.8 million or 2.2% of the portfolio and $92.4 million or 2.9% of the portfolio, respectively. The 2005 amount is comprised of loans of all types.

Other Loan Portfolio Information

Other information about the loan portfolio that may be helpful to readers of the financial statements follows.

Adjustable rate residential loans:  The adjustable loans generally have low initial “teaser” rates. While these loans have interest rate “caps,” all are repriced to a market rate of interest within a reasonable time. A few loans have payment caps that would result in negative amortization if interest rates rise appreciably.

Foreign Loans:  The Company does not assume foreign credit risk through either loan or deposit products. However, the Company does make loans to borrowers that have foreign operations and/or have foreign customers. Economic and currency developments in the international markets may therefore affect our domestic customers’ activities.

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Participations, Syndications and Multibank Facilities:  Occasionally in the ordinary course of business, the Company will participate in a credit facility, that is, it will sell or will purchase a portion of a loan to or from another bank. The usual reasons that banks sell or participate loans are (1) to stay within their regulatory maximum limit for loans to any one borrower; (2) to reduce the concentration of lending activity to a particular industry or geographical area or otherwise diversify risk; (3) to manage regulatory capital ratios; and (4) to provide services to large clients in their serving area. Occasionally, a portion of another bank’s loan may be purchased or participated in by the Company when the originating bank is unable to lend the whole amount under its regulatory lending limit to its borrower or wishes to diversify risk, or the borrower requests that the Company be involved in its financing process. This is done only if the loan represents a good investment for the Company and the borrower or project is in one of the Company’s market areas. In these cases, the Company conducts its own independent credit review and formal approval prior to committing to purchase. The Company has no ongoing commitments in place with other banks to participate or sell loans.

Loan to Value Ratio:  One of the underwriting criteria for loans is the loan to collateral value ratio. Depending on the type of project, policy limits for real estate construction and development loans range from 60-90% of the appraised value of the collateral. For permanent real estate loans, the policy limits generally are 75% of the appraised value for commercial property loans and 80% for residential real estate property loans. Mortgage insurance is generally required on most residential real estate loans with a loan to value ratio in excess of 80%. Such loans, which can reach up to 90% loan to appraised value, are strictly underwritten according to mortgage insurance standards. The above policy limits are sometimes exceeded when the loan is being originated for sale to another institution that does lend at higher ratios and the sale is immediate; when the exception is temporary; or when other special circumstances apply. There are other specific loan to collateral limits for commercial, industrial and agricultural loans which are secured by non-real estate collateral. The adequacy of such limits is generally established based on outside asset valuations and/or by an assessment of the financial condition and cash flow of the borrower, and the purpose of the loan. Consumer loans that are secured by collateral also have loan to collateral limits which are based on the loan type and amount, the nature of the collateral, and other financial factors on the borrower.

Loan Concentrations:  The concentration profile of the Company’s loans is discussed in Note 6 to the accompanying Consolidated Financial Statements.

Loan Sales and Servicing Rights:  Most loans sold are sold “servicing released” and the purchaser takes over the collection of the payments. However, some are sold with “servicing retained” and the Company continues to receive the payments from the borrower and forwards the funds to the purchaser. The Company earns a fee for this service. The sales are made without recourse, that is, the purchaser cannot look to the Company in the event the borrower does not perform according to the terms of the note.

GAAP requires companies engaged in mortgage banking activities to recognize the rights to service mortgage or other loans for others as separate assets. For loans sold, a portion of the investment in the loan is ascribed to the right to receive this fee for servicing less adequate compensation and this value is recorded as a gain on sale and as a receivable. The amount of the gain and receivable recorded is the net present value of the servicing fees to be received over the expected lives of the mortgages. The servicing rights are amortized in proportion to and over the life of the loans as a charge against income. Management periodically reviews the anticipated lives of the loans. When interest rates decline, borrowers prepay their loans more often and consequently, the net present value declines. As explained in Note 11, the Company has established a valuation allowance to recognize changes in the fair value of the asset due to changes in estimated rates of prepayments. Net of this valuation allowance, the balance of this separate asset was $1.7 million and $1.9 million at December 31, 2004 and 2005, respectively. The activity in the asset and valuation accounts is shown in a table in Note 11.

ALLOWANCE FOR CREDIT LOSSES

Credit risk is inherent in the business of extending loans and leases to individuals, partnerships, and corporations. The Company sets aside an allowance or reserve for credit losses through charges to earnings. These charges are shown in the Consolidated Statements of Income as provision for credit

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losses. All specifically identifiable and quantifiable losses are immediately charged off against the allowance. However, for a variety of reasons, not all losses that have occurred are immediately made known to the Company and of those that are known, the full extent of the loss may not be able to be specifically quantified. The allowance for credit losses is an estimate of losses that have occurred but have not been identified or are not currently quantifiable. In this discussion, “loans” include the lease contracts purchased and originated by the Company.

Determination of the Adequacy of the Allowance for Credit Losses and the Allocation Process

The Company formally determines the adequacy of the allowance on a quarterly basis. This determination is based on the periodic assessment of the credit quality or “grading” of loans. Loans are initially graded when originated. They are re-graded as they are renewed, when there is a new loan to the same borrower, when identified facts demonstrate heightened risk of nonpayment, or if they become delinquent. Re-grading of larger problem loans will occur at least quarterly. Confirmation of the quality of the grading process is obtained both by independent credit reviews conducted by firms specifically hired by the Company for this purpose and by banking examiners.

After reviewing the gradings in the loan portfolio, the second step is to assign or allocate a portion of the allowance to groups of loans and to individual loans to cover Management’s estimate of the loss that may be present in these loans. Allocation is related to the grade and other factors, and is done by the methods discussed in Note 1.

The last step is to compare the amounts allocated for estimated losses to the current available allowance. To the extent that the current allowance is insufficient to cover the estimate of unidentified losses, Management records additional provision for credit loss. If the allowance is greater than appears to be required at that point in time, provision expense is adjusted accordingly.

Consistent with GAAP and with the methodologies used in estimating the unidentified losses in the loan portfolio, the allowance is comprised of several components. These components are described in Note 1.

Uncertainties in Determining the Adequacy of the Allowance for Credit Losses

The process of determining an estimate of unidentified and/or unquantifiable losses inherently involves uncertainty. Among the sources of this uncertainty are the following:

· There are limitations to any credit risk grading process. The volume of loans makes it impracticable to re-grade every loan every quarter. Therefore, it is possible that some currently performing loans not recently graded will not be as strong as their last grading and an insufficient portion of the allowance will have been allocated to them. Grading and loan review often must be done without knowing whether all relevant facts are at hand. Troubled borrowers may inadvertently or deliberately omit important information from reports or conversations with lending officers regarding their financial condition and the diminished strength of repayment sources.

· Neither the historical loss factors nor the review of specific individual loans give consideration to interdependencies between borrowers, yet this could impact the magnitude of losses inherent in the portfolios. For example, a rise in interest rates may adversely impact the amount of home mortgage lending. This could cause a reduction in the amount of home building initiated by developers, and this could have an impact on the credit quality of loans to building contractors in the commercial or construction segments of the portfolio. This kind of interdependency could cause losses within a specific period to be greater than would be predicted by the simple application of historical loss rates.

· The loss estimation factors do not give consideration to the seasoning of the portfolios. Seasoning is relevant because losses are less likely to occur in loans that have been performing satisfactorily for several years than in loans that are more recent. In addition, term loans usually have monthly scheduled payments of principal and interest. With a term loan, a missed or late payment gives an immediate signal of a decline in credit quality. However, most of the Company’s commercial loans and lines of credit have short-term maturities and frequently require only interest payments until maturity. Because they have shorter maturities and lack regular principal amortization, the process of seasoning does not occur and the signaling of the missed principal payment is not available.

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The Company addresses these uncertainties in the allocated component of the allowance as discussed in Note 1.

Assignment Table

Table 9A shows the amounts of allowance assigned for the last five years to each loan type disclosed in Table 7. It also shows the percentage of balances for each loan type to total loans. In general, it would be expected that those types of loans which have historically more loss associated with them will have a proportionally larger amount of the allowance assigned to them than do loans which have less risk.

It would also be expected that the amount assigned for any particular category of loan will increase or decrease proportionately to both the changes in the loan balances and to increases or decreases in the estimated loss in loans of that category. Occasionally, changes in the amount assigned to a specific loan category will vary from changes in the total loan balance for that category due to the impact of the changes in credit rating for larger individual loans. The reduction in assigned allowance overall, and specifically in the categories of construction and development, and commercial, industrial and agricultural between 2002 and 2003 is attributable to two events. The first is the resolution by sale of a large hospitality related troubled loan in the first category, and the second is the restructuring of a significant agricultural loan relationship in the wine industry included in the second category.

Despite declining as a percentage of total loans, nonresidential real estate loans increased by $133 million or 13%. The increase in allowance allocated to this portfolio is attributable to the growth in the portfolio.

In general, changes in the risk profile of the various parts of the loan portfolio should be reflected in the allowance assignment. There is no assignment of allowance to RALs at December 31, 2005 because all of these loans not repaid are charged-off prior to year-end.

TABLE 9A—Assignment of the Allowance for Credit Losses

	December 31,
(dollars in thousands)	2005			2004			2003			2002			2001
		Amount	Percent of Loans to Total Loans		Amount	Percent of Loans to Total Loans		Amount	Percent of Loans to Total Loans		Amount	Percent of Loans to Total Loans		Amount		Percent of Loans to Total Loans
Real estate:
Residential	$	2,458	23.0%	$	2,031	22.2%	$	3,196	25.4%	$	2,844	23.7%	$	2,927		26.2%
Multi-family residential*		868	5.2%		613	4.5%
Nonresidential		6,271	23.8%		5,080	25.3%		6,442	26.8%		5,260	27.0%		4,751		21.2%
Construction and development		1,465	7.6%		1,233	7.0%		1,726	7.9%		4,681	9.6%		1,174		6.6%
Commercial, industrial, and agricultural		16,842	19.1%		22,771	20.4%		21,824	21.4%		23,775	21.4%		26,352		31.3%
Home equity lines		1,280	6.5%		797	5.2%		641	4.4%		800	3.9%		377		3.0%
Consumer		14,640	8.8%		11,413	9.5%		9,455	9.3%		10,001	9.5%		7,569		6.7%
Leases		11,774	5.9%		10,039	5.8%		6,266	4.7%		6,460	4.6%		5,669		4.6%
Other		—	0.1%		—	0.1%		—	0.1%		—	0.3%		—		0.4%
Not specifically allocated		—			—			—			—			53
Total allowance	$	55,598	100.0%	$	53,977	100.0%	$	49,550	100.0%	$	53,821	100.0%	$	48,872		100.0%
Allowance for credit loss as a percentage of year-end loans		1.14%			1.33%			1.56%			1.78%					1.75%
Year-end loans	$	4,897,286		$	4,062,294		$	3,180,879		$	3,019,820				$	2,799,092

* In prior years, multi-family residential loans were included in the nonresidential category. The breakout of multi-family residential loans prior to 2004 is not available.

At the bottom of Table 9A is the ratio of the allowance for credit losses to total loans for each of the last five years. At the bottom of Table 11 is the ratio of the allowance for credit losses to nonperforming loans. While the Company does not determine its allowance for credit loss by attempting to achieve particular target ratios, the Company nonetheless computes its ratios and compares them with peer ratios (Note J) as a check on its methodology. The ratio of the allowance

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to total loans is lower at the end of 2004 and 2005 compared to the ratios at the end of the three prior years while the ratio of the allowance to nonperforming loans for 2005 is higher than at the end of the prior years and the ratio for 2004 is higher than the two preceding years. These changes occurred for two reasons.

The first is that the Company has experienced a generally positive trend in credit quality in its portfolios, with more loans moving to more favorable classifications in 2004 and 2005 than moving to less favorable. In the Company’s allowance methodology, this trend would lessen the need for as much allowance relative to total loans.

Secondly, much of the growth in the loan portfolio during 2004 and 2005 occurred in residential, commercial real estate, and commercial loans, all of which have relatively low historical charge-off rates. Consequently, loan growth was disproportionate to the need for additional allowance for credit losses.

CREDIT LOSSES

Table 9B, “Summary of Credit Loss Experience,” shows the additions to, charge-offs against, and recoveries for, the Company’s allowance for credit losses. Also shown is the ratio of charge-offs to average loans for each of the last five years.

TABLE 9B—Summary of Credit Loss Experience

(dollars in thousands)	Years Ended December 31,
		2005		2004		2003		2002		2001
Balance of allowance for credit losses at beginning of year	$	53,977	$	49,550	$	53,821	$	48,872	$	35,125
Charge-offs:
Real estate:
Residential		107		—		—		—		457
Multi-family residential*		—		—
Nonresidential		—		6		369		12		—
Construction and development		—		—		1,469		—		127
Commercial, industrial, and agricultural		12,483		8,489		11,982		14,032		7,490
Home equity lines		55		—		—		—		—
Tax refund anticipation		48,955		12,511		13,712		6,615		9,189
Other consumer		9,791		7,266		6,769		4,144		6,046
Total charge-offs		71,391		28,272		34,301		24,803		23,309
Recoveries:
Real estate:
Residential		7		27		2		302		93
Multi-family residential*		—		—
Nonresidential		—		2		12		296		228
Construction and development		—		513		—		—		—
Commercial, industrial, and agricultural		3,180		8,315		4,136		3,926		3,918
Home equity lines		19		—		—		—		—
Tax refund anticipation		10,745		4,043		5,182		4,510		4,769
Other consumer		3,505		1,847		2,412		991		1,377
Total recoveries		17,456		14,747		11,744		10,025		10,385
Net charge-offs		53,935		13,525		22,557		14,778		12,924
Allowance for credit losses recorded in acquisition transactions		1,683		5,143		—		—		—
Provision for credit losses refund anticipation loans		38,210		8,468		8,530		2,105		4,420
Provision for credit losses all other loans		15,663		4,341		9,756		17,622		22,251
Balance at end of year	$	55,598	$	53,977	$	49,550	$	53,821	$	48,872

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(dollars in thousands)	Years Ended December 31,
	2005			2004			2003			2002			2001
Ratio of net charge-offs to average loans outstanding		1.22	%		0.36	%		0.72	%		0.50	%		0.48	%
Ratio of net charge-offs to average loans outstanding exclusive of RALs		0.36	%		0.14	%		0.46	%		0.44	%		0.33	%
Peer ratio of net charge-offs to average loans outstanding		0.29	%		0.37	%		0.59	%		0.88	%		1.03	%
Average RALs	$	73,940		$	102,769		$	121,659		$	67,991		$	58,900
Average loans, net of RALs		4,363,905			3,702,100			3,029,669			2,874,091			2,619,325
Average loans	$	4,437,845		$	3,804,869		$	3,151,328		$	2,942,082		$	2,678,225
RAL net charge-offs	$	38,210		$	8,468		$	8,530		$	2,105		$	4,194
Net charge-offs, exclusive of RALs		15,725			5,057			14,027			12,673			8,730
Net charge-offs	$	53,935		$	13,525		$	22,557		$	14,778		$	12,924
Recoveries to charge-offs, RALs		21.95	%		32.32	%		37.79	%		68.18	%		51.90	%
Recoveries to charge-offs, other loans		29.91	%		67.91	%		31.87	%		30.32	%		39.77	%
Recoveries to charge-offs		24.45	%		52.16	%		34.24	%		40.42	%		44.55	%

* In prior years, multi-family residential loans were included in the nonresidential category. The breakout of multi-family residential loans prior to 2004 is not available.

There are only two other banks in the country that have national RAL programs. Therefore, for comparability, charge-offs amounts and ratios for the Company are shown both with and without the RAL amounts. The large increase in RAL charge-offs is due to a change in the terms of one of the contracts involved in this program. This contract is discussed on page 64 in the section titled “Tax Refund Anticipation Loan and Refund Transfer Programs.”

Large pools of loans made up of numerous smaller loans tend to have consistent loss ratios. The Company’s concentration in loans secured by nonresidential real estate and other larger loans in the commercial category may cause a higher level of volatility in credit losses than would otherwise be the case. A group consisting of a smaller number of larger loans in the same industry is statistically less consistent and losses may tend to occur at roughly the same time.

Exclusive of RALs, the ratio of net charge-offs to loans over the last five years has varied from 0.14% to 0.46%. Management regards this range to be within normal expectations given the changing economic conditions over this period.

The Company has exposure to credit losses from extending loan commitments and letters of credit as well as from loans and leases. Because funds have not yet been disbursed on these commitments and letters of credit, the face amount is not included in the amounts reported for loans and leases outstanding. Consequently, any amount provided for credit losses related to these instruments is not included in the allowance for credit losses reported in the table above, but is instead accounted for as a loss contingency estimate. The recording of this separate liability is accomplished by a charge to other operating expense. During 2003 and 2004, the Company funded two of the letters of credit issued for one borrower for $5.9 million. The Company immediately wrote off these amounts because of concerns for the customer’s ability to repay.

TABLE 10—Off-balance Sheet Estimates

(dollars in thousands)	Years ended December 31,
		2005			2004			2003
Beginning estimate	$	1,232		$	3,942		$	2,446
Additions and other changes		571			50			4,624
Funded and written-off		(118	)		(2,760	)		(3,128	)
Ending estimate	$	1,685		$	1,232		$	3,942

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NONACCRUAL, PAST DUE, AND RESTRUCTURED LOANS

Table 11 summarizes the Company’s nonaccrual and past due loans for the last five years.

Past Due Loans:  Included in the amounts listed below as 90 days or more past due are commercial and industrial, real estate, and a diversity of secured consumer loans. These loans are well secured and in the process of collection. These figures do not include loans in nonaccrual status.

Nonaccrual Loans:  If there is reasonable doubt as to the collectibility of principal or interest on a loan, the loan is placed in nonaccrual status, i.e., the Company stops accruing income from the interest on the loan and reverses any uncollected interest that had been accrued but not collected. These loans may or may not be collateralized. Collection efforts are being pursued on all nonaccrual loans. Consumer loans are an exception to this reclassification. They are charged-off when they become delinquent by more than 120 days if unsecured and 150 days if secured. Nonetheless, collection efforts are still pursued.

Restructured Loans:  The Company’s restructured loans have generally been classified as nonaccrual even after the restructuring. Consequently, they have been included with other nonaccrual loans in Table 11. All restructured loans have been classified as nonaccrual during the past five years.

Foreclosed Collateral:  While it may include other types of property such as vehicles, since such property is generally sold very quickly after repossession, foreclosed collateral consists of primarily of real estate properties obtained through foreclosure or accepted in lieu of foreclosure that take longer to sell. At December 31 for each of the past five years, it consisted solely of real estate.

The following table sets forth information regarding risk elements.

TABLE 11—Risk Elements

(dollars in thousands)	December 31,
		2005			2004			2003			2002			2001
Nonaccrual loans	$	16,590		$	21,701		$	42,412		$	59,818		$	16,940
90 days or more past due		1,227			820			763			1,709			3,179
Restructured Loans		—			—			—			—			—
Total noncurrent loans		17,817			22,521			43,175			61,527			20,119
Foreclosed collateral		2,910			2,910			—			438			—
Total nonperforming assets	$	20,727		$	25,431		$	43,175		$	61,965		$	20,119
Total noncurrent loans as percentage of total loan portfolio		0.36	%		0.55	%		1.36	%		2.04	%		0.72	%
Allowance for credit losses as a percentage of nonperforming loans		312	%		240	%		115	%		87	%		243	%

In 2002, there was an increase in nonaccrual loans. Approximately $30 million, or three quarters of this increase, related to two credit relationships. One of these was in the hospitality industry and the other in the wine industry. Weaknesses in the credit quality of these loans had been identified in the fourth quarter of 2001 and allowance was allocated to them in that quarter and additional amounts in the first and second quarters of 2002. While payments were still being made according to the contractual terms of notes, these loans were placed in nonaccrual in the second half of 2002. The amount of the estimated loss had not become greater, but the probability of loss became great enough to warrant stopping the recognition of interest income. These loans were classified as impaired. An allowance of $6.5 million was specifically established for them.

By the end of 2003, nonaccrual loans had declined substantially to $42.4 million. Much of this reduction is specifically attributed to the sale by the Company of the loan to the distressed hospitality entity mentioned in the preceding paragraph. The loan was sold for more than the outstanding amount of the loan less the allowance that had been provided. The balance of the reduction in nonaccrual loans during 2003 is attributable to substantial resolution or collection of a

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number of troubled loans representing different industries consistent with the improvement in our economy and the Company’s portfolio diversification. The nonaccrual loan total continues to include the large wine related credit referred to in the discussion of 2002 events above. However, that loan relationship has been restructured such that it has been upgraded to the substandard classification and is paying according to the restructured terms. The outstanding balance at the time of the restructure was $15.1 million. The amount of allowance that had been allocated to the loans in this relationship was $4.4 million. $3.5 million was charged-off in the restructuring and $0.9 million of allowance was made available for other loans, lowering provision expense by that amount from what otherwise would have needed to be provided. In 2004, $1.7 million of the amount charged-off on this loan was recovered.

In 2005, the balance of other nonaccrual loans continued to decrease. In Management’s judgment, this is unlikely to continue. The ratio of nonaccrual loans at 0.36% is just more than half the latest ratio available for its FDIC peers, and with most economists forecasting rising interest rates as the FOMC seeks to temper inflation, even stronger economic conditions are unlikely to cause the credit environment to improve more than it has.

Table 12 sets forth interest income from nonaccrual loans in the portfolio at year-end that was not recognized.

TABLE 12—Foregone Interest

(dollars in thousands)	Years Ended December 31,
		2005		2004		2003
Interest that would have been recorded under original terms	$	1,449	$	1,411	$	1,536
Gross interest recorded		864		241		657
Foregone interest	$	585	$	1,170	$	879

DEPOSITS

An important component in analyzing net interest margin and, therefore, the results of operations of the Company is the composition and cost of the deposit base. Net interest margin is improved to the extent that growth in deposits can be focused in the lower cost core deposit accounts—demand deposits, NOW accounts, and savings. The average daily amount of deposits by category and the average rates paid on such deposits is summarized for the periods indicated in Table 13.

TABLE 13—Detailed Deposit Summary

(dollars in thousands)	Years Ended December 31,
	2005				2004				2003
		Average Balance	Rate			Average Balance	Rate			Average Balance	Rate
NOW accounts	$	973,009	1.00	%	$	741,864	0.48	%	$	469,122	0.13	%
Money market deposit accounts		748,159	1.56			761,469	0.84			853,890	1.01
Savings accounts		385,911	0.99			397,294	0.62			268,031	0.38
Time certificates of deposit for $100,000 or more		906,027	2.93			898,225	1.96			729,019	1.87
Time certificates of deposit for less than $100,000 and IRAs		709,918	2.99			548,983	2.20			511,296	2.40
Interest-bearing deposits		3,723,024	1.96	%		3,347,835	1.26	%		2,831,358	1.28	%
Demand deposits		1,134,952				1,046,870				909,915
Total Deposits	$	4,857,976			$	4,394,705			$	3,741,273

Trends in Interest Expense Rates

The average rate paid on all deposits decreased slightly from 1.28% in 2003 to 1.26% in 2004 and then increased in 2005 to 1.96%. These changes in rates were primarily due to the changes in interest rates brought about by FOMC actions (Note K). The changes in average rates that are paid

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on deposits are not as great as the changes in the target rates, i.e., deposit rates generally trail these money market rate changes, for three reasons: (1) financial institutions do not try to change deposit rates with each small increase or decrease in short-term rates; (2) in the low interest-rate environment of 2002 through 2004, banks were not able to decrease deposit rates as much as the FOMC decreased its Federal funds target rates; and (3) with time deposit accounts, even when new offering rates are established, the average rates paid during the year are a blend of the rates paid on individual accounts. Only new accounts and those that mature and are renewed will bear the new rate.

In late 2003, the Company introduced a suite of no-fee checking accounts. Most of the growth in 2004 in demand and NOW accounts came from these products. One product in the suite is a high balance, high interest account, resulting in the increase in the average rate for the NOW category compared to 2003.

The relatively large increase in the balance of savings accounts during 2004 was the result of the acquisition of PCCI, which had about 40% of its deposits comprised of business savings accounts. These accounts pay a higher rate of interest than individual savings accounts resulting in an increase in the average rate paid for this category over the rate paid in 2003. The $254 million in deposits obtained in the FBSLO transaction was more evenly distributed among deposit types with the largest category being $66 million in noninterest bearing demand deposits.

Through the date of this report, the FOMC raised its target rate again in 2006 in late January. Management expects that short-term interest rates will be increased several more times during 2006. Deposit rates are expected to increase though they will lag the FOMC actions. Just as the Company was unable to decrease the rates on administered rate deposit accounts by the same amount as the FOMC decreased its target rate in 2001-2003, it is unlikely that banks will increase their rates by as much as the FOMC increases its target rate.

Certificates of Deposit of $100,000 or More

Table 14 discloses the distribution of maturities of CDs of $100,000 or more at the end of each of the last three years.

TABLE 14—Maturity Distribution of Time

Certificates of Deposit of $100,000 or More

(in thousands)	December 31,
	2005		2004		2003
Three months or less	$	402,348	$	250,406	$	281,295
Over three months through six months		241,752		268,656		229,313
Over six months through one year		287,675		196,523		135,326
Over one year		270,148		275,224		188,885
	$	1,201,923	$	990,809	$	834,819

FDIC insurance is available up to $100,000 per account relationship. Because amounts over $100,000 are not covered by insurance, it is generally thought that these deposits are more volatile, i.e., these accounts are not the result of on-going customer relationships. The lack of insurance also means for many banks that these accounts have relatively short maturities—depositors do not want to have uninsured funds locked up for longer periods—and that higher interest rates must be paid to compensate for the lack of insurance.

As shown in Table 13, the average rate earned on these accounts is actually less than the rate earned on accounts with balances less than $100,000. This has occurred despite the fact that the Company’s offering rate for new or renewing accounts of $100,000 or more is higher than for certificates with a lower balance. The reason for this relates to the decrease in interest rates from the end of 2000 through 2003. Depositors are more willing to have longer maturities with smaller amounts. Consequently, the larger balance accounts reprice more often. In a declining interest rate environment, these repricings will result in lower rates for the over $100,000 CDs. In a rising interest rate environment, these shorter terms result in a narrower difference between the average rates of CDs with balances that are over and under $100,000.

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The proportion of the certificate accounts of $100,000 or more that have remaining maturities of more than one year increased from 2003 to 2004, but decreased to the same proportion in 2005 as in 2003. Some of this was due to customers extending the maturity of their large deposits as rates declined in 2003 and held stable in early 2004 to get the higher offering rates. However, most of the increase in this proportion in 2004 was due to Management’s use of longer-term brokered certificates to assist in managing interest rate risk. Brokered certificates of deposit have similar interest rate risk characteristics to FHLB advances, but do not require collateralization. Included in the over one year maturity range for 2005 in Table 14 are $215 million of longer-term brokered certificates of deposit used for this purpose. The comparable figure for December 31, 2004 was $224 million. New brokered CDs were not used as much in 2005 as funds with the desired maturities were obtained from other sources.

SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE AND FEDERAL FUNDS PURCHASED

Just as the Company uses Federal funds sold and securities purchased under agreements to resell for the overnight investment of excess funds (described above in the section titled “Money Market Instruments”), the Company uses these same instruments for borrowing overnight from other banks to manage liquidity. When the Company is borrowing rather than lending, these instruments are called Federal funds purchased and securities sold under agreements to repurchase (“repos”). The repos are collateralized by securities owned by the Company. Federal funds purchased are unsecured.

The Company also enters into repo agreements to provide business and other large customers with a secured alternative to deposits in excess of the $100,000 FDIC insured amount. These agreements are for terms of a few weeks to 90 days.

Information on the balances and rates paid for these two types of borrowings is disclosed in Note 13 on page 105. Average interest rates paid during each year and at the end of each year increased from 2003 to 2004 and increased again in 2005. The blended average rates paid of 1.11% for 2003, 1.32% for 2004, and 3.10 % for 2005 closely reflect the pattern of rate changes in Note K, as would be expected for instruments that are almost exclusively one day in term. The average combined amounts for these borrowings outstanding during the three years have increased from 1.44% in 2003 to 2.91% in 2005 of average assets. The maximum amount outstanding at any month-end during the year may be significantly different than the average amount outstanding during the year. For example, the largest month-end amount borrowed by the Company through Federal funds purchased during 2005 was $675 million while the average amount borrowed during 2005 was $187 million.

During the first quarter when the RAL program requires large amounts of funding, repos and federal funds purchased are a significant source of liquidity to the Company. As explained below on page 59 in the discussion of the Company’s RAL program, overnight borrowing is the most cost efficient means of funding these loans, so the Company attempts to maximize this source on a few days during the first quarter of the year. With the RAL program larger in 2005 than in prior years, the Company borrowed more funds. In addition, as explained above on page 32 in the section on securities, Management decided to remain more fully invested in securities and rely more on borrowed funds. This caused a larger average balance in 2005 for these borrowings. To support this decision, the acceptability as collateral for borrowing is an important criterion for the selection of securities for the Company’s investment portfolio.

With the addition of the $125 million in longer-term repos mentioned in Note 13, the Company expects that the average amount outstanding for these borrowings will be higher in 2006 than in 2005.

NONEARNING ASSETS

For a bank, nonearning assets are those assets like cash reserves, equipment, and premises that do not earn interest. The ratio of nonearning assets to total assets is important because it represents the efficiency with which funds are used. Locking up funds in nonearning assets either lessens the

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amount of interest that may be earned or it requires the investment of the smaller earning asset base in higher yielding but riskier assets to achieve the same income level. Management therefore believes that a low level of nonearning assets is part of a prudent asset/liability management strategy to reduce volatility in the earnings of the Company.

The ratio of average nonearning assets to average total assets has increased during the last three years with an average of 6.86% in 2003, 7.15% in 2004, and 7.94% in 2005. The reason for the rise relates to a larger increase in average nonearning assets (72% from 2003 to 2005) compared to an increase in average earning assets of 36.0%. Of the $214 million increase in average nonearning assets from 2003 to 2005, $111 million is the goodwill added in the purchase of PCCI and FBSLO. While classified as nonearning assets because of bank regulatory requirements, three components of this balance actually generate direct earnings. The first is $39 million of FRB and FHLB stock mentioned in Note 10 on page 104. The second is the $60 million investment in bank owned life insurance (“BOLI”) also described in Note 10. The third is the $33 million investment in low income housing tax credit partnerships mentioned in Note 21 on page 120. As of September 30, 2005, the latest date peer information is available, the average ratio of nonearning assets to total assets for bank holding companies of comparable size was 9.65%.

NONINTEREST REVENUE

Service Charges on Deposit Accounts

Service charges have increased with the growth in deposits and the Company’s efforts to be more effective in collecting fees that are assessed.

Trust Fees

Fees earned by the Trust and Investment Services Division are a large component of noninterest revenue, reaching $16.8 million in 2005. Fees increased by $1.4 million or 8.9% over fees for 2004 compared to an increase of $1.0 million in fees from 2003 to 2004. Included within these fees in 2005 were $1.1 million from trusteeship of employee benefit plans and $2.1 million from the sales of mutual funds and annuities. In the case of the latter activity, the Company provides assistance to customers to determine what investments best match their financial goals and helps the customers allocate their funds according to the customers’ risk tolerance and need for diversification. The mutual funds and annuities are not operated by the Company, but instead are managed by registered investment companies. Including retail investments, the market value of assets under administration on which the majority of fees are based increased to $3.0 billion at the end of 2005.

Other Service Charges, Commissions and Fees

Included within other service charges, commissions and fees are service fees arising from the processing of merchants’ credit card deposits, escrow fees, and a number of other fees charged for special services provided to customers. This fee category has continued to increase over the last three years. As shown in the table in Note 21 on page 120, there was a decrease in broker fees from the sale of residential real estate loans. As mentioned in the section on loans above on page 36, loan sales declined in 2004 and 2005 because the increase in interest rates slowed the market for refinancing, and the Company decided to keep a larger proportion of the loans that were originated. Debit card fees have increased with the growth in the no-fee checking products discussed in the section titled “Deposits” on page 46. The debit cards are provided without cost to customers with these accounts. Collection fees relate primarily to collections on refund loans and are likely to be less in 2006 than in prior years for reasons discussed in the section below titled “Tax Refund Anticipation Loan and Refund Transfer Programs” beginning on page 59.

Refund Transfer Fees and Net gain on Sale of Tax Refund Loans

These items of noninterest revenues are explained in the section below titled “Tax Refund Anticipation Loan and Refund Transfer Programs” beginning on page 59.

Net Gain (Loss) on Sales and Calls of Securities

Gains and losses from sales and calls of securities are explained in the securities section above on page 32.

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Other income

Losses on the tax credit partnerships increased in 2004 in part because of the sale of one partnership by the Company. The Company estimates the operating loss for the year for these partnerships based on the prior year because the actual loss is not known until the partnership tax reporting is sent to the Company later in the subsequent year. The Company had underestimated the losses in the prior years and as a result certain adjustments were made in the fourth quarter to appropriately reflect the carrying value. Such amounts were not material to prior year results of operation. In 2005, the loss was as expected for the year. While generating losses, these partnerships receive and pass on to the limited partners tax credits that exceed the after tax losses resulting in a positive impact to net income for the Company.

The Company acquired life insurance policies—Bank Owned Life Insurance or “BOLI”—in some of its acquisitions of other institutions. The Company earns income on the cash surrender value of the policies. At the beginning of 2005 the Company invested $25 million in additional BOLI and in December it invested another $35 million. Because the second investment came late in the year, other income for 2005 includes very little earnings on this investment. Earnings from this source should increase substantially in 2006.

OPERATING EXPENSES

Total operating expenses have increased over the last three years as the Company has grown. These increases related to additional staff, improvements in technology to handle higher transaction volumes, and amortization of leasehold improvements on new facilities.

The ratio of operating expenses to average assets is often reported as a means of providing comparisons with other financial institutions. This ratio for the last three years is shown in the table below.

TABLE 15A—Operating Expense and Efficiency Ratios (Note L)

	Years Ended December 31,
	2005		2004		2003
Operating expense as a percentage of average assets	3.35	%	3.15	%	3.49	%
Operating efficiency ratio	49.48	%	52.76	%	53.53	%

Another ratio that is used to compare the Company’s expenses to those of other financial institutions is the operating efficiency ratio. This ratio takes into account the fact that for many financial institutions much of their income is not asset-based, i.e., it is based on fees for services provided rather than income earned from a spread between the interest earned on assets and interest paid on liabilities. The operating efficiency ratio measures what proportion of each dollar of net revenue is spent earning that revenue (Note M). With a significant proportion of the Company’s revenues coming from Trust and Investment fees and RT fees, i.e., from programs that require operating expenses to run but are not related to assets on the Company’s balance sheet, management focuses more on this ratio than the operating expense to assets ratio. The operating efficiency ratios for the Company’s holding company peers were 56.6% for 2005, 60.0% for 2004, and 59.2% for 2003. The ratios for the Company without the RAL/RT programs are shown in Table 16G.

Salaries and Benefits

Included within salaries and benefits are actual salaries, bonuses, commissions, retirement benefits, payroll taxes and workers’ compensation. The following table shows the amounts included for these components for the last three years.

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TABLE 15B—Salaries and Benefits Detail

(in thousands)	Years ended December 31,
		2005		2004		2003
Salaries	$	75,708	$	64,072	$	57,904
Bonuses		12,423		12,372		9,164
Retirement benefits		11,974		10,904		9,729
Payroll taxes		6,855		5,682		5,210
Workers compensation		1,063		1,667		1,895
Total	$	108,023	$	94,697	$	83,902

Actual salaries have not increased significantly over the last three years compared to the growth in the Company’s loans, deposits, and revenues. Average loans increased 40.8%, average deposits increased 29.8%, and revenues increased 52.7% from 2003 to 2005, while salaries and benefits increased 28.7%.

Bonuses and other incentive pay are accrued during the year, but most payments are made at the end of February in the year following the year to which they relate. Net income for 2004 exceeded that for 2003 by almost 16% due to significant internal growth, strong credit quality, and the acquisition of PCCI. Bonus amounts were increased correspondingly. While net income for 2005 was up 12.9% over 2004, aggregate performance for the business segments other than RAL/RT did not exceed the Company’s plan and bonuses were not increased over the amounts accrued in 2004.

The workers’ compensation issue in California has received a significant amount of media attention. After researching its options and obtaining insurance quotations for the continuance of full coverage, Management concluded that the quoted premiums were too high and that it would be less expensive in the long run to self-insure for all but catastrophic levels of claims. This change requires the Company to establish a reserve for claims each year. The reserve is determined by independent actuaries and is based on past experience. The Company’s change became effective August 1, 2003. Claims for injuries that occurred prior to that date but have not yet been reported and further costs related to claims in process for injuries prior to that date are the responsibility of the insurance company from whom the Company had purchased coverage. Beginning August 1, 2003, the Company expensed a prorated share of the catastrophic coverage premium. It also recorded expenses related to claims for injuries incurred after the change to self-insurance and recorded a liability through a charge to this expense category for the estimated cost of injuries that occurred prior to December 31, 2003. For 2004, the Company recognized the cost of the catastrophic coverage and recognized a reserve for an estimate of the cost of injuries that occurred in 2004, both reported and unreported. Based on lower claims experience in 2003 and early 2004, the reserve set aside in 2004 was lower than that expensed in 2003. Because of legislative changes, the workers’ compensation environment has improved and the Company was both able to provide for a lower reserve in 2005 and recapture a portion of the 2003 reserve.

Net Occupancy Expense

Increases in occupancy expense in 2004 over 2003 and 2005 over 2004 reflect the renewals of leases, office renovations, and increases in utilities as well as the impact of the additional occupancy expenses for the properties leased by PCCI and FBSLO. Note 26 describes an adjustment posted in the fourth quarter of 2004 to recognize the cumulative effect of rent escalation clauses on operating leases.

Equipment Rental, Depreciation, and Maintenance

Variations in the accounts included on this line of the consolidated income statements are due to the continuing need to upgrade computers and processing equipment, offset by lower maintenance cost on newer equipment.

Other Expense

The major components of other expense are shown in Note 22 to the Consolidated Financial Statements on page 121.

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Consultant Expense:  The increases from 2003 to 2004 and from 2004 to 2005 are due primarily to increases in auditing fees and fees incurred for assistance with implementing the Sarbanes-Oxley Act as well as for assistance with the Company’s conversion to its new core accounting and customer relationship management systems. While many of the costs associated with these projects are capitalized as either purchases of software or software development, some costs must be expensed as incurred. In subsequent years, the external and internal costs are expected to be less.

Software Expense:  Software expense has increased over the three year period shown in the table in Note 22. The Company has completed installation of its new core banking data processing and customer relationship management systems for most business units, and the amortization of the capitalized costs began in the third quarter of 2005. The remaining conversions of the branches and lending units of PCCI and FBSLO are expected to be completed in the second and third quarters of 2006. Expenses related to other software also increased because, similar to computers, which must be upgraded when maintenance becomes more expensive than replacement, there is a continuing need to upgrade software as vendors no longer support earlier versions.

Off-balance Sheet Contingency Loss:  As explained in Notes 1, 7, and 17, the Company must establish a contingency loss for known or estimated losses relating to letters of credit or other unfunded loan commitments. In 2003, the Company was notified by one of its customers that the customer did not expect to be able to meet its contractual obligations regarding debt payments. The Company had guaranteed the obligations by means of standby letters of credit. As of the end of 2002, the Company had established a contingency loss reserve of $1.8 million for these letters of credit. With the new information received in 2003, the Company assumed that the third parties would eventually draw the letters of credit and, believing that reimbursement by the customer was unlikely, the Company increased the contingency loss reserve by another $4.3 million up to the whole amount of the letters of credit. One of the two letters of credit was in fact drawn in 2003,and the other in 2004. Because of doubts about collectibility, the whole amount of the draws, $5.9 million, was written off when drawn.

OFF-BALANCE SHEET ARRANGEMENTS

The Company has entered into a number of transactions, agreements, or other contractual arrangements whereby it has obligations that must be settled by cash or contingent obligations that must be settled by cash in the event certain specified conditions occur. These “off-balance sheet arrangements” are described in Note 18 to the Consolidated Financial Statements and a table is provided showing the estimated extent and timing of the payments required.

The Company has also entered into off-balance sheet arrangements that provide benefit to it in the form of sources of liquidity. These arrangements and any events, trends, or uncertainties that could limit the availability of these sources are described in the section below titled “Liquidity.”

CAPITAL RESOURCES

As of December 31, 2005, under current regulatory definitions, the Company and PCBNA were “well-capitalized,” the highest of the five categories defined under the Federal Deposit Insurance Corporation Improvement Act (“FDICIA”).

Capital Adequacy Standards

The primary measure of capital adequacy for regulatory purposes is based on the ratio of total risk-based capital to risk-weighted assets. This method of measuring capital adequacy is meant to accomplish several objectives: 1) to establish capital requirements that are more sensitive to the differences in risk associated with various assets; 2) to explicitly take into account off-balance sheet exposure in assessing capital adequacy; and, 3) to minimize disincentives to holding liquid, low-risk assets. Risk-weighted assets include a portion of the nominal amount of off-balance sheet items based on the likelihood of them becoming funded or otherwise being recorded on-balance sheet.

The risk-based capital ratio is impacted by three factors: (1) the growth in assets compared to the growth in capital; (2) the relative size of the various asset categories; and (3) the composition of the

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securities and money market portfolios. If assets increase faster than capital, the ratios will decline. Because almost all loans are risk-weighted at 100% while most securities are risk-weighted as some percentage less than 100%, to the extent that loans increase as a proportion of total assets, the ratio will decline. Lastly, there are different risk-weightings within the securities and money market portfolios. As the proportion of securities or money market instruments with lower risk-weightings increase, the ratios will increase.

The Company, as a bank holding company, is required by the FRB to maintain a total risk-based capital to risk-weighted asset ratio of at least 8.0%. To be considered “well-capitalized”, the ratio must be at least 10%. At the end of 2005, the Company’s total risk-based capital to risk-weighted asset ratio was 11.3%. The Company also must maintain a Tier I capital to risk-weighted asset ratio of 6% and a Tier I capital to average assets of 5% to be considered well-capitalized. The actual ratios at December 31, 2005 for the Company were 8.0% and 6.6%, respectively. While the Company remained well-capitalized, the ratios decreased during 2005 because (1) the acquisition of FBSLO for cash only resulted in an increase in assets with no corresponding addition of capital, and (2) the strong growth in loans near the end of the year increased 100% risk-weighted assets with little earnings during the year to increase capital.

Based on average balances the Company has maintained equity to asset ratios of 8.08%, 7.59%, and 8.38% for the years ended December 31, 2005, 2004, and 2003, respectively.

The composition of Tier I and Tier II capital, the minimum levels established by the FRB, the minimum levels necessary to be considered well-capitalized by regulatory definition, and the Company’s ratios as of December 31, 2005 and 2004 are presented in Note 20 on page 118.

PCBNA is also required to maintain a total risk-based capital to risk-weighted asset ratio of 10.0% to be considered well-capitalized. PCBNA’s ratio at the end of 2005 was 11.18%. The Bank has issued a total of $121 million in subordinated debt. Each issue had a maturity of 10 years. While shown on the consolidated balance sheets as long-term debt, for the first half of their 10-year terms they are included as Tier II capital in the computation of the Total Capital to Risk-Weighted Asset ratio for both the Company and PCBNA. In the final five years their terms, one fifth of the balance will be excluded each year from Tier II capital in this computation. As of the end of 2005, all issues were still within the first five years of their term, but one of the issues will start to have its capital benefit reduced in 2006. The subordinated debt issued by the Bancorp was issued in connection with the issuance of trust preferred debt as described in Note 14. Though the subsidiary trusts are not consolidated with the Company—see “Consolidation of Variable Interest Entities”—the $39 million in trust preferred debt issued by them count as Tier 1 capital for the Company for their full term.

Share Repurchases

In prior years, the Company occasionally repurchased shares of its common stock to offset the increased number of shares issued as a result of the exercise of employee stock options. Shares were also repurchased as a means of managing capital levels. The purchases are generally conducted as open-market transactions. Occasionally the Company will purchase shares in private transactions as the result of unsolicited offers.

As mentioned in Note 19 on page 116, the Company purchased shares in 2003. No shares were repurchased in 2004 and 2005 other than fractional shares resulting from the stock split. At December 31, 2005, there was approximately $18.6 million remaining to purchase outstanding shares from the most recent repurchase program authorized by the Board of Directors.

Dividend Reinvestment Program

On August 24, 2005, the Company announced the introduction of a Dividend Reinvestment and Direct Stock Purchase Plan for shareholders of the Company’s common stock. The Plan enables current stockholders to automatically utilize the cash dividends paid on their common stock holdings to purchase additional shares of Pacific Capital Bancorp common stock. Shareholders can register to participate in the Plan by going to the Investor Relations section of the Company’s website. As of December 31, 2005, there were approximately 65 shareholders actively participating in the Plan. As more shareholders become aware of the Plan, we anticipate more shareholders will become participants in the program.

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Future Sources and Uses of Capital and Expected Ratios

Over the last five years, the Company’s assets have been increasing at a compound annual growth rate of 13.3%. To maintain its capital ratios, the Company must continue to increase capital at the same rate. Net income, the major source of capital growth for the Company, has been increasing at a compound annual growth rate of 14.0% over the same period of time, but this is reduced by dividends distributed to shareholders. The Company’s dividend payout ratio over the last three years has been 36.4% for 2005, 35.9% for 2004, and 36.5% for 2003. Though offset by some share repurchases, the retained earnings have resulted in capital increasing at a compound annual growth rate of 13.0%.

There are three primary considerations Management must keep in mind in managing capital levels and ratios. The first is that customers are attracted to the Company because of the relationship that is built with the customer, not the individual transaction. This requires the Company to be able to meet the credit needs of the borrower when they need to borrow. Therefore, it is essential that management maintain sufficient capital to avoid needing to alternate between being able to make loans and not able to make loans. If capital were not sufficient, the Company might not be able to lend.

The second consideration is that to maintain the ability to provide for those customers, the Company must be prepared to sell some of the loans it originates. This involves structuring loans to meet the purchase requirements of secondary markets, or charging an interest rate premium for those loans that cannot be sold. As mentioned above, the Company has sold loans both as a means of limiting the rate of asset increase and to test its ability to sell loans from different portfolios should more sales become necessary to manage capital.

The third consideration is that as loan demand picks up in an improving economy, raising additional capital is likely to be necessary. Because the capital ratios are primarily a regulatory issue, it is not always necessary for the Company to issue more common stock. There is generally less impact on the return on equity and on earnings per share by using other forms of regulatory capital like additional subordinated debt or trust preferred securities. Interest would need to be paid on this capital, but the current shareholders would not have their ownership diluted by additional shares. Management has had on-going discussions with investment bankers regarding the issuance of such capital as well as common stock and has been informed either form of capital could be issued with relative ease.

In addition to the capital generated from the operations of the Company, over the years a secondary source of capital growth has been the exercise of employee and director stock options. The extent of the growth from this source in any one year depends on a number of factors. These include the current stock price in relation to the price at the time options were granted and the number of options that would expire if not exercised during the year.

The net increase to capital from the exercise of options is lessened by the ability of option holders to pay the exercise price of options by trading shares of stock they already own, termed “swapping”. In 2005 the increase to capital from the exercise of options (net of shares surrendered as payment for exercises and taxes) was $7.5 million or 8.8% of the net growth in shareholders’ equity in the year. At December 31, 2005, there were approximately 1.1 million options outstanding and exercisable at less than the then-current market price of $35.61, with an average exercise price of $20.04. This represents a potential addition to capital of $22.0 million, if all options were exercised with cash. However, many options are likely to be exercised by swapping. Therefore, some amount less than the $22.0 million in new capital will result from the exercise of options. In addition, except for those options expiring in 2006, the options are likely to be exercised over a number of years.

The impact of the RAL program on the Company’s capital is discussed below.

Aside from the $18.6 million amount authorized for share repurchases and those commitments, there are no material commitments for capital expenditures or “off-balance sheet” financing arrangements as of the end of 2005. There is no specified period during which the share repurchases must be completed.

In any case, Management intends to take the actions necessary to ensure that the Company and the Bank will continue to exceed the capital ratios required for well-capitalized institutions.

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Impact of RAL Program on Capital Adequacy

Formal measurement of the capital ratios for the Company and PCBNA are done at each quarter-end. However, the Company does more frequent estimates of its capital classification during late January and early February of each year because of the large amount of RAL loans. Management estimates that, were it to do a formal computation, on certain days during those weeks it and PCBNA may be classified as adequately-capitalized, rather than well-capitalized. The Company has discussed this with its regulators. Payments are received from the IRS each Friday during the RAL season and generally the Company and PCBNA move back into the well-capitalized classification with each payment.

In Note 11 is a description of the securitization that the Company utilizes as one of its funding sources for funding RALs. This securitization is a sale of some of the RALs to other financial institutions, and except for the capital that must be allocated for the small retained interest kept by the Company, it eliminates their impact on the capital ratios for the Company.

LEGISLATION AND REGULATION

The Company is strongly impacted by legislation and regulation. The Company and its subsidiaries may engage only in lines of business that have been approved by their respective regulators, and cannot open, close, or relocate offices without their approval. Disclosure of the terms and conditions of loans made to customers and deposits accepted from customers are both heavily regulated as to content. Among the important banking legislation are the Federal Deposit Insurance Corporation Improvement Act (“FDICIA”), the Community Reinvestment Act (“CRA”), and the Gramm-Leach-Bliley Act (“GLBA”).

FDICIA specified capitalization standards, required stringent outside audit rules, and established stricter internal controls. There were also requirements to ensure that the Audit Committee of the Board of Directors is independent.

PCBNA is required by the provisions of CRA to make significant efforts to ensure that access to banking services is available to every segment of the community. It is also required to comply with the provision of various other consumer legislation and regulations.

The provisions of GLBA have been phased in over the last several years. These provisions permit banking organizations to enter into areas of business from which they were previously restricted. Similarly, other kinds of financial organizations are permitted to conduct business provided by banks. The act also imposed new restrictions on the sharing of customer information with other entities. The Company has responded to these new restrictions.

The Company and PCBNA must file periodic reports with the various regulators to keep them informed of their financial condition and operations as well as their compliance with all the various regulations.

Two regulatory agencies—the FRB for the Company and the OCC for PCBNA—conduct periodic examinations of the Company and the Bank to verify that their reporting is accurate and to ascertain that they are in compliance with regulations.

A banking agency may take action against a bank holding company or a bank should it find that the financial institution has failed to maintain adequate capital. This action has usually taken the form of restrictions on the payment of dividends to shareholders, requirements to obtain more capital from investors, and restrictions on operations. The FDIC may also take action against a bank that is not acting in a safe and sound manner. Given the strong capital position and performance of the Company and the banks, Management does not expect to be impacted by these types of restrictions in the foreseeable future.

There are legal limitations on the ability PCBNA to declare dividends to the Bancorp as disclosed in Note 20.

In 2002, the Sarbanes-Oxley Act was enacted as Federal legislation. This legislation imposes a number of new requirements on financial reporting and corporate governance on all corporations.

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Among the new requirements is the inclusion in the Company’s Annual Report of a report by Management on the Company’s internal controls over financial reporting and the safeguarding of assets. The report must be evaluated by the Company’s independent registered public accounting firm. The Company has documented these internal controls, evaluated their effectiveness, and conducted testing to determine if they are functioning as intended. The Company has also responded to all of the other new requirements.

While financial institutions have long been required by regulation to report large cash transactions to assist in preventing money laundering activities, the USA Patriot Act of 2001 and subsequent implementing regulations have imposed significant additional reporting requirements to limit the access to funds by terrorists. The Company, along with all other financial institutions, must not only report cash transactions above a certain threshold, it must now report activities deemed by the banking regulators to be “suspicious.” To comply with this new level of reporting requirement, the Company has installed new “rule-based” software to detect suspicious activity. The Company has also implemented enhanced customer identification procedures as well as processes for detecting and reporting suspicious activity. It has provided new training for its employees in how to confirm whether the suspicious activity detected is in fact questionable or whether it represents the normal business activity for the specific customer.

IMPACT OF INFLATION

Inflation has been minimal for a number of years and has had little or no adverse impact on the financial condition and results of operations of the Company during the periods discussed here.

LIQUIDITY

Liquidity is the ability to raise funds on a timely basis at an acceptable cost in order to meet cash needs. Adequate liquidity is necessary to handle fluctuations in deposit levels, to provide for customers’ credit needs, and to take advantage of investment opportunities as they are presented in the market place.

The Company’s objective is to ensure adequate liquidity at all times by maintaining liquid assets, by being able to raise deposits and liabilities, and by having access to funds via capital markets. Having too little liquidity can result in difficulties in meeting commitments and lost opportunities. Having too much liquidity can result in less income because liquid assets usually do not earn as high an interest rate as less liquid assets, and interest expense paid on unnecessarily borrowed funds reduces profitability.

As indicated in the Consolidated Statements of Cash Flows principal sources of cash for the Company have included proceeds from the maturity or sale of securities, and the growth in deposits and other borrowings. The principal uses of cash have included increases in loans to customers and the purchase of securities. The use of cash for the purchase of securities was particularly high in 2003 due to the leveraging strategy described above on page 33. It is important to note that the purchase of securities is largely discretionary and the Company could reduce this use of cash if loan demand were to increase substantially.

To manage the Company’s liquidity properly, however, it is not enough to merely have large cash inflows; they must be timed to coincide with anticipated cash outflows. Also, the available cash on hand or cash equivalents must be sufficient to meet the exceptional demands that can be expected from time to time relating to natural catastrophes such as flood, earthquakes, and fire.

The Company manages the adequacy of its liquidity by monitoring and managing its immediate liquidity, intermediate liquidity, and long term liquidity.

Immediate liquidity is the ability to raise funds today to meet today’s cash obligations. Sources of immediate liquidity include cash on hand, the prior day’s Federal funds sold position, unused Federal funds and repurchase agreement lines and facilities extended by other banks and major brokers to the Company, access to the FHLB for short-term advances, and access to the FRB’s Discount Window. The Company has established a target amount for sources of available immediate liquidity. This amount is increased during certain periods to accommodate any liquidity risks of special programs like RALs.

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At various times strong loan demand outpaces deposit growth. At these times, the Company draws down any excess funds invested in overnight money market instruments or uses overnight borrowings to maintain immediate liquidity. The rate paid on these borrowings is more than would be paid for transaction (NOW & MMDA) deposits, but aside from this, there have been no adverse consequences from relying more on borrowing ability than on holding liquid assets in excess of the immediate amounts needed. The Company’s strong capital position and earnings prospects have meant that these sources of borrowing have been readily available.

The Company has access to uncommitted lines at a variety of other financial institutions for overnight Federal funds purchases, each of which is used or tested at least annually.

Intermediate liquidity is the ability to raise funds during the next few months to meet cash obligations over those next few months. Sources of intermediate liquidity include maturities or sales of commercial paper and securities, term repurchase agreements, and term advances from the FHLB. The Company monitors the cash flow needs of the next few months and determines that the sources are adequate to provide for these cash needs.

PCBNA issues brokered CDs utilizing several brokers as a funding component for the RAL program and for interest rate risk management. PCBNA also used brokered CDs in late 2003 to provide the funds for the PCCI acquisition. PCBNA must be well-capitalized in order to issue brokered CDs.

Long-term liquidity is the ability to raise funds over the entire planning horizon to meet cash needs anticipated due to strategic balance sheet changes. Long-term liquidity sources include: initiating special programs to increase core deposits in expanded market areas; reducing the size of securities portfolios; taking long-term advances from the FHLB; securitizing loans; and accessing capital markets for the issuance of debt or equity. The fixed-rate advances the Company borrowed from the FHLB to fund the purchase of securities under the leveraging strategy, described on page 33, is an example of coordinating a source of long-term liquidity with asset/liability management.

For the Company, the most significant challenge relating to liquidity management is providing sufficient liquidity to fund the large amount of RALs in late January and early February of each year. As discussed in the “Funding and Liquidity Issues” sub-section of the RAL section of this discussion above, the following considerations are kept in mind in providing the needed liquidity:

· using a large number of other institutions so as to not become overly reliant on a particular source;

· using a mixture of committed and uncommitted lines so as to assure a minimum amount of funding in the event of tight liquidity in the markets; and

· arranging for at least a third more funding than it is anticipated will be needed.

The securitization of RAL loans assists in the management of the Company’s capital position during the RAL season by selling them to investor participants in the securitization. In addition, it represents a significant source of liquidity as the proceeds from the sales of the loans are lent out to new RAL customers.

Banks’ largest sources and uses of operating liquidity arise from activities that are not defined as operating activities in the required format of the statement of cash flows, e.g. from deposits and loans. Therefore, looking at the cash flow statement of a bank is not of as much assistance nor is it evaluated the same way as for a commercial business. More emphasis must be placed on the investing and financing sections of the statement in assessing liquidity.

For the three years reported in the consolidated statements of cash flows, the Company has shown ample ability to maintain a significant amount of asset liquidity through financing activities at the same time as it increased its investing in loans, securities, and fixed assets.

In early 2004, the Company entered into a long term lease for some real property that includes one of its branches. To ensure the continued availability of this branch site, it was necessary to lease the larger parcel. The space not currently used by the Company is now leased to other commercial enterprises. These leases will continue for a variety of terms. The Company does not anticipate problems in maintaining tenants in these spaces because the property is in a high-traffic commercial area. The signing of this lease added approximately $46 million in contractual obligations. These

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obligations are split between non-cancelable leases for the operating lease portion for the land and capital leases for the buildings in the first Table in Note 18. However, with the offsetting rents received from subtenants, the Company does not expect that net liquidity demands will be any larger than they would have been if the current individual lease arrangement could have been maintained.

The senior debt issued by Bancorp in 2001 matures in 2006. The Company plans to refinance this note. It has had conversations with a number of investment banking firms all of whom have indicated that new debt would be well received in the market. Management is considering refinancing these notes with debt that would qualify as regulatory capital to provide for future asset growth.

INCOME TAX EXPENSE

Income tax expense is the sum of two components: the current tax expense or provision and the deferred tax expense or provision. Current tax expense is the result of applying the current tax rate to taxable income.

The deferred tax provision is intended to account for the fact that income on which the Company pays taxes with its returns differs from pre-tax income in the accompanying Consolidated Statements of Income. Some items of income and expense are recognized in different years for income tax purposes than in the financial statements. For example, the Company is only permitted to deduct from Federal taxable income actual net loan charge-offs, irrespective of the amount of provision for credit loss (bad debt expense) recognized in its financial statements. This causes what is termed a temporary difference. Eventually, as loans are charged-off, the Company will be able to deduct for tax purposes what has already been recognized as an expense in the financial statements. Another example is the accretion of discount on certain securities. Accretion is the recognition as interest income of the excess of the par value of a security over its cost at the time of purchase. For its financial statements, the Company recognizes income as the discount related to these securities is accreted. For its tax return, however, the Company can defer the recognition of that income until the cash is received at the maturity of the security. The first example causes a deferred tax asset to be created because the Company has recognized as an expense for its current financial statements an item that it will be able to deduct from its taxable income in a future year’s tax return. The second example causes a deferred tax liability, because the Company has been able to delay until a subsequent year the paying of tax on an item of current year financial statement income.

There are some items of income and expense that create permanent differences. Examples of permanent differences would include:

· tax-exempt income from municipal securities that is recognized as interest income for the financial statements but never included in taxable income; and

· a portion of meal and entertainment expense that is recognized as an expense for the financial statements, but never deductible in computing taxable income.

The significant items of income and expense that create permanent differences are disclosed in the second table of Note 16 as amounts that cause a difference between the statutory Federal tax rate of 35% and the effective tax rate. The effective tax rate is the amount of the combined current and deferred tax expense divided by the Company’s income before taxes as reported in the Consolidated Statements of Income.

The amount of the deferred tax assets and liabilities are calculated by multiplying the temporary differences by the current tax rate. The Company measures all of its deferred tax assets and liabilities at the end of each year. The difference between the net asset or liability at the beginning of the year and the end of the year is the deferred tax provision for the year.

Most of the Company’s temporary differences involve recognizing substantially more expenses in its financial statements than it has been allowed to deduct for taxes in the return for the year. This results in a net deferred tax asset. Deferred tax assets are dependent for realization on past taxes paid, against which they may be carried back, or on future taxable income, against which they may be offset. If there were a question about the Company’s ability to realize the benefit from the asset, then it would have to record a valuation allowance against the asset to reflect the uncertainty. Given the amount and nature of the Company’s deferred assets, the past taxes paid, and the likelihood of future taxable income, realization is assured for the full amount of the net deferred tax asset and no valuation allowance is needed.

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The amounts of the current expense and deferred benefit, the amounts of the various deferred tax assets and liabilities, and the tax effect of the principal temporary differences between taxable income and pre-tax financial statement income are shown in Note 16.

Included in the reconciliation table is an item for state taxes. In addition to the 35% Federal income tax included in tax expense, the Company pays a California franchise tax. This tax is equivalent to a tax on the Company’s income. While the franchise tax rate is almost 11%, the Company may deduct its state franchise tax from its Federal taxable income. This reduces the effective tax rate for the state tax by 35%.

There are a number of differences between the Federal and state rules in the tax treatment of certain items of income and expense. The primary one is that income from municipal securities exempt from Federal income tax are not exempt from the California franchise tax.

The effective tax rate has increased from 35.9% in 2003 to 37.3% in 2005 as the Company’s tax exempt income has not increased the same rate as its taxable income. For example, very few of PCCI’s or FBSLO’s securities were tax exempt. These acquisitions added taxable income with no corresponding increase in tax exempt income.

COMMON STOCK AND DIVIDENDS

Stock prices and cash dividends declared for the last eight quarters are shown on page 8. The Company’s stock is listed on the Nasdaq National Market System. The trading symbol is PCBC. Stock prices represent trading activity through the Nasdaq National Market System.

For the years 2005, 2004, and 2003, the Company has declared cash dividends which were 36.4%, 35.9%, and 36.5%, respectively, of its net income. The Company’s policy is to pay dividends of approximately 35%-40% of net income. The most recent information for the Company’s peers shows an average payout ratio of 28.6%. The Board of Directors periodically increases the per share dividend rate in acknowledgment that earnings have been increasing by a sufficient amount to ensure adequate capital and also provide a higher return to shareholders. The most recent increase was declared in the first quarter of 2006, raising the quarterly dividend rate to $0.22 per share.

MERGERS AND ACQUISITIONS

On March 5, 2004, the Company completed its acquisition of Pacific Crest Capital, Inc. (PCCI) in an all cash transaction valued at $135.8 million, or $26 per each diluted share of Pacific Crest Capital common stock. The assets and liabilities acquired and the goodwill recognized are disclosed in Note 2.

On August 1, 2005, the Company completed its acquisition of First Bancshares, Inc. (FBSLO) in an all cash transaction valued at $60.8 million, or $48 per each diluted share of FBSLO stock. The assets and liabilities acquired and the goodwill recognized are disclosed in Note 2.

TAX REFUND ANTICIPATION LOAN AND REFUND TRANSFER PROGRAMS

As indicated in the overall summary at the beginning of this discussion, part of the upward trend in earnings is attributable to the RAL and RT programs. The Company is one of three financial institutions which together provide over 90% of these products on a national basis. Management estimates that the Company has a market share in excess of 30%. The Company provides these services to taxpayers that file their returns electronically. RALs are a loan product; RTs are strictly an electronic transfer service.

Description of the RAL and RT Products

For the RAL product, a taxpayer typically requests a loan from the Company through a tax preparer, with the anticipated tax refund as the source of repayment. The Company subjects the application to an automated credit review process. If the application passes this review, the Company advances to the taxpayer the amount of the refund due on the taxpayer’s return up to specified amounts based on certain criteria less the loan fee due to the Company and, if requested by the taxpayer, the fees due for preparation of the return. Each taxpayer signs an agreement permitting the Internal Revenue

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Service (the “IRS”) to send their refund directly to the Company instead of to the taxpayer. The refund received from the IRS is used by the Company to pay off the loan. Any amount due the taxpayer above the amount of the RAL is then sent by the Company to the taxpayer. The fee is withheld by the Company from the advance, but the fee is recognized as income only after the loan is collected from the IRS payment. The fee varies based on the amount of the loan. However, unlike interest earned on most loans, it does not vary with the length of time the loan is outstanding. Nonetheless, because the taxpayer must sign a loan document, the advance on the refund is considered a loan and the fee is classified as interest income.

Generally, interest income earned on loans is a function of the outstanding balance multiplied by the rate specified in the loan agreement multiplied by the period of time the loan is outstanding. For RALs, however, the interest income is unrelated to the length of time the loan is outstanding and there is no explicit interest rate. The flat fee charged is instead simply recognized as income when the loan is collected from the IRS. No late fees are charged to customers whose loans are not paid within the expected time.

While the loan application form is completed by the taxpayer in the tax preparer’s office, the credit criteria is set by the Company and the underwriting decision is made by the Company. The Company closely monitors and, in many cases, does not lend on those returns where Earned Income Tax Credit (“EIC”) represents an overly large portion of the refund. This is because the IRS closely scrutinizes returns where a major portion of the refund is based on a claim for EIC and the Company has found that there is a higher denial rate by the IRS of these refund claims.

Many taxpayers not qualifying for loans or not desiring to pay the loan fee still choose to receive their refunds more quickly by having the refund sent electronically by the IRS to the Company. The Company then prepares a check or authorizes the tax preparer to issue a check to the taxpayer. This service is termed a refund transfer. There is no credit risk associated with the RT product and there is no cost of borrowing for the Company for RTs because funds are not sent to the customer until received by the Company from the IRS.

Many of the customers for these products do not have bank accounts into which they could have the IRS directly deposit their refund and do not have a safe or permanent mailing address at which to receive a check. These products provide not only quick access to funds, but also a safe delivery method in the form of hand delivery by the tax preparer to the taxpayer.

Many of the customers also do not feel comfortable preparing their own tax returns but do not have the cash available to pay for the preparation. These products provide a means for payment of the preparation fee by withholding it from the remittance.

The following table shows fees by product for the last three years and the percentage of growth:

TABLE 16A—RAL and RT Fees

(dollars in millions)		RAL Income			RT Fees			Pre-tax Income
2003	$	31.9		$	19.8		$	40.4
$ change	$	4.6		$	1.3		$	5.1
% change		14.5	%		6.6	%		12.6	%
2004	$	36.5		$	21.1		$	45.5
$ change	$	28.2		$	3.9		$	16.8
% change		77.2	%		18.4	%		36.9	%
2005	$	64.7		$	25.0		$	62.3

RAL Credit Losses

The IRS may reject or partially disallow the refund. The tax preparers participating in the program are located across the country and few of the taxpayers have any customer relationships with the Company other than their RAL. Many taxpayers make use of the service because they do not have a permanent and/or safe mailing address at which to receive their refund. Therefore, if a problem occurs with the return, collection efforts may be less effective than with local customers.

The Company has taken several steps to minimize losses from these loans. Preparers are screened before they are allowed to submit their electronic filings; procedures have been defined for the

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preparers to follow to ensure that the agreement signed by the taxpayer is a valid loan; and the preparers’ IRS reject rates are monitored very carefully. If a preparer’s rejects are above normal, he or she may be dropped from the program. If rejects are below expectations, the preparer may be paid an incentive fee.

In accordance with the loan application signed by the taxpayer, if the taxpayer applies for a loan the following year, the unpaid proceeds from the prior year are deducted from the current year’s loan proceeds. In addition, the Company has entered into cooperative collection agreements with the other banks with RAL programs. Under those agreements, if a taxpayer owing money to one bank from a prior year applies for a loan from another bank, the second bank repays the delinquent amount to the first bank before remitting the refund to the taxpayer. As shown in Table 9B, in some years these steps result in a relatively high rate of recovery on the prior year’s losses, but net losses nonetheless remain higher than for other loans.

Total net RAL charge-offs in 2005 were $38.2 million compared to $8.5 million in 2004 and $8.5 million in 2003. There are two reasons for the increase. The first is the growth in the program. The second is the change in one of the Company’s contracts described below in the section titled “Summary of Operating Results” on page 64.

RAL/RT Product Mix and Impact on Pre-tax Income

The product mix has remained relatively the same over the period 2003 through 2005—approximately 30% RALs and 70% RTs. The fees for the RAL product are higher because there are funding and credit costs that must be covered in addition to the processing costs that are the only costs for the RT product. The Company anticipates that the total number of products sold will continue to grow as more taxpayers file their returns electronically. It is also expected that more of the increase will be in the RT product, because the self-prepared returns are more common in the RT product and self-prepared returns are the faster growing segment of the market. It appears that the preparer segment may be approaching saturation. This would suggest that revenues and pre-tax profitability will not increase at the same rate as the numerical volume.

Funding and Liquidity Issues

While RTs are strictly a processing business—the Company simply remits the refund to the taxpayer after it has received it from the IRS—RALs present the Company with some special funding or liquidity needs. Funds are needed for RAL lending only for the very short period of time that RAL loans are made. The season starts in the middle of January and continues into April, but even within that time frame, RAL originations are highly concentrated in the last week of January and first two weeks of February. The first issue then is that the Company must arrange for a significant amount of very short-term borrowings. A portion of the need can be met by borrowing overnight from other financial institutions through the use of Federal funds purchased (unsecured) and repurchase agreements (borrowings collateralized by securities or loans). These two sources match the short-term nature of the RALs and therefore are an efficient source of funding. However, they are not sufficient to meet the total need for funds, and other sources like some term advances from the FHLB and brokered deposits must be used that are more expensive and less efficient.

The IRS pays refunds to the Company each Friday. This frequently results in such a large amount of cash that the Company is able to pay back all of its overnight borrowing from the day before and still have an excess of cash that must be invested. Multi-day sources of funding like the FHLB advances and brokered deposits are less efficient because they involve borrowing on those days when the Company has the excess funds.

As mentioned in Note 11, the Company has also securitized some of the RALs. As explained below, this accounting has the effect of reclassifying interest income, interest expense, and provision expense related to the sold loans and recognizing the net amount as a gain on sale of loans.

Management is expecting that total volume of transactions will be higher in 2006 than in 2005 as the number of taxpayers filing their returns electronically increases. This has required the Company to add additional funding arrangements to the mix for 2006, but they are of the same types as used in prior years. The Company has arranged a slightly larger securitization for 2006 and has arranged for increases in its overnight credit lines issued by other financial institutions a larger proportion of the more efficient overnight funds.

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All of the direct costs of the funding are charged to the program in the segment results shown in Note 25 on page 123, but some of the costs, specifically the opportunity cost of holding more liquid and therefore more easily pledged securities, are too difficult to allocate.

RAL Average and Period-end Balances

The balances of RALs outstanding during each tax-filing season are included in the average balance for consumer loans shown in Table 2 on pages 22 and 23, but there are no such loans included in the Consolidated Balance Sheets as of December 31, 2005 and 2004, because all loans not collected from the IRS by the end of each year are charged-off.

Litigation and Regulatory Risk

Several suits have been filed against the Company relating to the RAL and RT programs. The three that are currently in litigation are disclosed in Note 18 starting on page 114.

The Company is also aware that RALs are in disfavor among consumer advocacy groups for a variety of reasons. Among these reasons are claims that (1) customers are not adequately advised that a RAL is indeed a loan product, (2) that alternative, less expensive means of obtaining the proceeds from their refund such as RTs are available, and (3) that the interest rates, specifically the annualized percentage rates (“APR”), are too high.

Management has reviewed its loan documents with compliance counsel to ensure that the disclosure is complete and fair as to these claims. Its ratio of RTs to RALs—two-thirds to one third—suggests that alternatives are in fact explained. The APR on RALs is high because of the short time on average that they are outstanding. However, the funding, processing, and credit costs also need to be recovered over that very short period of time and computed as an APR, they too are high (Note N).

The Company has reviewed its RAL program in the context of the OCC’s guidelines as to what it holds to be “predatory lending practices,” and is confident that its practices are not predatory.

Classification of RAL and RT Fees and the Effect of Securitization Accounting

Generally, the fees earned on the RALs are included in the accompanying Consolidated Income Statements for 2005, 2004 and 2003 within interest and fees on loans. The fees earned on the RTs are reported as a separate item within noninterest revenue.

The securitization changes how some of the income and expenses with the program are accounted for. All of the cash flows associated with the RALs sold to the Company’s securitization partners are reported net as a gain on sale of loans. This gain is reported in a separate noninterest revenue line on the Consolidated Statements of Income. Based on the availability of other, cheaper sources of funds relative to the expected growth in the amount of funding needed, the amount of loans securitized each year varies significantly. This means that the cash flows and, therefore, the net gains associated with the sold RALs have also varied significantly. This does not mean that the securitization activity was more or less profitable, only that more or less loans were funded by means of the securitization. In 2005, because of the change in the contract described above, both the revenue and the losses for the loans originated by that firm that were sold into the securitization were higher than in previous years.

(dollars in thousands)	Twelve Months Ended December 31,
		2005			2004			2003
RAL fees	$	39,310		$	5,920		$	12,472
Fees paid to investor		(1,082	)		(162	)		(612	)
Commitment fees paid		(1,250	)		(678	)		(800	)
Credit losses		(10,955	)		(2,135	)		(3,029	)
Net gain on sale of RAL loans	$	26,023		$	2,945		$	8,031

The gain on the securitization was much larger in 2005 than in 2004 for the following reasons: First, the capacity of the securitization in 2005 was twice the size of 2004, $1.0 billion versus $500 million. Second, in 2004, the Company sold $491 million into the securitization and then paid off the securitization as the underlying loans were paid. In 2005, as payments were received, new

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loans were sold into the securitization, resulting in $1.5 billion in loans being sold. Lastly, the change discussed below in the Company’s contract with one of the tax preparation firms that markets its products, Jackson Hewitt Tax Services (JHTS), meant that the fees on JHTS loans sold into the securitization in 2005 were substantially greater than the fees on JHTS loans sold in 2004.

As noted in various sections of this discussion, this accounting had the effect of causing substantial differences between some items of income and expense for 2005, 2004, and 2003 despite there being no substantive differences in the economics or profitability between the years. In other words, a year with a large gain occurring because more loans were sold is not necessarily more profitable than a year with less gains but more interest income. Therefore, the Company measures the performance of the segment without respect to the sale of loans, instead treating the securitization for internal profitability reporting as if it were a secured borrowing.

To assist the reader in understanding how Management compares the profitability of one year to the last, the following pro forma table compares selected items of income and expense for the Company as if the securitization had not taken place, i.e. as if the Company had borrowed the funds from the securitization participants instead of selling the loans to them. It should be noted that there is no difference in the figures in the table below for income before taxes and the comparable figure for income before taxes in the Consolidated Statements of Income. Because all cash flows related to the securitization each year are completed during the first quarter, securitization accounting has the effect simply of moving items from one category of the income statement to another. The securitization does not have the effect of moving income or expense from one period to another. This pro forma table is not intended to be a presentation in accordance with GAAP.

TABLE 16B—RAL Securitization Proforma

(in thousands)	Years Ended December 31,
		In accordance with GAAP 2005		Pro Forma Amounts 2005		In accordance with GAAP 2004		Pro Forma Amounts 2004		In accordance with GAAP 2003		Pro Forma Amounts 2003
Interest income from loans	$	365,953	$	405,263	$	264,900	$	270,820	$	226,413	$	238,885
Interest expense on other borrowed funds	$	32,769	$	35,101	$	25,480	$	26,320	$	17,029	$	18,441
Net interest income	$	314,652	$	351,630	$	256,970	$	262,050	$	218,256	$	229,316
Provision for credit losses	$	53,873	$	64,828	$	12,809	$	14,944	$	18,286	$	21,315
Net gain on sale of tax refund loans	$	26,023	$	—	$	2,945	$	—	$	8,031	$	—
Income before income taxes	$	158,297	$	158,297	$	139,890	$	139,890	$	118,013	$	118,013

	Years Ended December 31,
(in thousands)		Pro Forma Adjustments 2005		Pro Forma Adjustments 2004		Pro Forma Adjustments 2003
Interest income from loans	$	39,310	$	5,920	$	12,472
Interest expense on other borrowed funds	$	2,332	$	840	$	1,412
Provision for credit losses	$	10,955	$	2,135	$	3,029

The top portion of the table above shows amounts reported by the Company in its Consolidated Statements of Income and pro forma amounts showing the effect of treating the securitization as a borrowing arrangement. The bottom portion of the table discloses the pro forma adjustments used in preparing the pro forma amounts.

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Summary of Operating Results

The following table summarizes operating results for the RAL and RT programs for the three years ended December 31, 2005, 2004, and 2003.

TABLE 16C—Operating Results for the RAL and RT Programs

(dollars in thousands)	Years Ended December 31,
		2005			2004			2003
Interest income from RALs	$	64,747		$	36,674		$	31,984
Interest expense on funding		(3,107	)		(1,119	)		(814	)
Intersegment revenues		7,020			4,704			1,824
Internal charge for funds		(2,929	)		—			(2,684	)
Net interest income		65,731			40,259			30,310
Provision for credit losses—RALs		(38,210	)		(8,468	)		(8,530	)
Refund transfer fees		24,982			21,049			19,841
Collection Fees		5,573			4,737			4,210
Gain on sale of loans		26,023			2,945			8,031
Other income		578			136			51
Operating expense		(18,345	)		(15,110	)		(13,473	)
Income before taxes	$	66,332		$	45,548		$	40,440
Charge-offs	$	48,955		$	12,511		$	13,712
Recoveries		(10,745	)		(4,043	)		(5,182	)
Net charge-offs	$	38,210		$	8,468		$	8,530

The most obvious differences between the operating results for 2005 versus 2004 and 2003 are the large increases in RAL interest income, provision expense, and the gain on sale of loans. The Company experienced a 10% increase in volume of RALs and RTs originated during 2005 compared to 2004. However, the primary reason for these changes relates to to a change in the contract between the Company and one of the tax preparer groups that is a major source of RALs. In May 2004 the Company and JHTS renegotiated their contract. In prior years, JHTS (and its predecessor) was responsible for the first two and a half percent of total credit losses on the loans originated through JHTS. If losses in excess of that amount occurred, they would be shared by the Company and JHTS. With JHTS assuming the credit risk, JHTS received most of the fee paid by the customer for the RAL. Under the terms of the new contract, the Company assumes virtually all of the credit risk and retains most of the RAL fee. This accounts for most of the increase in revenues above the 10% growth in volume. Whereas in prior years the provision expense related only to the loans made through preparers other than JHTS, in 2005 the Company had to provide for losses on approximately 933,000 loans originated through JHTS. This accounts for the substantial increase in provision expense. As noted in the above section titled “Accounting for the RAL Securitization,” the change in the contract also impacted the gain on sale. The increase in the loan fees increased the gain, while the assumption of the losses on JHTS loans resulted in more credit exposure for loans securitized-in previous years there were no credit losses on the JHTS loans sold.

Collection fees in Table 16C relate include two components. The first is the collection fees paid to the Company by other financial institutions for delinquent amounts collected for them under the cooperative collection agreement mentioned above. The second is a portion of the delinquent loan balances from prior years collected for JHTS by the Company. Because of the change in the contract with JHTS, collection fees will be less in future years. The Company will be collecting for itself rather than for JHTS and consequently the loans collected will be counted as recoveries rather than a portion of them being retained as collection fees.

The four tables below show the balances and amounts of interest income and expense that are excluded in computing the without RAL or without RAL/RT amounts and ratios disclosed in various sections of Management’s Discussion and Analysis. These pro forma tables are not intended to be presentations in accordance with GAAP.

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TABLE 16D—RAL Amounts Used in Computation of Net

Interest Margin and Other Ratios Exclusive of RALs

	Years Ended December 31,
(dollars in thousands)	2005						2004
		Consolidated		RAL/RT		Excluding RAL/RT		Consolidated		RAL/RT		Excluding RAL/RT
Average consumer loans	$	697,673	$	73,940	$	623,733	$	565,142	$	102,769	$	462,373
Average loans		4,437,845		73,940		4,363,905		3,804,869		102,769		3,702,100
Average total assets		6,405,547		86,978		6,318,569		5,707,971		392,547		5,315,424
Average earning assets		5,886,201		107,421		5,778,780		5,299,914		185,658		5,114,256
Average certificates of deposit		1,615,945		12,452		1,603,493		1,447,208		11,718		1,435,490
Average interest bearing liabilities		4,744,130		135,311		4,608,819		4,188,768		225,992		3,962,776
Average equity		517,583		87,276		430,307		433,268		65,049		368,219
Consumer loans interest income		108,167		64,747		43,420		68,165		36,540		31,625
Loan interest income		365,953		64,747		301,206		264,900		36,540		228,360
Interest income		426,157		64,747		361,410		326,181		36,673		289,508
Interest expense		111,505		3,107		108,398		69,211		1,118		68,093

	2003
		Consolidated		RAL/RT		Excluding RAL/RT
Average consumer loans	$	523,033	$	121,659	$	401,374
Average loans		3,151,328		121,659		3,029,669
Average total assets		4,645,654		139,794		4,505,860
Average earning assets		4,326,896		121,659		4,205,237
Average certificates of deposit		2,831,358		11,604		2,819,754
Average interest bearing liabilities		3,267,652		11,604		3,256,048
Average equity		389,269		49,815		339,454
Consumer loans interest income		61,749		31,712		30,037
Loan interest income		226,413		31,712		194,701
Interest income		272,189		31,984		240,205
Interest expense		53,933		814		53,119

*The Company does not keep separate equity accounts for the RAL/RT segment. The equity amount disclosed in this Table is computed by adding all pretax income for the segment, applying a statutory tax rate as there are no tax-advantaged assets in the program, and applying an assumed dividend payout ratio of 37.5%. As indicated in Note 25, no attempt is made to allocate indirect overhead.

TABLE 16E—Calculation of Ratios of Net Charge-offs Including and Excluding RALs

(dollars in thousands)		2005			2004			2003			2002			2001
Total Including RALs
Net charge-offs	$	53,935		$	13,525		$	22,557		$	14,778		$	12,924
Average loans	$	4,437,845		$	3,804,869		$	3,151,328		$	2,942,082		$	2,678,225
Ratio		1.22	%		0.36	%		0.72	%		0.50	%		0.48	%
Total Excluding RALs
Net charge-offs	$	15,725		$	5,057		$	14,027		$	12,673		$	8,730
Average loans	$	4,363,905		$	3,702,100		$	3,029,669		$	2,874,091		$	2,619,325
Ratio		0.36	%		0.14	%		0.46	%		0.44	%		0.33	%

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TABLE 16F—Reconciliation of Other Amounts With and Without RAL/RT Amounts

	Years Ended December 31,
(dollars in thousands)	2005						2004
		Consolidated		RAL/RT		Excluding RAL/RT		Consolidated		RAL/RT		Excluding RAL/RT
Noninterest revenue	$	111,923	$	57,156	$	54,767	$	75,635	$	28,867	$	46,768
Operating expense		214,405		18,345		196,060		179,906		15,110		164,796
Provision for credit losses		53,873		38,210		15,663		12,809		8,468		4,341
Income before income taxes		158,297		62,241		96,056		139,890		40,844		99,046
Provision for income taxes		59,012		26,182		32,830		51,946		17,175		34,771
Net Income		99,285		36,059		63,226		87,944		23,669		64,275

	2003
		Consolidated		RAL/RT		Excluding RAL/RT
Noninterest revenue	$	80,281	$	32,133	$	48,148
Operating expense		162,238		13,473		148,765
Provision for credit losses		18,286		8,530		9,756
Income before income taxes		118,013		41,300		76,713
Provision for income taxes		42,342		17,367		24,975
Net Income		75,671		23,933		51,738

TABLE 16G—Ratios Including and Excluding RAL/RT Programs

	Years Ended December 31,
	2005				2004				2003
	Consolidated		Excluding RALs		Consolidated		Excluding RALs		Consolidated		Excluding RALs
Return on average assets	1.55	%	1.00	%	1.54	%	1.21	%	1.63	%	1.15	%
Return on average equity	19.18	%	14.69	%	20.30	%	17.46	%	19.44	%	15.24	%
Operating efficiency	49.48	%	62.34	%	52.76	%	59.59	%	53.53	%	62.04	%
Net interest margin	5.45	%	4.48	%	4.97	%	4.45	%	5.20	%	4.61	%

Expectations for 2006 and Subsequent Years

The Company has estimated that it expects the number of RAL and RT transactions will increase by 8% in 2006 above the 2005 volume. No significant changes in net operating results like the change to the JHTS contract are expected for 2006. However, the Company and JHTS again renegotiated their agreements for the 2006 season. Rather than paying JHTS a portion of the RAL or RT fee from each transaction, the Company will pay JHTS fixed fees for the marketing and technology services fees for those provided by JHTS to the Company. The Company does not expect any material financial impact from this change in the fee structure. The renegotiated agreements also provide for a lowering of the proportion of JHTS transactions that will be handled by the Company. The Company expects that growth in transactions from other sources as well as growth in the number of total transactions originated by JHTS will offset the reduction in revenues from the lower proportion of transactions.

More generally, the Company also expects that there will be some pricing pressure in the programs and a shift in the product mix towards RTs, both leading to a growth in profitability in the long term of less than the increase in volume.

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FOURTH QUARTER 2004 ADJUSTMENTS

The Company identified three accounting errors that it corrected in the fourth quarter of 2004. These errors are described in the succeeding paragraphs. The portions of these adjustments that relate to any prior period financial statements were immaterial.

On February 7, 2005, the Chief Accountant of the SEC sent a letter to the American Institute of Certified Public Accountants calling attention to several issues in the accounting for leases. One of the issues is the requirement to recognize minimum or fixed rent increases on a straight-line basis. When the Company reviewed its lease accounting in response to the letter, it discovered that it had not followed the straight-line recognition in all cases. The Company determined that it had under-recognized lease expense over the terms of these leases going back as far as 1993 by a cumulative amount of $885,000.

During the fourth quarter of 2004, the Company recognized that it had not posted all of the losses on its low income housing tax credit partnerships. The cumulative amount of the unrecognized losses was $1.4 million. Most of this amount relates to the years prior to 2002 and in no case would adjustment for any prior period financial statements be material.

During the fourth quarter of 2004, the Company recognized $1.4 million in stay put payments, of which $980,000 was attributable to prior quarters in 2004. Adjustment to the financial statements for these prior quarters is not material.

These adjustments had an impact on net income for the fourth quarter of 2004 of $2.2 million or 5 cents per diluted share. For the year of 2004, the impact on net income was $1.3 million or 3 cents per diluted share.

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NOTES TO MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

NOTE A  TAX EQUIVALENCY

For Tables 1, 2, and 3, the yield on tax-exempt state and municipal securities and loans has been computed on a tax equivalent basis. The interest on these securities and loans is subject to California franchise tax no matter what the state of origin of the issuer. The California franchise tax rate is 10.84%. The Federal tax rate used for the computation is 35%. While the income from these securities and loans is taxable for California, the Company does receive a Federal income tax benefit of 35% of the California tax paid. That is, state taxes are deductible for Federal taxes, and to the extent that the Company pays California franchise tax on this income from these loans and securities, the deduction for state taxes on the Company’s Federal return is larger. The tax equivalent yield is also impacted by the disallowance of a portion of the underlying cost of funds used to support tax-exempt securities and loans. To compute the tax equivalent yield for these securities one must first add to the actual interest earned an amount such that if the resulting total were fully taxed, and if there were no disallowance of interest expense, the after-tax income would be equivalent to the actual tax-exempt income. This tax equivalent income is then divided by the average balance to obtain the tax equivalent yield. The dollar amount of the adjustment is shown at the bottom of Table 2 as “Tax equivalent income included in interest income from non-taxable securities and loans.”

NOTE  B AVERAGE BALANCES

When comparing interest yields and costs year to year, the use of average balances more accurately reflects trends since these balances are not significantly impacted by period-end transactions. The amount of interest earned or paid for the year is also directly related to the average balances during the year and not to what the balances happened to be on the last day of the year. Average balances are daily averages, i.e., the average is computed using the balances for each day of the year, rather than computing the average of the first and last day of the year.

NOTE C  FAIR VALUE ADJUSTMENTS TO SECURITIES AND NONACCRUAL LOANS IN TABLE 2

The yield information in Table 2 does not give effect to changes in fair value that are reflected as a component of shareholders’ equity. Loans in a nonaccrual status are included in the computation of average balances in their respective loan categories.

NOTE D  ALLOCATION OF CHANGES IN INTEREST BETWEEN RATE AND VOLUME

For purposes of the amounts in Table 3 relating to the volume and rate analysis of net interest margin, the portion of the change in interest earned or paid that is attributable to changes in rate is computed by multiplying the change in interest rate by the prior year’s average balance. The portion of the change in interest earned or paid that is attributable to changes in volume is computed by multiplying the change in average balances by the prior year’s interest rate. The portion of the change that is not attributable either solely to changes in volume or changes in rate is prorated on a weighted basis between volume and rate.

NOTE E  INTEREST RATE SENSITIVITY AND MATURITY

In general, the longer the period to maturity of a fixed-rate financial instrument, the more sensitive is its market value to changes in interest rates. This occurs because any difference between current market rates and the original rate at issuance will remain in place longer for a longer period. For example, if interest rates increase by 1%, then the investor in a bond or other financial instrument with 10 years remaining until maturity will receive 1% less than the current market rate for 10 times longer than an investor that holds a bond or other financial instrument with one year remaining until maturity. In other words, the second investor will be able to reinvest the proceeds from the maturing bond after only one year and consequently will incur less of an economic loss than the first investor when interest rates go up.

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NOTE F  HYPOTHETICAL INTEREST RATE CHANGES

Although interest rates normally would not change in this sudden manner, the very steep decline in interest rates during 2001—a 4.75% decline in 10 months—make the 2% shock a more realistic scenario than most observers would have believed four years ago.

At December 31, 2003, the FOMC’s target rate for Federal funds sold between banks was 1.00%. It is clear that this target rate could not be decreased another 2.00% as modeled on page 29 of this discussion. Nonetheless the Company uses a hypothetical decrease of 2.00% along with an increase of 2.00% to show changes in the sensitivity to interest rates comparable with the prior year.

NOTE G  INTEREST RATE YIELD CURVES

A yield curve is a graphic representation of the relationship between the interest rate and the maturity term of financial instruments. Generally, interest rates on shorter maturity financial instruments are less than those for longer term instruments. For example, at December 31, 2004, 2 year U.S. Treasury notes sold at a price that yielded 3.08% while 10-year notes sold at a price that yielded 4.24%. A line drawn that plots this relationship for a whole range of maturities will be “steeper” when the rates on long-term maturities are substantially higher than those on shorter term maturities. The curve is said to be “flatter” when there is not as much of a difference. The following table shows rates for some selected maturities to demonstrate how the yield curve has changed over the last three years.

	Target Fed Funds Rate		3 Month Treasury Bills		2 Year Treasury Notes		10 Year Treasury Notes		30 Year Treasury Notes		Shape
December 31
2002	1.25	%	1.19	%	1.60	%	3.81	%	4.78	%
2003	1.00	%	0.95	%	1.84	%	4.27	%	n/a		Steeper
2004	2.25	%	2.22	%	3.08	%	4.24	%	n/a		Less steep
2005	4.25	%	3.89	%	4.40	%	4.47	%	n/a		Flat with small inversion in short-term

NOTE H  NATURAL OR ON-BALANCE SHEET HEDGES

A natural hedge is formed when two components of the balance sheet respond to changes in interest rates in an opposite manner. Assets and liabilities that have similar maturities and repricing characteristics form natural, i.e., non-derivative hedges to each other. For example, the market value of fixed rate Treasury securities with a remaining life of two years would tend to increase the same amount as fixed-rate FHLB advances (borrowings) with the same maturity. Two assets or two liabilities can also hedge each other. For example fixed rate residential loans lose value when interest rates rise, but the servicing rights created when loans are sold with servicing retained will gain value when rates rise. The loans lose value because they earn less than the new market rate. The servicing rights increase in value because prepayments on the underlying loans will slow and the servicing fees will be received for a longer than expected period of time.

NOTE I  MORTGAGE-BACKED SECURITIES

A large number of home mortgage loans may be grouped together by a financial institution into a pool. Interest in this pool may then be sold to investors as securities. The payments received from the borrowers on their mortgages are used to pay the investors. The mortgage instruments themselves are the security or backing for the investors and the securities are termed mortgage-backed. The credit risk on the loans is not passed to the buyers of the securities.

Collateralized mortgage obligations are like mortgage-backed securities in that they involve a pool of mortgages. However, payments received from the borrowers are not equally paid to investors. Instead, investors purchase portions of the pool that have different repayment characteristics. This permits the investor to better time the cash flows that will be received.

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Asset-backed securities are like mortgage-backed securities except that loans other than mortgages are the source of repayment. For instance, these might be credit card loans or auto loans.

NOTE J  PEER DATA

In various places throughout this discussion, comparisons are made between ratios for the Company and for its holding company or FDIC peers.

The Bancorp or holding company peers are a nation-wide group of 89 companies with an asset size of $3 billion to $10 billion. The peer information is reported in the Bank Holding Company Performance Report received from the FRB for the 3rd Quarter of 2005, the latest quarter for which the report has been distributed as of this writing.

The FDIC peer group comprises 300+ banks with an asset size of $1 billion to $10 billion, and the information set forth above is reported in or calculated from information reported in the FDIC Quarterly Banking Profile, Third Quarter 2005, which is the latest issue available. The publication does not report some of the statistics cited in this report by the separate size-based peer groups. In these instances, the figure cited is for all FDIC banks regardless of size.

The particular peer group used for comparison depends on the nature of the information in question. Company data like capital ratios and dividend payout are compared to other holding companies, because capital is generally managed at the holding company level and dividends to shareholders are paid from the holding company, not the individual banks. Expense and revenue ratios are also compared to other holding company data because many holding companies provide significant services to their subsidiary banks and may also provide services to customers as well. These items would not be included in FDIC bank-level data. Credit information relates to the making of loans, which is generally a bank-level activity. Therefore, FDIC data in this area is more pertinent.

NOTE K  CHANGES IN TARGET FEDERAL FUNDS RATES

From January 1, 2001 through December 31, 2005, the FOMC changed the target rates for Federal funds as follows:

Date	Amount of Change		New Target Rate
January 2001	-0.50	%	6.00	%
January 2001	-0.50	%	5.50	%
March 2001	-0.50	%	5.00	%
April 2001	-0.50	%	4.50	%
May 2001	-0.50	%	4.00	%
June 2001	-0.25	%	3.75	%
August 2001	-0.25	%	3.50	%
September 2001	-0.50	%	3.00	%
October 2001	-0.50	%	2.50	%
November 2001	-0.50	%	2.00	%
December 2001	-0.25	%	1.75	%
November 2002	-0.50	%	1.25	%
June 2003	-0.25	%	1.00	%
June 2004	+0.25	%	1.25	%
August 2004	+0.25	%	1.50	%
September 2004	+0.25	%	1.75	%
November 2004	+0.25	%	2.00	%
December 2004	+0.25	%	2.25	%
February 2005	+0.25	%	2.50	%
March 2005	+0.25	%	2.75	%
May 2005	+0.25	%	3.00	%
June 2005	+0.25	%	3.25	%
August 2005	+0.25	%	3.50	%
September 2005	+0.25	%	3.75	%
November 2005	+0.25	%	4.00	%
December 2005	+0.25	%	4.25	%

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NOTE L  COMPARISON OF CHANGES IN THE OPERATING EXPENSE TO AVERAGE ASSETS AND OPERATING EFFICIENCY RATIOS

The importance of not relying on one ratio or measurement to assess performance is illustrated by the changes from year to year in the two ratios in Table 15A. The two ratios changed dissimilarly from 2003 to 2004 and from 2004 to 2005. Operating expense as a percentage of assets and the operating efficiency ratio both decreased from 2003 to 2004. Operating expense as a percentage of assets increased from 2004 to 2005 while the operating efficiency ratio continued to decrease. The operating efficiency ratio, the denominator of which is operating income benefited by the large increase in RAL/RT profitability in 2005, i.e., revenues increased proportionally more than expenses. The extra operating expenses incurred in 2005 discussed above on page 50 for consultants and software did not arise from an increase in assets.

NOTE M  COMPUTATION OF THE OPERATING EFFICIENCY RATIO

The operating efficiency ratio is computed by dividing noninterest or operating expense by the sum of tax-equivalent (Note A) net interest income plus noninterest revenues exclusive of gains or losses on securities transactions.

NOTE N  ANNUALIZED PERCENTAGE RATE OF CREDIT COSTS FOR RALS

To understand what appears to be a high APR for RALs, it may help to see the credit cost of the average RAL expressed as an APR. The average RAL in 2005 was approximately $3,050. For 2005, the Company charged-off an average of about 101 basis points. 101 basis points for an average loan would be $30.95. Expressed as an APR, the $30.95 would be 37.0%. Funding and processing costs are incurred in addition to the credit costs.

NOTE O  MARKET EFFICIENCY

In general, more active markets are more efficient, i.e., there is a narrower spread between the bid and asked price for a financial instrument the more frequently the instrument is traded. Consequently, if the Company is selling a thinly traded asset, it is not likely to get as high a price for the asset as it would for one that is widely traded. Similarly, the frequency of trading for a particular class of asset can vary and therefore the spread between bid and asked can increase or decrease for that same asset. Such variances can occur at different times of the year or based on economic news or conditions.

NOTE P  DERIVATIVE COSTS

Depending on the term and rate environment, there would likely be a difference in the starting rates between the two parties. For example, in an environment in which it is generally believed that rates will rise, to get another financial institution to enter into a swap contract under which it would receive fixed rate payments, the two rates would be set in a manner that the contract would start with the Company’s fixed rate obligation paying more than it received from the other institution on its variable rate obligation. Consequently, only if interest rates rose at least by the amount of that difference in initial rates would the swap have achieved its objective in the transaction.

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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We have provided the required quantitative and qualitative disclosures about market risk in Management’s Discussion and Analysis on pages 10 through 71.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Audited consolidated financial statements and related documents required by this item are included in this Annual Report on Form 10-K on the pages indicated:

Reports of Independent Registered Public Accounting Firm—Ernst & Young LLP	73
Report of Independent Registered Public Accounting Firm—PricewaterhouseCoopers LLP	76
Consolidated Balance Sheets as of December 31, 2005 and 2004	77
Consolidated Statements of Income for the years ended December 31, 2005, 2004, and 2003	78
Consolidated Statements of Comprehensive Income for the years ended December 31, 2005, 2004, and 2003	79
Consolidated Statements of Changes in Shareholders’ Equity for the years ended December 31, 2005, 2004, and 2003	80
Consolidated Statements of Cash Flows for the years ended December 31, 2005, 2004, and 2003	81
Notes to Consolidated Financial Statements	82

The following unaudited supplementary data is included in this Annual Report on Form 10-K on the page indicated:

Quarterly Financial Data 131

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Shareholders of Pacific Capital Bancorp:

We have audited the accompanying consolidated balance sheets of Pacific Capital Bancorp and subsidiaries (the “Company”), a Delaware corporation, as of December 31, 2005, and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity and cash flows for the year ended December 31, 2005. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Pacific Capital Bancorp and subsidiaries at December 31, 2005, and the consolidated results of their operations and their cash flows for the year ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Pacific Capital Bancorp and subsidiaries’ internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 13, 2006 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

March 13, 2006

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REPORT ON MANAGEMENT’S 404 ASSESSMENT

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Shareholders of Pacific Capital Bancorp:

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that Pacific Capital Bancorp and subsidiaries (the “Company ”) maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO criteria”). Pacific Capital Bancorp’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

As indicated in the accompanying Management’s Report on Internal Control Over Financial Reporting management’s assessment of and conclusion on the effectiveness of internal control over financial reporting excluded certain elements of internal control over financial reporting of First Bancshares, Inc. of San Luis Obispo (“FBSLO”), which is included in the December 31, 2005 consolidated financial statements of Pacific Capital Bancorp and constituted $232 million and $231 million of loans and deposits, respectively, as of December 31, 2005 and $2.9 million of net income for the year then ended. Management excluded certain elements from its evaluation of the effectiveness of internal control over financial reporting at this entity because FBSLO was acquired by the Company in a purchase business combination during 2005. Our audit of internal control over financial reporting of Pacific Capital Bancorp also excluded certain elements of the internal control over financial reporting of FBSLO. FBSLO’s investment portfolio was integrated with the Company’s investment portfolio at the time of closing of the acquisition and was included in management’s and our evaluation of internal control over financial reporting.

In our opinion, management’s assessment that Pacific Capital Bancorp maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects,

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based on the COSO criteria. Also, in our opinion, Pacific Capital Bancorp maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the accompanying consolidated balance sheets of Pacific Capital Bancorp and subsidiaries as of December 31, 2005, and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity and cash flows for the year ended December 31, 2005, of Pacific Capital Bancorp and our report dated March 13, 2006 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

March 13, 2006

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders of Pacific Capital Bancorp:

In our opinion, the consolidated balance sheet as of December 31, 2004 and the related consolidated statements of income, comprehensive income, shareholders’ equity and cash flows for each of two years in the period ended December 31, 2004 present fairly, in all material respects, the financial position of Pacific Capital Bancorp and its subsidiaries at December 31, 2004, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

PricewaterhouseCoopers LLP

San Francisco, CA

March 22, 2005, except as to the effects of the

reclassification of 2004 and 2003 amounts for

reportable segments as discussed in Note 25,

as to which the date is March 15, 2006.

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CONSOLIDATED BALANCE SHEETS

Pacific Capital Bancorp and Subsidiaries

(amounts in thousands except per share amounts)	December 31,
	2005		2004
Assets:
Cash and due from banks	$	158,880	$	133,116
Securities—available-for-sale at fair value		1,369,549		1,524,874
Loans		4,897,286		4,062,294
Less: allowance for credit losses		55,598		53,977
Net loans		4,841,688		4,008,317
Premises, equipment and other long-term assets		115,831		100,282
Accrued interest receivable		28,994		24,000
Goodwill and other intangible assets		150,472		115,066
Other assets		210,745		119,130
Total assets	$	6,876,159	$	6,024,785
Liabilities:
Deposits:
Noninterest-bearing demand deposits	$	1,061,711	$	1,013,772
Interest-bearing deposits		3,956,155		3,498,518
Total deposits		5,017,866		4,512,290
Securities sold under agreements to repurchase and Federal funds purchased		446,642		179,041
Long-term debt and other borrowings		793,895		823,122
Obligations under capital lease		9,317		9,130
Accrued interest payable and other liabilities		63,183		41,520
Total liabilities		6,330,903		5,565,103
Commitments and contingencies (Note 17)
Shareholders’ equity:
Preferred stock—no par value; shares authorized: 1,000; shares issued and outstanding: none		—		—
Common stock—no par value; $0.25 per share stated value; shares authorized: 100,000; shares issued and outstanding:
46,631 in 2005 and 45,719 in 2004		11,662		11,434
Surplus		107,829		78,903
Accumulated other comprehensive income		987		7,970
Retained earnings		424,778		361,375
Total shareholders’ equity		545,256		459,682
Total liabilities and shareholders’ equity	$	6,876,159	$	6,024,785

The accompanying notes are an integral part of these consolidated financial statements.

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CONSOLIDATED STATEMENTS

OF INCOME

Pacific Capital Bancorp and Subsidiaries

(in thousands, except per share data)	Years Ended December 31,
	2005			2004			2003
Interest income:
Loans	$	365,953		$	264,900		$	226,413
Securities		59,412			60,533			44,713
Federal funds sold and securities purchased under agreement to resell		792			748			1,050
Commercial paper		—			—			13
Total interest income		426,157			326,181			272,189
Interest expense:
Deposits		72,955			42,142			36,161
Securities sold under agreements to repurchase and Federal funds purchased		5,781			1,589			743
Long-term debt and other borrowings		32,769			25,480			17,029
Total interest expense		111,505			69,211			53,933
Net interest income		314,652			256,970			218,256
Provision for credit losses		53,873			12,809			18,286
Net interest income after provision for credit losses		260,779			244,161			199,970
Noninterest revenue:
Service charges on deposit accounts		17,073			16,529			15,464
Trust fees		16,800			15,429			14,399
Refund transfer fees		24,982			21,049			19,841
Other service charges, commissions and fees		20,991			17,756			16,939
Net gain on sale of tax refund loans		26,023			2,945			8,031
Net (loss) gain on sales and calls of securities		(730	)		(2,018	)		2,018
Other income		6,784			3,945			3,589
Total noninterest revenue		111,923			75,635			80,281
Operating expense:
Salaries and benefits		108,023			94,697			83,902
Net occupancy expense		17,150			15,970			14,744
Equipment rental, depreciation, and maintenance		11,703			8,939			9,156
Other expense		77,529			60,300			54,436
Total operating expense		214,405			179,906			162,238
Income before provision for income taxes		158,297			139,890			118,013
Provision for income taxes		59,012			51,946			42,342
Net income	$	99,285		$	87,944		$	75,671
Basic earnings per share	$	2.16		$	1.93		$	1.66
Diluted earnings per share	$	2.14		$	1.92		$	1.64
Average number of shares—basic*		45,964			45,535			45,646
Average number of shares—diluted*		46,358			45,911			46,083
Dividends declared per share	$	0.78		$	0.69		$	0.60

* Prior year shares were adjusted to account for stock split in June 2004.

The accompanying notes are an integral part of these consolidated financial statements.

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CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

Pacific Capital Bancorp and Subsidiaries

(in thousands)	Years Ended December 31,
	2005			2004			2003
Net income	$	99,285		$	87,944		$	75,671
Other comprehensive income—
Unrealized gain on securities:
Unrealized holding (losses) gains arising during period		(12,780	)		(10,364	)		4,168
Less: reclassification adjustment for (losses) gains included in net income		(730	)		(2,018	)		2,018
Less: income tax (benefit) expense related to items of other comprehensive income		(5,067	)		(3,509	)		904
Other comprehensive (loss) income		(6,983	)		(4,837	)		1,246
Comprehensive income	$	92,302		$	83,107		$	76,917

The accompanying notes are an integral part of these consolidated financial statements.

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CONSOLIDATED STATEMENTS OF

CHANGES IN SHAREHOLDERS’ EQUITY

Pacific Capital Bancorp and Subsidiaries

(in thousands except per share amounts)									Accumulated Other Comprehensive Income			Retained Earnings
	Common Stock
	Shares		Amount			Surplus									Total
Balance, December 31, 2002	34,550		$	8,641		$	94,314		$	11,561		$	256,559		$	371,075
Activity for 2003:
Exercise of stock options	337			84			6,579			—			—			6,663
Retirement of common stock	(924	)		(231	)		(27,977	)		—			—			(28,208	)
Cash dividends declared at $0.60 per share	—			—			—			—			(27,399	)		(27,399	)
Changes in unrealized gain on securities available-for-sale, net	—			—			—			1,246			—			1,246
Net income	—			—			—			—			75,671			75,671
Balance, December 31, 2003	33,963			8,494			72,916			12,807			304,831			399,048
Activity for 2004:
Exercise of stock options	399			100			8,911			—			—			9,011
Stock split	11,357			2,840			(2,840	)		—			—
Retirement of common stock	—			—			(84	)		—			—			(84	)
Cash dividends declared at $0.69 per share	—			—			—			—			(31,400	)		(31,400	)
Changes in unrealized gain on securities available-for-sale, net	—			—			—			(4,837	)		—			(4,837	)
Net income	—			—			—			—			87,944			87,944
Balance, December 31, 2004	45,719			11,434			78,903			7,970			361,375			459,682
Activity for 2005:
Exercise of stock options	332			83			7,424			—			—			7,507
Issuance of common stock	580			145			21,502			—			—			21,647
Cash dividends declared at $0.78 per share	—			—			—			—			(35,882	)		(35,882	)
Changes in unrealized gain on securities available-for-sale, net	—			—			—			(6,983	)		—			(6,983	)
Net income	—			—			—			—			99,285			99,285
Balance, December 31, 2005	46,631		$	11,662		$	107,829		$	987		$	424,778		$	545,256

The accompanying notes are an integral part of these consolidated financial statements.

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CONSOLIDATED STATEMENTS

OF CASH FLOWS

Pacific Capital Bancorp and Subsidiaries

(dollars in thousands)	Years Ended December 31,
	2005			2004			2003
Cash flows from operating activities:
Net Income	$	99,285		$	87,944		$	75,671
Adjustments to reconcile net income to net cash provided by operations:
Depreciation and amortization		12,827			10,782			9,920
Provision for credit losses		53,873			12,809			18,286
Provision (benefit) for deferred income taxes		(991	)		2,497			2,708
Net amortization of discounts and premiums for securities and commercial paper		460			1,618			2,944
Amortization of net deferred loan fees		6,095			5,298			3,854
Change in accrued interest receivable and other assets		(3,680	)		(16,969	)		3,292
Change in accrued interest payable and other liabilities		8,830			5,666			1,796
Net loss (gain) on sales and calls of securities		730			2,018			(2,018	)
Increase (decrease) in income taxes payable		(647	)		1,436			8,813
Net cash provided by operating activities		176,782			113,099			125,266
Cash flows from investing activities:
Purchase of banks or branches, net of cash acquired		(49,544	)		(123,282	)		—
Proceeds from sale of securities		47,400			86,745			145,926
Proceeds from calls, maturities, and partial pay downs of AFS securities		352,977			305,808			290,866
Proceeds from calls and maturities of HTM securities		—			—			3,987
Purchase of AFS securities		(206,995	)		(492,847	)		(888,259	)
Proceeds from sale or maturity of commercial paper		—			—			15,000
Purchase of commercial paper		—			—			(14,987	)
Purchase of bank-owned life insurance		(60,000	)		—			—
Net increase in loans made to customers		(677,833	)		(484,505	)		(187,470	)
(Purchase) sale of tax credit investments		(4,603	)		(180	)		3,922
Net purchase or investment in premises and equipment		(25,480	)		(25,362	)		(15,662	)
Net cash used in investing activities		(624,078	)		(733,623	)		(646,677	)
Cash flows from financing activities:
Net increase in deposits		251,852			366,202			338,640
Net increase in borrowings with maturities of 90 days or less		276,251			93,797			28,616
Proceeds from long-term debt and other borrowing		183,811			244,314			273,200
Payments on long-term debt and other borrowing		(232,126	)		(111,220	)		(38,621	)
Proceeds from issuance of common stock		29,154			8,927			6,663
Payments to retire common stock		—			—			(28,208	)
Dividends paid		(35,882	)		(31,400	)		(27,399	)
Net cash provided by financing activities		473,060			570,620			552,891
Net increase (decrease) in cash and cash equivalents		25,764			(49,904	)		31,480
Cash and cash equivalents at beginning of year		133,116			183,020			151,540
Cash and cash equivalents at end of year	$	158,880		$	133,116		$	183,020
Supplemental disclosure:
Interest paid during the year	$	107,273		$	67,370		$	53,906
Income taxes paid during the year	$	58,323		$	49,000		$	33,000
Non-cash additions to other real estate owned	$	—		$	2,910		$	—

The accompanying notes are an integral part of these consolidated financial statements.

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NOTES TO CONSOLIDATED FINANCIAL

STATEMENTS

Pacific Capital Bancorp

and Subsidiaries

1.    SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Operations

Pacific Capital Bancorp (the “Company”) is a bank holding company organized under the laws of California. Through its banking subsidiary, Pacific Capital Bank, N.A. (“PCBNA”), the Company provides a full range of commercial banking services to individuals and business enterprises. The banking services include making commercial, leasing, consumer, commercial and residential real estate loans and Small Business Administration guaranteed loans. Deposits are accepted for checking, interest-bearing checking (“NOW”), money-market, savings, and time accounts. PCBNA also offers safe deposit boxes, travelers’ checks, money orders, foreign exchange services, and cashiers checks. A wide range of wealth management services is offered through the Trust and Investment Services division. PCBNA is also one of the largest nationwide providers of financial services related to the electronic filing of income tax returns.

PCBNA conducts its banking services under six brand names: Santa Barbara Bank & Trust (“SBB&T”), First National Bank of Central California (“FNB”), South Valley National Bank (“SVNB”), San Benito Bank (“SBB”) Pacific Capital Bank (“PCB”), and First Bank of San Luis Obispo (“FBSLO”). The offices using the SBB&T brand are located in Santa Barbara and Ventura Counties. Offices using FNB are located in the counties of Monterey and Santa Cruz. Offices in southern Santa Clara County use SVNB, offices in San Benito County are branded SBB and offices in San Luis Obispo county are branded FBSLO. These brand names were formally the names of independent banks merged at various times and eventually into PCBNA. The offices of the former Pacific Crest Bank that were acquired in the purchase by the Company of Pacific Crest Capital Inc. (“PCCI”) described in Note 2 were merged into PCBNA and use the brand name Pacific Capital Bank.

The Company has eight other subsidiaries. One of these is used solely for securitization activities relating to the Company’s refund anticipation loan program. Four other subsidiaries are business trust entities discussed on page 107 used in connection with the trust preferred securities discussed below on page 90. For reasons discussed there, these subsidiaries are not consolidated with the Company in these financial statements. The last three subsidiaries are essentially inactive.

Basis of Presentation

The accounting and reporting policies of the Company are in accordance with accounting principles generally accepted in the United States (“GAAP”) and conform to practices within the banking industry. The Consolidated Financial Statements include the accounts of the Company and its consolidated subsidiaries. All significant intercompany balances and transactions are eliminated.

The preparation of consolidated financial statements in accordance with GAAP requires Management to make certain estimates and assumptions which affect the amounts of reported assets and liabilities as well as contingent assets and liabilities as of the date of these financial statements. These estimates and assumptions also affect the reported amounts of revenues and expenses during the reporting period(s). Although Management believes these estimates and assumptions to be reasonably accurate, actual results may differ.

Certain amounts in the 2003 and 2004 financial statements have been reclassified to be comparable with classifications used in the 2005 financial statements.

Securities

The Company purchases securities with funds that are not needed for immediate liquidity purposes and have not been lent to customers. Securities may be classified as held-to-maturity, as available-for-sale, or as trading securities. The appropriate classification is decided at the time of

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purchase. Only those securities that the Company both intends to hold and has the ability to hold until their maturity may be classified as held-to-maturity. Securities that might be sold prior to maturity because of interest rate changes, to meet liquidity needs, or to better match the repricing characteristics of funding sources are classified as available-for-sale. Securities purchased specifically for later resale at a gain are classified as trading securities. All securities currently held by the Company are classified as available-for-sale. The Company does not classify any of its securities as trading.

Interest income is recognized based on the coupon rate increased by the accretion of discounts or decreased by the amortization of premiums using the effective interest method including the accretion of discounts and the amortization of premiums. Discount is the excess of the face value of the security over the cost, and accretion of the discount is the periodic recognition of interest income above any cash interest received to increase the carrying amount up to the face value that will be received at maturity. Accretion thus increases the effective yield for the security above the interest rate for its coupon. Premium is the excess of cost over the face value of the security, and amortization of the premium is a periodic charge to interest income to reduce the carrying amount to the face value that will be received at maturity. Amortization reduces the effective yield for the security below the coupon rate. Discounts are accreted and premiums are amortized using the effective yield method over its estimated life.

Securities classified as available-for-sale are reported on the consolidated balance sheets at their fair value. As the fair value of these securities changes, the changes are included as elements of comprehensive income in the consolidated statements of comprehensive income. The sum of the accumulated change since purchase for these securities is reported net of the income tax effect on the consolidated balance sheets as a separate component of equity captioned “Accumulated other comprehensive income.” When securities are sold, the unrealized gain or loss is reclassified from other comprehensive income to net income.

In December 2003, the Company recognized that the flexibility to sell any of its securities prior to maturity to manage interest rate risk or to provide liquidity was more desirable than the avoidance of the balance sheet volatility and consequently reclassified all of its held-to-maturity securities to available-for-sale. All subsequent security purchases have been classified as available-for-sale.

All investments reported by the Company as securities are debt securities. However, PCBNA is a member of both the Federal Reserve Bank of San Francisco (“FRB”) and the Federal Home Loan Bank of San Francisco (“FHLB”), and as a condition of membership in both organizations, it is required to purchase stock. In the case of the FRB, the amount of stock that is required to be held is based on PCBNA’s capital accounts. As PCBNA’s capital (and the capital of SBB&T and FNB before the merger of their charters) has increased, it has been required to purchase additional shares. In the case of the FHLB, the amount of stock required to be purchased is based on the borrowing capacity desired by PCBNA. While technically these are considered equity securities, there is no market for the FRB and FHLB stock. Therefore, the shares are considered as restricted investment securities and reported as other assets in the Consolidated Balance Sheets. Such investments are carried at cost which is equal to their redemption value. The dividend income received from the stock is reported in the other income category within noninterest revenue.

A security may become impaired, i.e. there may be an unrecognized loss. The impairment may be temporary or other than temporary. In the case of debt securities, the impairment may imply a judgment by the market that the issuer will not be able to make interest and principal payments as contractually required. Alternatively, the impairment may be due only to changes in interest rates that do not impact the issuer’s ability to meet its contractual obligations. The Company periodically reviews impaired securities to determine whether the impairment is other than temporary. Factors that would be considered in deciding whether the impairment is other than temporary include:

· the nature of the investment;

· the cause(s) of the impairment;

· the severity and duration of the impairment;

· the strength of the market for the security;

83

· the length of time the Company intends and is able to hold the security; and

· credit ratings for the security and its sector.

If the impairment is determined to be other than temporary, the Company will recognize this impairment by charging a realized loss to earnings in the period in which the impairment occurs or is otherwise deemed to be other than temporarily impaired.

The Company uses specific identification to determine the cost of securities sold.

Repurchase agreements

The Company occasionally enters into repurchase agreements where by it purchases securities or loans from another institution and agrees to resell them at a later date for an amount in excess of the purchase price. While in form these are agreements to purchase and resell, in substance they are short-term secured investments in which the excess of the sale proceeds over the purchase price represents interest income. For security or collateral, the Company receives assets with a higher fair value than the amount invested.

Loans and Interest and Fees from Loans

Loans are carried at cost which generally represents amounts advanced to the borrowers less principal payments collected. Interest on loans is calculated on a simple interest basis, that is, interest is not compounded. The Company collects loan origination and commitment fees. These fees are not recognized as income when they are collected. Instead they are offset by certain direct loan origination costs and then recognized over the contractual life of the loan as an adjustment to the interest earned using the effective interest method. The net unrecognized fees represent unearned revenue, and they are reported as reductions of the loan principal outstanding. If the deferred costs are greater than the deferred fees, the net amount will be an addition to the loan principal.

Included in loans are lease receivables, which are in substance loans.

Nonaccrual Loans:  When a borrower is not making payments as contractually required by the note, the Company must decide whether it is appropriate to continue to accrue interest. Generally, the Company places loans in a nonaccrual status and ceases recognizing interest income when the loan has become delinquent by more than 90 days. The Company may decide that it is appropriate to continue to accrue interest on some loans more than 90 days delinquent if they are well-secured by collateral and collection efforts are being actively pursued.

When a loan is placed in a nonaccrual status, any accrued but uncollected interest for the loan is written off against interest income in the period in which the status is changed. Subsequent payments received from the customer are applied to principal and no further interest income is recognized until the principal has been paid in full or until circumstances have changed such that payments are again consistently received as contractually required. In the case of commercial customers, the pattern of payment must also be accompanied by a change in the financial condition of the borrower such that there are strong prospects of continued timely payments.

Impaired Loans:  A loan is identified as impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement. Because this definition is very similar to that of a nonaccrual loan, most impaired loans will be classified as nonaccrual. However, there are some loans that are termed impaired because of doubt regarding collectibility of interest and principal according to the contractual terms, but which are presently both fully secured by collateral and are current in their interest and principal payments. These impaired loans are not classified as nonaccrual. Under GAAP, the term “impaired” only applies to certain types or classes of loans. Consequently, there may be some nonaccrual loans that are not categorized as impaired.

Prepayments:  Generally, consumer borrowers may prepay their loans. When interest rates are declining, the Company expects the rate of prepayments to increase. Changes in the rate of prepayments impact amortization of deferred origination fees and costs as the Company recognizes the remaining unamortized amounts when a pay off occurs. Prepayment assumptions are developed from commonly available industry data.

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Allowance for Credit Losses

If a borrower’s financial condition becomes such that he or she is not able to fully repay a loan or lease obligation extended by the Company, a loss to the Company has occurred. When the Company has determined that such a loss has occurred, the uncollectible principal amount of the loan is charged-off. It is necessary to make an estimate of the amount of loss inherent but unrecognized in the credit portfolios prior to the realization of such losses through charge-off. GAAP, banking regulations, and sound banking practices require that the Company record this estimate of unrecognized losses in the form of an allowance for credit losses. When losses are recognized, they are charged-off against this allowance. When the Company recovers an amount on a loan previously charged-off, the recovery increases the amount of allowance.

The Company’s estimate of unrecognized losses changes from period to period based on the size and composition of the loan portfolio, current economic conditions, information about specific borrowers, and a variety of other factors. The amount of the allowance is changed to reflect the change in this estimate. It is recorded through the provision for credit losses.

The allowance for credit losses consists of several components. The first component is that portion of the allowance specifically related to those loans that are categorized as impaired under provisions of Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan (“SFAS 114”). The remaining components include a statistically determined portion assigned to groups or pools of loans, a specifically assigned portion relating to individual loans, and an allocated portion. These components are reported together in the allowance for credit loss in the accompanying consolidated balance sheets and in Note 7. In total, the allowance for credit losses is maintained at a level considered adequate to provide for losses inherent in the loan portfolio. However, the allowance is based on estimates, and ultimate losses may vary from the current estimates. These estimates are reviewed periodically and, as adjustments become necessary, they are reported as provisions expenses in the periods in which they become known.

Component for Impaired Loans:  GAAP recognizes that some impaired loans may have risk characteristics that are unique to the individual borrower and other impaired loans may have risk characteristics in common with other impaired loans. In the former case, the Company applies the measurement methods mentioned in the preceding paragraph on a loan-by-loan basis. Because all of the loans currently identified as impaired by the Company have unique risk characteristics, the valuation allowance for impaired loans is determined on a loan-by-loan basis. The amount of the valuation allowance for any particular impaired loan is determined by comparing the recorded investment in each loan with its value measured by one of three methods: (1) by discounting estimated future cash flows at the effective interest rate of the loan; (2) by observing the loan’s market price if it is of a kind for which there is a secondary market; or (3) by valuing the underlying collateral. A valuation allowance is established for any amount by which the recorded investment exceeds the value of the impaired loan, if any.

Statistical or Historical Loss Component:  The amount of this component is determined by applying loss estimation factors to outstanding loans and leases. The loss factors are based on the Company’s historical loss experience for each category of credits. Because historical loss experience differs for the various categories of credits, the loss estimation factors applied to each category also differ.

Component for Specific Credits:  There may be credits, even though not classified as impaired, for which an allowance computed by application of the appropriate historical or statistical loss estimation factor would not adequately provide for the loss inherent in the credit. This might occur for a variety of reasons such as the size of the credit, the industry of the borrower, or the terms of the credit. In these situations, Management will estimate an amount of allowance adequate to absorb the probable loss that has occurred. The specific component is made up of the sum of these specific amounts.

Allocated Component:  The allocated component of the allowance for credit losses relates to the statistical or historical loss component, in that the allocated component is used to modify the historical loss rates applied to different groups of loans. For example, the historical loss rates are the averages for the last five years of losses. This period includes periods of both strong and weak economic growth. If the current economy were strong, the historical loss rates used alone to

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estimate losses inherent in the portfolio would tend to overestimate the losses. In weak economic periods the average loss rate for the last five years would tend to underestimate the inherent losses.

Among the considerations addressed by this component are the following:

· the historical loss estimation factors used for statistical allocation may not give sufficient weight to such considerations as the current general economic and business conditions that affect the Company’s borrowers or to specific industry conditions that affect borrowers in that industry;

· the historical loss factors may not give sufficient weight to current trends in credit quality and collateral values and the duration of the current business cycle; and

· the historical loss factors are not derived in a manner that considers loan volumes and concentrations and seasoning of the loan portfolio.

Allocation factors for these considerations are multiplied by the outstanding balances in the various loan categories to adjust the historical loss rates and thereby provide what Management believes is the best estimate of the loss inherent in the loan portfolios.

Each of these considerations could perhaps be addressed by developing additional loss estimation factors for smaller, discrete groups of loans and for different phases of the economic cycle. However, the factors are used precisely so that the losses in smaller loans do not have to be individually estimated. Segmenting the loan portfolio and then developing and applying separate factors becomes impracticable and, with the smaller groups, the factors themselves become less statistically valid. Even for experienced reviewers, grading loans and estimating possible losses involves a significant element of judgment regarding the present situation with respect to individual loans and the portfolio as a whole. Therefore, Management regards it as both a more practical and prudent practice to allocate allowance for the above risk elements as modifications to the allowance assigned by specific or historical loss factors.

Allowance for credit loss from refund anticipation loans (RALs):  RAL’s are all originated in the first and second quarters of the year. The process of estimating an allowance for credit losses related to RALs is similar to that used for the other categories that have large numbers of small-balance loans, e.g. consumer and residential real estate. Specifically, the Company uses loss rates from prior years to estimate the inherent losses. However, because of the uncertainty of repayment after more than nine months after origination, all RAL’s unpaid at year-end are charged-off. Therefore, the Company does not have an allowance for credit loss for unpaid loans at the end of each year.

Credit loss from off-balance sheet instruments:  In addition to the exposure to credit loss from outstanding loans, the Company is also exposed to credit loss from certain off-balance sheet instruments such as loan commitments and letters of credit. Losses are experienced when the Company is contractually obligated to make a payment under these instruments and must seek repayment from a financially weak borrower.

As with its outstanding loans, the Company determines an estimate of losses inherent in these contractual obligations. The estimate for credit losses on off-balance sheet instruments is included within other liabilities and the charge to income that establishes this liability is included as a noninterest expense.

Income Taxes

The Company uses the accrual method of accounting for financial reporting purposes as well as for tax return purposes. However, there are still several items of income and expense that are recognized in different periods for tax return purposes than for financial reporting purposes. When items of income or expense are recognized in different years for financial reporting purposes than for tax return purposes, they represent “temporary differences.” Some of these temporary differences are resolved or unwound in the next year, while others take a number of years to unwind. The Company is required to provide in its financial statements for the eventual liability or deduction in its tax return for these temporary differences until the item of income or expense has been recognized for both financial reporting and for taxes. The provision is recorded in the form of deferred tax expense or benefit as the temporary differences arise. Deferred tax assets represent future deductions in the Company’s income tax return, while deferred tax liabilities represent future payments that must be made.

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Premises, Equipment and Other Long-term Assets

Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is charged against income over the estimated useful lives of the assets. For most assets with longer useful lives, accelerated methods of depreciation are used in the early years, switching to the straight-line method in later years. Assets with shorter useful lives are generally depreciated by straight-line method. Generally, the estimated useful lives of other items of premises and equipment are as follows:

Buildings and improvements	10-25 years
Furniture and equipment	5-7 years
Electronic equipment and software	3-5 years

The cost of developing or modifying software is capitalized in accordance with the provisions of Statement of Position 98-1 issued by American Institute of Certified Public Accountants (“AICPA”) and is included with the cost of purchased software in other assets. Amortization of these costs is included with software expense in other operating expense.

Leasehold improvements are amortized over the terms of the leases or the estimated useful lives of the improvements, whichever is shorter.

Leases

The Company leases most of its branch and support offices. Leases are accounted for as capital leases or operating leases based on the requirements of GAAP. Specifically, when the terms of the lease indicate that the Company is leasing the building for most of its useful economic life or the sum of lease payments represents most of the fair value of the building, the transaction is accounted for as a capital lease wherein the building is recognized as an asset of the Company and the net present value of the contracted lease payments is recognized as a long-term liability. The amortization charge relating to assets recorded under capital leases is included with depreciable expense.

Most of the Company’s leases have cost-of-living adjustments based on the consumer price index. Some of the leases have fixed increases provided for in the terms or increases based on the index but have a minimum increase irrespective of the change in index. In these cases, the total fixed or minimum lease expense is recognized on a straight-line basis over the term of the lease.

Mortgage and Other Loan Servicing Rights

Included in other assets are mortgage and other loan servicing rights. The Company receives a fee for servicing loans for other investors. The right to receive this fee for performing servicing (mortgage servicing rights or “MSR”) is of value to the Company and could be sold should the Company choose to do so. Companies engaged in mortgage banking activities or in servicing loans for others are required to recognize MSRs as separate assets. The rights are recorded at the net present value of the fees that will be collected; less estimated servicing costs, which approximates fair value. The capitalized fees are amortized against noninterest revenue over the expected lives of the loans. The longer the period of time over which the fees will be collected, the more valuable they are. Prepayment by the borrowers of these loans reduces the value of the MSR because the Company will not receive servicing fees for as long as it would if the loans were paid back over the original terms.

Because the rate at which consumers prepay their loans is impacted by changes in interest rates—prepayments increase as rates fall, and decrease as rates rise—the value of the servicing right changes with changes in interest rates. Changes in the value are reflected in the financial statements by adjustments to a valuation allowance, which offsets the asset, and by changes or credits to non-interest revenue. Changes to the valuation allowance are only made to reflect impairment or increases in value up to the amount of previously recognized impairments.

Estimates of the lives of the loans are based on several industry standard sources. These sources are tested periodically to determine how close to actual prepayment rates their estimates were. In applying the estimated prepayment rates, the Company segregates the rights into separate strata based on time to contractual maturity and coupon rate of the underlying loans.

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Trust Assets and Fees

The Company has a trust department that has fiduciary responsibility for the assets that it holds on behalf of its trust customers. These assets are not owned by the Company and accordingly are not reflected in the accompanying consolidated balance sheets.

Fees for most trust services are based on the market value of customer assets, and the fees are accrued monthly. The amount of fees for unusual or infrequent services are often determined by a court or other third party after the service has been provided. Such fees are recognized when the fee can be determined.

Earnings Per Share

The computation of basic earnings per share for all periods presented in the Consolidated Statements of Income is based on the weighted average number of shares outstanding during each year retroactively restated for stock dividends and stock splits.

Diluted earnings per share include the effect of common stock equivalents for the Company, which consist of shares issuable on the exercise of outstanding options and restricted stock awards. The number of options assumed to be exercised is computed using the “Treasury Stock Method.” This method assumes that all options with an exercise price lower than the average stock price for the period have been exercised at the average market price for the period and that the proceeds from the assumed exercise have been used for market repurchases of shares at the average market price. The Company receives a tax benefit for the difference between the market price and the exercise price of non-qualified options when options are exercised. The treasury stock method also assumes that the tax benefit from the assumed exercise of options is used to retire shares.

Restricted stock is accounted for as described below in the section titled, “Stock-Based Compensation” on page 91. Unvested stock for which compensation expense has been recognized is included as an addition to the weighted average shares outstanding during each period. Once vested, the shares are included in the weighted average shares outstanding.

Statement of Cash Flows

For purposes of reporting cash flows, “cash and cash equivalents” include cash and due from banks, Federal funds sold, and securities purchased under agreements to resell. Federal funds sold and securities purchased under agreements to resell are one-day transactions, with the Company’s funds being returned to it the next business day.

Postretirement Health Benefits

The Company provides eligible retirees with postretirement health care and dental benefit coverage. These benefits are also provided to the spouses and dependents of retirees on a shared cost basis. Benefits for retirees and spouses are subject to deductibles, co-payment provisions, and other limitations. The expected cost of such benefits is charged to expense during the years that the employees render service to the Company and thereby earn their eligibility for benefits.

Other Real Estate Owned and Other Foreclosed Property

Real estate acquired through foreclosure on a loan or by surrender of the real estate in lieu of foreclosure is called other real estate owned (“OREO”). OREO is originally recorded in the Company’s financial records at the fair value of the OREO less estimated costs to sell. If the outstanding balance of the loan is greater than the fair value of the OREO at the time of the acquisition, the difference is charged-off against the allowance for credit losses. Any senior debt to which other real estate owned is subject is included in the carrying amount of the property and an offsetting liability is reported along with other borrowings. Other collateral obtained through foreclosure proceedings is accounted for in a similar fashion.

During the time the property is held, all related operating or maintenance costs are expensed as incurred. Later decreases in the fair value of the property are charged to operating expense by establishing valuation allowances in the period in which they become known. Increases in the fair value may be recognized as reductions of operating expense but only to the extent that they represent recoveries of amounts previously written-down. Expenditures related to improvements of

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the property are capitalized to the extent that they are realizable through increases in the fair value of the properties. Increases in market value in excess of the fair value at the time of foreclosure are recognized only when the property is sold.

At December 31, 2005 and 2004, the Company held OREO that had a recorded value, less estimated costs, of $2.9 million which is less than the Company’s estimate of the fair value of the property.

Derivative Financial Instruments

GAAP requires that all derivatives be recorded at their current fair value on the balance sheet. Certain derivative transactions that meet specified criteria qualify for hedge accounting under GAAP. If a derivative does not meet the specific criteria gains or losses associated with changes in its fair value are immediately recognized in the income statement.

Goodwill

In connection with the acquisitions of financial institutions the Company has recorded the excess of the purchase price over the estimated fair value of the assets received and liabilities assumed as goodwill. When originally recorded, goodwill recorded in connection with pre-2002 acquisitions was amortized on the straight-line method over 15 years. Amortization of the goodwill was discontinued on January 1, 2002 under the provisions of Statement of Financial Accounting Standards No.142, Goodwill and Other Intangible Assets (“SFAS 142”).

Management annually reviews the goodwill in order to determine if facts and circumstances suggest that it is not recoverable. The Company has determined the reporting units at which goodwill impairment will be assessed, specifically, one level below its operating segments. The goodwill was allocated to these reporting units based on the perceived value of the acquired institution. Generally, this has meant allocation to the Branch Services unit within the Community Banking segment because the value of the acquisition was attributed to the deposit relationships. In the case of the PCCI acquisition, the value was attributed to the lending activities, while goodwill from the FBSLO acquisition was associated with the customer relationships and growth prospects.

Comprehensive Income

Comprehensive income includes all revenues, expenses, gains, and losses that affect the capital of the Company aside from issuing or retiring shares of stock. Net income is one component of comprehensive income. Based on the Company’s current activities, the only other components of comprehensive income consist of changes in the unrealized gains or losses on securities that are classified as available-for-sale.

Segment Reporting

GAAP requires that the Company disclose certain information related to the performance of various segments of its business. Segments are defined based on the factors by the chief operating decision-maker for making operating decisions and assessing performance. Such factors could be products and services, geography, legal structure, management structure or any manner by which a company’s management distinguishes major operating units. While the Company’s products and services all relate to commercial banking, for the purposes of this disclosure, Management has determined that the Company has five reportable segments: Community Banking, Commercial Banking, Tax Refund Programs, Fiduciary, and All Other. During 2005, the management and reporting structure for the lending operations acquired with PCCI changed and these operations were included in the Community Banking segment whereas it was a separate segment in 2004. The factors used in determining these reportable segments are more fully explained in Note 25 beginning on page 123.

Accounting for Business Combinations

For all business combinations initiated after June 30, 2001, Statement of Financial Accounting Standards No. 141, Business Combinations (“SFAS 141”) requires them to be accounted for by the purchase method of accounting.

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With the adoption of SFAS 142, on January 1, 2002, the Company ceased amortizing the goodwill that had resulted from purchase transactions entered into prior to the adoption of SFAS 141. However, as discussed above, goodwill is subject to at least an annual assessment for impairment by applying a fair-value-based test. Based on its annual assessment for impairment, Management does not believe that any material impairment of goodwill has occurred.

In addition to goodwill, other intangible assets may be acquired in a business combination. If the benefit of the intangible asset is obtained through contractual or other legal rights, or if the intangible asset can be sold, transferred, licensed, rented, or exchanged, regardless of the acquirer’s intent to do so, the acquired intangible asset will be separately recognized. Such intangible assets are subject to amortization over their useful lives. Among these intangibles assets are core deposit intangibles and loan servicing rights. The Company amortizes core deposit intangibles over their estimated useful life which is generally not longer than five years. The loan servicing rights are amortized in proportion to and over the life of the anticipated service fee revenue.

Consolidation of Variable Interest Entities

As described above on page 82, the Company has a number of subsidiaries in addition to the Bank. Some of these are consolidated with the Bank in the statements of the Company. If, by design, the owners of the entity have not made an equity investment sufficient to absorb its expected losses and the owners lack any one of three essential characteristics of controlling financial interest, the entity is termed a “variable interest entity” and is to be consolidated in the financial statements of its primary beneficiary. The three characteristics are the ability to make decisions about the entity’s activities, the obligation to absorb the expected losses of the entity, and the right to receive the expected residual returns of the entity.

Variable Interest Entities used for Securitizations:  The Company has one special-purpose entity used for the securitization described in Note 11 on page 104. This subsidiary is wholly owned by the Company. This special-purpose entity is consolidated with the Company. In the structure of this securitization, the loans are sold by the special-purpose entity to multi-seller conduits. The Company has considered whether these conduits to which it has sold the RALs should be consolidated with the Company in its financial statements. Based on the following factors, the Company has concluded that it is not the primary beneficiary of these entities and therefore does not consolidate them:

(1) the Company sells assets to these entities only during the first quarter of each year that are held by the entities for less than two months;

(2) these entities hold assets purchased from other financial institutions during the remainder of the year;

(3) the assets sold by the Company to these entities are never more than a third of the assets held by the entities;

(4) the Company can make no decisions for these entities as to whether they will purchase assets from the Company or from any other source; and

(5) the Company is not responsible for any losses from RALs sold to these entities other than the minimal interest in the loans retained by the Company.

Trust Preferred Subsidiaries:  In connection with the acquisitions of FBSLO and PCCI, Bancorp added four business trust subsidiaries which had been originally created by FBSLO and PCCI for the exclusive purpose of issuing trust preferred securities. These subsidiaries are wholly owned by the Company. The four subsidiaries are FBSLO Trust I, PCC Trust I, PCC Trust II, and PCC Trust III. The purchasers of the securities issued by these business trusts are the primary beneficiaries of these entities and they are therefore not consolidated with the Company. However, the Company has included the investments in these subsidiaries in “Other assets” and the subordinated debt owed by the Company to these subsidiaries is included in “Long-term debt and other borrowings” on its Consolidated Balance Sheets. This subordinated debt has the same terms as the trust preferred securities owed by the trusts, except that the debt owed to the entities is subordinated debt for the Company, whereas the debt owed by the entities to the holders of their securities is senior debt.

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Consequently, were the Company to consolidate these entities, there would be no additional amounts of debt shown in the Company’s financial statements, but the characterization of the debt would be different, in that it would be senior debt rather than subordinated debt. In its Consolidated Statements of Income, the Company has reported dividend income from the subsidiaries in “Other income” and interest expense on the subordinated debt in “Other borrowed funds.” If the Company consolidated the entities, the dividend income and the interest expense would be eliminated and the Company would report the interest expense that was paid directly to the holders of the securities.

Low-income Tax Credit Partnerships:  The Company has invested $33 million in limited partnerships that construct low-income housing. The partnerships generate tax credits for the Company. Generally, the Company’s partnership interests are less than 50% of the total interests. There are two partnerships for which the Company owns a greater than 50% interest. The Company is the primary beneficiary of these partnerships and, if material, would consolidate these partnerships in its financial statements.

For one of these two, the Company owns 100% and therefore the inclusion of its share interest effectively is consolidating the partnership in its financial statements. The Company owns 51% of the second partnership. In 2005, if the Company were to consolidate this partnership, it would result in an additional $3.1 million in assets and a liability for the minority interest of $3.1 million. This represents less than 0.05% of the Company’s assets. The Company would also have recognized the whole amount of the operating losses of this partnership, decreasing noninterest revenue by approximately $300,000 and recognized a reduction of other expense for $300,000 for the other partners’ share of the losses. These amounts represent less than 0.2% of income before taxes. There would be no net effect on pre-tax income or net income. Based on these immaterial amounts, the Company has decided not to consolidate this second partnership.

Other Subsidiaries:  The remaining subsidiaries of the Company are inactive, but they are consolidated in the financial statements of the Company.

The Company is not aware of any other entities that should be considered for consolidation.

Other Recent Accounting Pronouncements

In December 2003, the Accounting Standards Executive Committee of the AICPA issued Statement of Position 03-3 (“SOP 03-3”). The Company adopted SOP 03-3 on January 1, 2005 with no financial impact. SOP 03-3 requires loans that are acquired in a transfer or business combination, the credit quality of which has deteriorated since origination, to be recorded at fair value. No allowance for loan losses or other valuation allowance is permitted for these loans at the time of acquisition. Valuation allowances for them should reflect only losses incurred after the acquisition. An allowance is permitted to be established at the time of acquisition for other loans purchased in the transaction.

Stock-Based Compensation

The Company adopted Statement of Financial Accounting Standards No. 123R, Share Based Payment (“SFAS 123R”) on January 1, 2006. This statement requires issuers to record compensation expense over the vesting period of the share-based award. In the case of stock options, the amount of compensation expense to be recognized over this term is the “fair value” of the options at the time of the grant as determined by an option pricing model. The option pricing model computes fair value for the options based on the length of their term, the volatility of the stock price in past periods, and other factors. Under this method, the issuer recognizes compensation expense regardless of whether the officer or director eventually exercises the options.

The statement further requires that not only must stock options awarded in 2006 and subsequent years be accounted for in this manner, but as part of the implementation, the Company must recognize compensation expense for stock options awarded in past years. This may be done by one of two transition methods—the modified prospective method or the modified retrospective method. Under the modified prospective method, awards that are granted, modified, or settled after the date

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of adoption should be measured and accounted for in accordance with SFAS 123R. Unvested awards that were granted prior to the January 1, 2006 should be accounted for in accordance with the earlier issued Statement of Financial Accounting Standards No. 123, i.e. by the fair value method. Compensation expense will be recognized in the income statement for those prior year awards beginning in the first quarter of 2006. Under the modified retrospective approach, the previously reported results of operations are restated, either to the beginning of the year of adoption or for all periods presented, to reflect the SFAS 123 amounts in the income statement.

The Company has decided to use the modified prospective method of adopting SFAS 123R. Management expects the adoption of this statement will have an effect on its annual earnings in 2006 approximately equivalent to the proforma adjustments disclosed below for SFAS 123 for 2005, i.e. a reduction of $1.2 million or $0.02 per share. The amount for 2005 represents a reduction of 1.4% of 2005 earnings.

Had the Company recognized compensation expense over the expected life of the options using the fair value method, the Company’s pro forma salary expense, net income, and earnings per share for the years ended December 31, 2005, 2004, and 2003 would have been as follows:

	Years Ended December 31,
(dollars in thousands)	2005			2004			2003
Net Income, as reported	$	99,285		$	87,944		$	75,671
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(1,225	)		(2,250	)		(618	)
Pro forma net income	$	98,060		$	85,694		$	75,053
Earnings Per Share:
Basic—as reported	$	2.16		$	1.93		$	1.66
Basic—pro forma	$	2.13		$	1.88		$	1.64
Diluted—as reported	$	2.14		$	1.92		$	1.64
Diluted—pro forma	$	2.12		$	1.87		$	1.63

For purposes of this computation for 2005, the significant assumptions used, computed on a weighted average basis, were:

Risk free interest rate:	4.18%
Expected life:	4 years for 5-year options, 5 years for 10-year options
Expected volatility 2 years:	0.3155
Expected volatility 4 years:	0.2837
Expected volatility 5 years:	0.2691
Expected dividend	$0.80 per year

For purposes of this computation for 2004, the significant assumptions used, computed on a weighted average basis, were:

Risk free interest rate:	3.53%
Expected life:	4 years for 5-year options, 5 years for 10-year options
Expected volatility 2 years:	0.2841
Expected volatility 4 years:	0.2636
Expected volatility 5 years:	0.2651
Expected dividend:	$0.72 per year

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For purposes of this computation for 2003, the significant assumptions used, computed on a weighted average basis, were:

Risk free interest rate:	2.62%
Expected life:	4 years for 5-year options, 5 years for 10-year options
Expected volatility 2 years:	0.2025
Expected volatility 5 years:	0.2276
Expected dividend:	$0.63 per year

2.    MERGERS AND ACQUISITIONS

On February 28, 2005, the Company entered into a definitive agreement with First Bancshares, Inc. (“FBSLO”) under which the Company would acquire FBSLO in an all cash transaction. The FBSLO transaction closed on August 1, 2005. The consideration paid was $60.8 million in cash, or $48 per each diluted share of FBSLO stock. FBSLO was headquartered in San Luis Obispo, California, had two branches in that city, and provided traditional deposit and loan products to its customers, including commercial and commercial real estate loans; checking, savings, and certificate of deposits; and other traditional banking services through its banking subsidiary. At the time of the acquisition of FBSLO, the banking subsidiary, First Bank of San Luis Obispo, was merged into PCBNA. The Company acquired FBSLO for its customer relationships and as an entry vehicle into the San Luis Obispo County, which lies between the Company’s two primary market areas, Santa Barbara County and Monterey County. The Company believes that there are many customers in the San Luis Obispo County similar to its current customers in those primary market areas. The Company’s Consolidated Financial Statements include the operations of FBSLO from the period of August 1, 2005 through December 31, 2005. The Company acquired $51.3 million in investment securities, $217 million in loans, $254 million in deposits, and other assets and liabilities. The excess of the purchase price over the net fair value of the assets and liabilities, $32.1 million, was recognized as goodwill as discussed in Note 9 of these financial statements.

On March 5, 2004, the Company acquired PCCI in an all cash transaction valued at $136 million, or $26 per each diluted share of PCCI common stock. PCCI was an Agoura Hills, California-based bank holding company that conducted business through its wholly-owned subsidiary, Pacific Crest Bank. The bank had three branches located in Beverly Hills, Encino and San Diego. Since its establishment in 1974, Pacific Crest Bank had operated as a specialized business bank serving small businesses, entrepreneurs and investors. Its products include customized loans on income producing real estate, business loans under the U.S. Small Business Administration (“SBA”) 7(a) and 504 programs, lines of credit and term loans to businesses and professionals, and savings and checking account programs. Pacific Crest Bank was an SBA-designated “Preferred Lender” in California, Arizona and Oregon. In addition to three branches, it operated six loan production offices in California and Oregon. The Company acquired PCCI primarily for its commercial real estate and SBA commercial business lending operations. The Company’s Consolidated Statements of Income include the operations of PCCI from March 6, 2004 through December 31, 2005. The Company acquired $121 million in investment securities, $419 million in loans, $291 million in deposits, and other assets and liabilities. The excess of the purchase price over the net fair value of the assets and liabilities, $78.5 million, was recognized as goodwill as discussed in Note 9 of these financial statements.

The Company recognized and added $5.1 million to the allowance for loan losses in connection with the March 5, 2004 acquisition of PCCI and $1.7 million to the allowance for loan losses in connection with the August 1, 2005 acquisition of FBSLO.

The Company has not disclosed pro forma information about combined operations as the acquisitions were not material to the Company as a whole.

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3.    EARNINGS PER SHARE

The following table presents a reconciliation of basic earnings per share and diluted earnings per share. The denominator of the diluted earnings per share ratio includes the effect of dilutive securities. The only securities outstanding that are potentially dilutive are the employee stock options and the restricted stock. In the second quarter of 2004 the Company’s Board of Directors approved a 4 for 3 stock split. The share and per share amounts appearing in the following table have been restated to reflect this split.

(amounts in thousands other than per share amounts)	Basic Earnings Per Share		Diluted Earnings Per Share
For the Year Ended December 31, 2005
Numerator—Net Income	$	99,285	$	99,285
Denominator—weighted average shares outstanding		45,964		45,964
Plus: net shares issued in assumed stock option exercises				394
Diluted denominator				46,358
Earnings per share	$	2.16	$	2.14
Anti-dilutive options excluded				157
Weighted average stock price during the year			$	32.85
For the Year Ended December 31, 2004
Numerator—Net Income	$	87,944	$	87,944
Denominator—weighted average shares outstanding		45,535		45,535
Plus: net shares issued in assumed stock option exercises				376
Diluted denominator				45,911
Earnings per share	$	1.93	$	1.92
Anti-dilutive options excluded				28
Weighted average stock price during the year			$	29.17
For the Year Ended December 31, 2003
Numerator—Net Income	$	75,671	$	75,671
Denominator—weighted average shares outstanding *		45,646		45,646
Plus: net shares issued in assumed stock option exercises *				437
Diluted denominator *				46,083
Earnings per share	$	1.66	$	1.64
Anti-dilutive options excluded				40
Weighted average stock price during the year			$	24.29

* Prior year shares were adjusted to account for stock split in June 2004.

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4.    CASH AND DUE FROM BANKS

All depository institutions are required by law to maintain reserves against their transaction deposits. The reserve must be held in cash or with the Federal Reserve Bank (“FRB”) for their area. The amount of reserve may vary each day as banks are permitted to meet this requirement by maintaining the specified amount as an average balance over a two-week period. The average daily cash reserve balances required to be maintained by PCBNA totaled approximately $6.9 million in 2005 and $5.6 million in 2004. In addition, PCBNA must maintain sufficient balances to cover the checks written by bank customers that are clearing through the FRB because they have been deposited at other banks. This generally means that PCBNA holds substantially more than the $6.9 million minimum amount at FRB.

5.    SECURITIES

A summary of securities owned by the Company at December 31, 2005 and 2004, is as follows:

(dollars in thousands)	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value
December 31, 2005
Available-for-sale:
U.S. Treasury obligations	$	100,208	$	34	$	(1,189	)	$	99,053
U.S. agency obligations		261,854		23		(3,194	)		258,683
Collateralized mortgage obligations		63,429		9		(1,186	)		62,252
Mortgage-backed securities		721,704		662		(18,585	)		703,781
Asset-backed securities		7,114		—		(20	)		7,094
State and municipal securities		213,537		25,828		(679	)		238,686
	$	1,367,846	$	26,556	$	(24,853	)	$	1,369,549
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value
December 31, 2004
Available-for-sale:
U.S. Treasury obligations	$	112,401	$	401	$	(576	)	$	112,226
U.S. agency obligations		209,353		1,513		(821	)		210,045
Collateralized mortgage obligations		63,663		76		(486	)		63,253
Mortgage-backed securities		916,987		4,598		(9,786	)		911,799
Asset-backed securities		20,274		72		(39	)		20,307
State and municipal securities		188,444		19,225		(425	)		207,244
	$	1,511,122	$	25,885	$	(12,133	)	$	1,524,874

The Mortgage Backed Securities in the two tables above primarily consist of securities issued by Government Sponsored Enterprises, specifically Fannie Mae, Freddie Mac, and Federal Home Loan Banks.

The amortized cost and estimated fair value of debt securities at December 31, 2005 and 2004, by contractual maturity, are shown in the next table. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. With interest rates on a number of the Company’s securities higher than the current rates on similarly rated securities, Management expects that if the issuers have the right to call the security—pay it off early—they will do so.

Principal payments to be received from securities that do not have a single maturity date—asset-backed securities, mortgage-backed securities, and collateralized mortgage obligations—are

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included in the table below. The timing of those payments is estimated based on the contractual terms of the underlying loans adjusted for estimates of prepayments. However, similarly to security issuers that retained the right to call the security before maturity, homeowners may prepay their mortgages if interest rates have fallen to the extent that refinancing becomes advantageous. While not included in the above table based on contractual maturities, prepayments are estimated by the Company and reviewed at the end of each period in response to the then current interest rate environment, they are included in the following table. These estimates are used in valuing securities and in planning cash flows and managing interest rate risk.

(dollars in thousands)	December 31,
	2005		2004
Available for Sale
Amortized cost:
In one year or less	$	141,264	$	137,209
After one year through five years		876,075		722,391
After five years through ten years		158,206		400,647
After ten years		192,301		250,875
Total Securities	$	1,367,846	$	1,511,122
Estimated fair value:
In one year or less	$	140,082	$	138,017
After one year through five years		857,932		720,168
After five years through ten years		158,525		401,657
After ten years		213,010		265,032
Total Securities	$	1,369,549	$	1,524,874

The proceeds received from sales and calls of debt securities and the gross gains and losses that were recognized for the years ended December 31, 2005, 2004, and 2003 are shown in the next table.

(in thousands)	2005							2004							2003
	Proceeds		Gross Gains		Gross Losses			Proceeds		Gross Gains		Gross Losses			Proceeds		Gross Gains		Gross Losses
Held-to-maturity:
Sales	$	—	$	—	$	—		$	—	$	—	$	—		$	—	$	—	$	—
Calls	$	—	$	—	$	—		$	—	$	—	$	—		$	627	$	12	$	—
Available-for-sale:
Sales	$	47,400	$	—	$	(730	)	$	86,745	$	37	$	(2,055	)	$	145,924	$	2,420	$	(414	)
Calls	$	1,550	$	—	$	—		$	1,869	$	—	$	—		$	65	$	—	$	—

As mentioned in Note 1, the Company reclassified all of its held-to-maturity securities to available-for-sale as of December 31, 2003. The amount reclassified was $65 million and the unrealized gain related to these securities was $10.8 million.

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The fair value of securities can change due to credit concerns, i.e. whether the issuer will in fact be able to pay the obligation when due. The fair value can also change due to changes in interest rates. Specifically the fair value of fixed rate securities will decline as interest rates rise and increase as rates decline. The following table shows those securities for which there is an unrealized loss by category of security and for how long there has been an unrealized loss.

	Less than 12 months					12 months or more					Total
As of December 31, 2005 (dollars in thousands)	Fair Value		Unrealized Loss			Fair Value		Unrealized Loss			Fair Value		Unrealized Loss
US Treasury/US Agencies	$	164,351	$	(1,925	)	$	133,877	$	(2,458	)	$	298,228	$	(4,383	)
Mortgage Backed Securities		281,303		(3,610	)		410,473		(14,975	)		691,776		(18,585	)
Municipal Bonds		25,074		(216	)		11,481		(463	)		36,555		(679	)
Asset backed Securities		6,176		(19	)		918		(1	)		7,094		(20	)
Collateralized mortgage obligations		32,284		(411	)		28,629		(775	)		60,913		(1,186	)
Total temporarily impaired securities	$	509,188	$	(6,181	)	$	585,378	$	(18,672	)	$	1,094,566	$	(24,853	)
	Less than 12 months					12 months or more					Total
As of December 31, 2004 (dollars in thousands)	Fair Value		Unrealized Loss			Fair Value		Unrealized Loss			Fair Value		Unrealized Loss
US Treasury/US Agencies	$	161,519	$	(1,397	)	$	—	$	—		$	161,519	$	(1,397	)
Mortgage Backed Securities		379,722		(3,881	)		239,932		(5,905	)		619,654		(9,786	)
Municipal Bonds		5,252		(69	)		8,066		(356	)		13,318		(425	)
Asset backed Securities		6,282		(39	)		—		—			6,282		(39	)
Collateralized mortgage obligations		52,678		(486	)		—		—			52,678		(486	)
Total temporarily impaired securities	$	605,453	$	(5,872	)	$	247,998	$	(6,261	)	$	853,451	$	(12,133	)

As shown in the table, at December 31, 2004 and 2005, some of the securities have had unrealized losses for more than twelve months. Generally these securities were purchased within the first half of 2003 when intermediate and long term interest rates were lower than at December 31, 2004 and 2005. The Company does not hold any securities that it believes to be other than temporarily impaired where the impairment is due to credit concerns as described in Securities and Exchange Commission Staff Accounting Bulletin #59. If the Company holds securities to maturity for which the market value has declined because of changes in interest rates, the principal will be collected in full. As of December 31, 2004 and 2005, the Company had both the ability and intent to hold these securities to their maturity or recovery. The Company has concluded that none of these securities is other than temporarily impaired.

At December 31, 2004, the Company had identified three of its securities with a market value of $23.0 million to be sold subsequent to year-end. Because of this intention to sell, the impairment in the case of these securities was other than temporary, and the Company recorded a loss by a charge against income to adjust the carrying amount of these securities to their fair value at December 31, 2004. The amount of the loss, totaling $501,000, is included in net gain or loss on sales and calls of securities on the Consolidated Statement of Income for the year ended December 31, 2004. These securities are not included in the table above because the losses have been realized through this adjustment. At December 31, 2005, the Company had identified no securities that it intended to sell.

Securities with a carrying value of approximately $1.28 billion at December 31, 2005, and $1.37 billion at December 31, 2004, were pledged to secure public funds, trust deposits, repurchase agreements and other borrowings as required or permitted by law.

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These amounts pledged are substantially in excess of the amount of such funds that are normally required to be supported by collateral. The Company borrows extensively during the first quarter of each year to fund its RAL program, and pledges securities not otherwise used as collateral in advance of the need for such borrowings.

6.    LOANS

The loan portfolio consists of the following:

(dollars in thousands)	December 31,
	2005		2004
Real estate:
Residential—1 to 4 family	$	1,128,318	$	901,679
Multi-family residential		256,857		182,936
Nonresidential		1,160,864		1,028,278
Construction		374,500		286,387
Commercial loans		934,840		826,684
Home equity loans		319,195		212,064
Consumer loans		431,542		387,257
Leases		287,504		234,189
Other Loans		3,666		2,820
Total loans	$	4,897,286	$	4,062,294

The amounts above are shown net of deferred loan origination, commitment, and extension fees and origination costs of $6.2 million for 2005 and $7.1 million for 2004. Nonresidential real estate loans consist of a variety of commercial buildings including office, manufacturing facilities, wineries and warehouses.

The Company had outstanding partial participations of loans totaling $27.4 million, $23.5 million and $35.6 million at December 31, 2005, 2004, and 2003 respectively.

Related Parties

In the ordinary course of business, the Company has extended credit to directors and executive employees of the Company totaling $6.7 million at December 31, 2005 and $7.1 million at December 31, 2004. Such loans are subject to ratification by the Board of Directors, exclusive of the borrowing director. Federal banking regulations require that any such extensions of credit not be offered on terms more favorable than would be offered to borrowers of similar credit worthiness that are not related parties.

Impaired Loans

The table below discloses information about the loans classified as impaired and the valuation allowance related to them:

(dollars in thousands)	December 31,
	2005		2004
Loans identified as impaired	$	60,476	$	35,966
Impaired loans for which a valuation allowance has been established	$	1,960	$	7,476
Amount of valuation allowance for impaired loans	$	308	$	4,821
Impaired loans for which no valuation allowance has been established	$	58,516	$	28,490

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	Years Ended December 31,
	2005		2004		2003
Average amount of recorded investment in impaired loans for the year	$	46,372	$	42,803	$	46,081
Interest recognized during the year for loans identified as impaired at year-end	$	4,835	$	1,093	$	372
Interest received in cash during the year for loans identified as impaired at year-end	$	4,696	$	1,972	$	983

As indicated in Note 1 on page 82, a valuation allowance is established for an impaired loan when the fair value of the loan is less than the recorded investment. The valuation allowance amounts disclosed above are included in the allowance for credit losses reported in the balance sheets for December 31, 2005 and 2004. While the balance of impaired loans has almost doubled, the amount of allowance for impaired loans has decreased. The reason for this seeming inconsistency is that loans are required to be classified as impaired when the Company expects that it will not be repaid according to the terms of the loan agreement. With respect to the loans that were classified as impaired in 2005, the Company expects that it will eventually be repaid later than agreed or through the foreclosure of collateral and consequently believes that very little if any loss has been incurred. With payment of principal and interest expected, the Company has not classified these loans as nonaccrual. Total nonaccrual loans as disclosed in the table below are thus substantially lower than total impaired loans.

Nonaccrual and Past Due Loans Still Accruing:

(dollars in thousands)	December 31,
	2005		2004
Nonaccrual loans	$	16,590	$	21,701
90 days or more past due		1,227		820
Restructured Loans		—		—
Total noncurrent loans		17,817		22,521
Foreclosed collateral		2,910		2,910
Total nonperforming assets	$	20,727	$	25,431

All restructured loans at December 31, 2005 and 2004 were classified as nonaccrual.

Refund Anticipation Loans

The Company offers tax refund anticipation loans (“RALs”) to taxpayers desiring to receive advance proceeds based on their anticipated income tax refunds. The loans are repaid when the Internal Revenue Service later sends the refund to the Company. The funds advanced are generally repaid within several weeks. Therefore, the processing costs and provision for loan loss represent the major costs of the loans. This is in contrast to other loans for which the cost of funds is the major cost to the Company. Because of their short duration, the Company cannot recover the processing costs through interest calculated over the term of the loan. Consequently, the Company has a tiered fee schedule for this service. The larger the loan, the larger the amount at risk from nonpayment and therefore the fee varies by the amount of funds advanced due to the increased credit risk rather than the length of time that the loan is outstanding. Nonetheless, because the customer signs a loan application and note, the Company reports the fees as interest income. These fees totaled $64.7 million in 2005, $36.5 million for 2004, and $31.7 million for 2003. As more fully described under Summary of Operating Results for the RAL program in Management’s Discussion and Analysis on page 64, the increase in fees for 2005 was primarily due to changes in the contract with one of the Company’s largest tax preparer groups. The loans are all made during the tax-filing season of January through April of each year. Any loans for which repayment has not been received by the end of the year are charged off. Consequently, there were no RALs included in the above table of outstanding loans at December 31, 2005 or 2004.

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As one of its sources of funding the RAL program in 2004 and 2005, the Company sold some of the loans through the securitization as described in Note 11 on page 104. The gains on these securitizations representing the net amounts of the fees from the loans, the fees paid, and the provision expense classified as gain on sale of loans in 2005, 2004 and 2003 were $26.0 million, $2.9 million and $8.0 million, respectively. As noted above, the large increase in net fees for 2005 was primarily due to changes in the contract with one of the Company’s largest tax preparer groups.

Pledged Loans

At December 31, 2005 loans secured by first trust deeds on residential and commercial property with principal balances totaling $613.5 million were pledged as collateral to the FRB. At December 31, 2005, loans secured by first deeds on residential and commercial property with principal balances of $1.7 billion were pledged to the FHLB.

These amounts pledged do not represent the amount of outstanding borrowings that are required to be supported by collateral. The Company borrows extensively during the first quarter of each year to fund its RAL program, and pledges loans not otherwise used as collateral in advance of the need for such borrowings.

Sale of Loans

Based on consideration of interest rates, concentrations, and size of loans, the Company may sell loans to other banks or financial institutions. The Company had no commitments to sell and as of December 31, 2005 and 2004, the Company had no loans held for sale. For loans other than RALs sold through the securitization, the Company realized $2.8 million, $3.4 million, and $1.9 million of gains from the sale of loans for 2005, 2004 and 2003 respectively. The Company realized gains of $26.0 million, $2.9 million, and $8.0 million for the same years for RALs sold through the securitization.

Letters and Lines of Credit

In order to meet the financing needs of its customers in the normal course of business, the Company is a party to financial instruments with “off-balance sheet” risk. These financial instruments consist of commitments to extend credit and standby letters of credit.

The maximum non-discounted exposure to credit risk is represented by the contractual notional amount of those instruments. The majority of the commitments are for one year or less. The majority of the credit lines and commitments may be withdrawn by the Company subject to applicable legal requirements. As of December 31, 2005 and 2004, the contractual notional amounts of these instruments are as follows:

(dollars in thousands)	As of December 31, 2005										As of December 31, 2004
	Less than one year		One to three years		Three to five years		More than five years		Total
Commercial lines of credit	$	307,111	$	109,521	$	51,006	$	82,527	$	550,165	$	485,374
Consumer lines of credit		4,365		7,182		14,307		304,403		330,257		247,783
Standby letters of credit and financial guarantees		43,494		19,888		28,599		4,093		96,074		102,631
Total	$	354,970	$	136,591	$	93,912	$	391,023	$	976,496	$	835,788

Commitments to extend credit—lines of credit—are agreements to lend to a customer as long as there is no violation of any condition established in the contract. The Company has not usually charged fees in connection with loan commitments.

Changes in market rates of interest for those few commitments and undisbursed loans which have fixed rates of interest represent a possible cause of loss because of the contractual requirement to lend money at a rate that is no longer as great as the market rate at the time the loan is funded. To minimize this risk, if rates are quoted in a commitment, they are generally stated in relation to the

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Company’s prime or base lending rate. These rates vary with prevailing market interest rates. Fixed-rate loan commitments are not usually made for more than three months.

The Company anticipates that a majority of the above commitments will not be fully drawn on by customers. Consumers do not tend to borrow the maximum amounts available under their home equity lines and businesses typically arrange for credit lines in excess of their expected needs to handle contingencies.

Standby letters of credit and financial guarantees are conditional commitments issued by the Company to guarantee the performance of a customer to a third party in borrowing arrangements. At December 31, 2005, the maximum undiscounted future payments that the Company could be required to make was $96.1 million. Approximately 89% of these arrangements mature within one year. The Company generally has recourse to recover from the customer any amounts paid under these guarantees. Most of the guarantees are fully collateralized by the same types of assets used as loan collateral, however several are unsecured. The Company has a $244,000 liability recorded that is associated with the fair market value of the guarantees at December 31, 2005.

In the case of lines of credit, this arises from the Company being obligated to lend money to a borrower whose financial condition may indicate less ability to pay than when the commitment was originally made. In the case of standby letters of credit, this risk arises from the possibility of the failure of the customer to perform according to the terms of a contract. In such a situation the third party might draw on the standby letter of credit to pay for completion of the contract and the Company would have to look to its customer to repay these funds to the Company with interest. To minimize the risk, the Company uses the same credit policies in making commitments and conditional obligations as it would for a loan to that customer. The decision as to whether collateral should be required is based on the circumstances of each specific commitment or conditional obligation. Because of these practices, Management does not generally anticipate that any significant losses will arise from such draws. In 2003 and 2004, however, the third party for two letters of credit issued for one customer made several draws on the letters of credit because of the borrower’s inability to meet its financial commitment. The Company did not recognize a receivable for the amount of the draw because of doubts regarding the borrower’s ability to pay the Company.

The Company has established an estimate for credit loss on letters of credit. In accordance with GAAP, this estimate is not included as part of the allowance for credit loss reported on the consolidated balance sheets for outstanding loans. Instead, the amount is included in other liabilities.

The table below shows charges in this estimate for the last three years. The funding of the letters of credit mentioned above are included in the table for 2003 and 2004.

(dollars in thousands)	Years ended December 31,
	2005			2004			2003
Beginning estimate	$	1,232		$	3,942		$	2,446
Additions and other changes		571			50			4,624
Funded and written-off		(118	)		(2,760	)		(3,128	)
Ending estimate	$	1,685		$	1,232		$	3,942

Concentration of Lending Activities

With the exception of the RAL program, the Company has concentrated its lending activity primarily with customers in the market areas served by its branch offices. Mergers and acquisitions have introduced some geographical diversity as each market area now represents only a portion of the whole Company. The business customers are in widely diversified industries, and there is a large consumer component to the portfolio. The Company monitors concentrations within four broad categories: industry, geography, product, and collateral. One significant concentration in the loan portfolio is represented by loans collateralized by real estate. The nature of this collateral, however, is quite varied, namely 1-4 family residential, multifamily residential, and commercial buildings of various kinds. The Company has considered this concentration in evaluating the adequacy of the allowance for credit loss in the allocated component.

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7.    ALLOWANCE FOR CREDIT LOSSES

The following summarizes the changes in the allowance for credit losses:

(in thousands)	Years Ended December 31,
	2005			2004			2003
Balance, beginning of year	$	53,977		$	49,550		$	53,821
Tax refund anticipation loans:
Provision for credit losses		38,210			8,468			8,530
Recoveries on loans previously charged-off		10,745			4,043			5,182
Loans charged-off		(48,955	)		(12,511	)		(13,712	)
All other loans:
Additions from bank acquisitions		1,683			5,143			—
Provision for credit losses		15,663			4,341			9,756
Recoveries on loans previously charged-off		6,711			10,704			6,562
Loans charged-off		(22,436	)		(15,761	)		(20,589	)
Balance, end of year	$	55,598		$	53,977		$	49,550

The ratio of losses to total loans for the RALs is higher than for other loans. As mentioned in Note 6, all RALs unpaid by the end of the year are charged-off. Therefore, no allowance for RALs is necessary. The provision for credit loss, the loans charged-off, and the loans recovered are reported separately from the corresponding amounts for all other loans.

The Company has exposure to credit losses from extending loan commitments and letters of credit as well as from loans and leases. Because funds have not yet been disbursed on these commitments and letters of credit, the face amount is not included in the amounts reported for loans and leases outstanding. Consequently, any amount provided for credit losses related to these instruments is not included in the allowance for credit losses reported in the table above, but is instead accounted for as a loss contingency. The recording of this separate liability is accomplished by a charge to other operating expense.

8.    PREMISES, EQUIPMENT AND OTHER LONG-TERM ASSETS

Premises and equipment consist of the following:

(in thousands)	December 31,
	2005			2004
Land	$	5,764		$	5,764
Buildings and improvements		30,331			30,259
Leasehold improvements		37,472			32,263
Furniture and equipment		112,308			95,986
Developed software		44,137			12,228
Software in development		3,789			21,112
Total cost		233,801			197,612
Accumulated depreciation and amortization		(117,970	)		(97,330	)
Net book value	$	115,831		$	100,282

Software purchased by the Company is included above in furniture and equipment. Developed software represents the cost of developing or modifying software and primarily relates to the Company’s core accounting and retail delivery systems implemented in 2005. Included in the development costs is capitalized interest. For the years ended December 31, 2005, 2004, and 2003, the Company capitalized interest costs of approximately $661,000, $250,000, and $114,000, respectively. These capitalized costs are amortized over the expected life of the software. The software was installed in 2005 for each of the Company’s brands except for the operations acquired from FBSLO and PCCI.

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Depreciation and amortization on fixed assets included in operating expenses totaled $10.8 million in 2005, $8.9 million in 2004, and $9.1 million in 2003. The amount for 2004 and 2005 include the amortization of the capital lease for the year.

9.    GOODWILL AND OTHER INTANGIBLE ASSETS

Goodwill is recorded on the balance sheets in connection with acquisitions of other financial institutions or branches of other institutions that qualify as a business. The Company recognizes the excess of the purchase price over the estimated fair value of the assets received less the fair value of the liabilities assumed as goodwill. The balance at December 31, 2005 was $140.6 million and at December 31, 2004 was $109.7 million. Of the balance of goodwill at December 31, 2005, $32.1 million is related to the acquisition of FBSLO in 2005. $78.5 million is related to the acquisition of PCCI in 2004 and $30.0 million is related to previous acquisitions. The goodwill related to the acquisition of PCCI was adjusted during 2005 and did not impact the balance at December 31, 2004.

Goodwill is allocated to the unit(s) of the acquired company that are deemed by Management to have provided the value in the acquisition. PCCI was acquired primarily for the lending units while FBSLO was acquired for its customer relationships and growth prospects. In the case of the prior purchases and FBSLO, the perceived value was in the deposit relationships and the consumer and small business lending. Consequently, all of the goodwill is recorded in the “Community Banking” segment, which includes the Company’s deposit activities and consumer and small business lending. In 2004, a portion of PCCI’s goodwill was originally recorded in the “Pacific Capital” segment but, due to a change in reporting segments discussed in Note 25 on page 123, all goodwill from acquisitions is now reported in the “Community Banking” segment, which includes consumer and small business deposit and lending activities.

In addition to the goodwill recorded in the FBSLO and PCCI acquisitions, the Company recognized separate intangibles for the value of the core deposit relationships. Similar intangible assets were recorded at the time of the purchase of the deposits and/or branches from other financial institutions. The Company has allocated these intangible assets in the business units within the Community Banking segment. Core deposit intangibles are amortized over the expected life using effective yield of the deposit relationships. The initial amounts, accumulated amortization, and the total amount of these core deposit intangibles as of December 31, 2005 and 2004 are shown in the following table:

(Dollars in thousands)	December 31, 2005			December 31, 2004
Initial amount recorded	$	13,174		$	6,867
Accumulated amortization		(5,159	)		(3,224	)
Unamortized balance	$	8,015		$	3,643

Amortization expense for these intangibles was $1.9 million, $1.7 million and $0.8 million for the years ended December 31, 2005, 2004 and 2003, respectively. Amortization expense over the next five years on this core deposit intangible is calculated over a weighted average life of 7.3 years and is expected to be:

Year	(Dollars in thousands)
2006	$	2,235
2007	$	1,192
2008	$	863
Thereafter	$	3,725

Intangible assets, including goodwill, have been and will be reviewed at least each year to determine if circumstances related to their valuation have been materially affected. In the event that the current market values are determined to be less than the current book values (impairment), a

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charge against current earnings will be recorded. The Company adjusted the value of the core deposit intangible recognized in the purchase of PCCI by $0.5 million during 2004 as the deposits decreased more than expected. No further impairment existed at December 31, 2005 or 2004.

10.    OTHER ASSETS

During 2005, the Company purchased two Bank Owned Life Insurance polices for $60 million. A majority of the increase in other assets since December 31, 2004 is due to this additional investment in BOLI. The excess of the one-time premium over the mortality cost is invested in assets that earn a return for the Company. The increase in the cash surrender value of the life insurance is reported in other income. This income and the proceeds received upon the death of covered employees are generally tax exempt and will be used to fund benefit plans.

Included in other assets are deferred tax assets and investment in tax credit partnerships of $18.2 million and $33.0 million at December 31, 2005, respectively, which are disclosed in more detail in Note 16. Investment in FRB and FHLB Stock of $39.3 million at of December 31, 2005 is included in other assets. Because of the restrictive nature of the investments there are not readily determinable fair values for the purposes of SFAS No. 115 and the investments are carried at cost. As FHLB advances increase, the Company is required to increase the investment in FHLB Stock. Dividends received for the investment in FHLB Stock are recorded in other income. As the Bank’s capital accounts increase, the Bank must purchase additional FRB stock.

11.    TRANSFERS AND SERVICING OF FINANCIAL ASSETS

Refund Anticipation Loan Securitization

The Company established a special purpose, wholly owned subsidiary corporation named SBB&T RAL Funding Corporation to securitize RALs into multi-seller conduits, backed by commercial paper. PCBNA acted as the servicer for all such RALs during the securitization periods. These occur during the first quarter of each year. Generally, the securitization holds loans for only three or four weeks during January and February of each year. As of March 31, 2004 and 2005, all loans sold into the securitization had been either fully repaid or charged-off and no securitization-related balances were outstanding at December 31 of either year. The potential existed at March 31 of each year for subsequent recoveries on loans charged-off in the securitization during the remainder of the year. The Company believes the impact of these recoveries are immaterial to the financial statements and has recognized such recoveries in subsequent quarters along with recoveries of other charges-off RALs as they are realized.

In December 2005, the Company entered into an agreement with other financial institutions to again make use of SBB&T RAL Funding Corporation for the 2006 RAL season by selling RALs into their multi-seller conduits or to the other institution directly. The terms of this agreement are substantially the same as the agreements used in prior years.

Mortgage and Other Loan Servicing Rights

As explained in Note 1 on page 82, the Company recognizes an asset for the value of the fees it will receive for the servicing of loans for others in excess of normal servicing costs and periodically adjusts the carrying value of this asset by means of a valuation allowance.

As of December 31, 2005, the Company serviced $53.6 million in residential loans for investors. Adjustments are made to the valuations allowance almost each quarter. In 2005 as mortgage rates increased, the value of the MSRs increased such that no allowance was necessary. The value of the unamortized MSR at December 31, 2005 was $334,000.

In connection with the acquisitions of PCCI and FBSLO, the Company obtained non-mortgage servicing assets of $1.9 million and $535,000, respectively. These assets were created by sales of SBA and commercial business loans. The servicing asset was recorded at the present value of the excess of the contractual fees that will be collected over the estimated cost of servicing the loans. The Company has continued this activity subsequent to the acquisitions. The servicing asset is

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amortized against noninterest revenue over the expected lives of the underlying loans. As with servicing rights on residential mortgages, prepayments by the borrowers on these loans reduce the value of the servicing asset. The amount of the loans sold and serviced by the Company at December 31, 2005 was $85.9 million, and the amount of the unamortized servicing rights was $1.5 million.

(in thousands)	As of and for the years ended December 31,
	2005			2004			2003
Servicing rights recognized	$	1,789		$	1,139		$	995
Servicing rights added in year, net		492			272			541
PCCI Servicing rights acquired		—			866			—
FBSLO Servicing rights acquired		535			—			—
Servicing rights amortized		(944	)		(488	)		(397	)
Servicing rights at end of period, gross		1,872			1,789			1,139
Valuation allowance beginning of year		(111	)		(602	)		—
Aggregate additions to the allowance		(68	)		(75	)		(602	)
Aggregate reductions of the allowance		179			566			—
Valuation allowance end of year		—			(111	)		(602	)
Servicing rights at end of period, net	$	1,872		$	1,678		$	537

12.    DEPOSITS

Deposits and the related interest expense consist of the following:

(in thousands)	Balance December 31,				Interest Expense Years Ended December 31,
	2005		2004		2005		2004		2003
Noninterest-bearing deposits	$	1,061,711	$	1,013,772	$	—	$	—	$	—
Interest-bearing deposits:
NOW accounts		1,074,368		887,874		9,734		3,527		631
Money market deposit accounts		807,762		703,889		11,645		6,420		8,638
Other savings deposits		363,801		408,101		3,827		2,482		1,030
Time certificates of $100,000 or more		1,201,923		990,809		26,719		18,547		14,525
Other time deposits		508,301		507,845		21,030		11,166		11,337
Total	$	5,017,866	$	4,512,290	$	72,955	$	42,142	$	36,161

Of the total deposits at December 31, 2005, $4.7 billion matures within 1 year, $282 million within 1 to 3 years, $81 million within 3 to 5 years, and $383,000 in more than 5 years. Only certificates of deposit have a specified maturity. The balances of other deposit accounts are assigned to the less than one-year time range.

13. SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE AND FEDERAL FUNDS PURCHASED

Federal funds purchased consist of unsecured overnight borrowings from other financial institutions. Securities sold under agreements to repurchase (“repos”) are borrowings by the Company collateralized by pledging some of the Company’s investment securities. Federal funds purchased and overnight repos are used to balance short-term mismatches between cash inflows from deposits, loan repayments, and maturing securities and cash outflows to fund loans, purchase securities and deposit withdrawals. During the first quarter of the year, they may also be used to provide a portion

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of the short-term funding needed for the RAL program. Throughout the year, repos of several weeks to several months maturity are offered to customers that wish to place funds with the Company in excess of the $100,000 FDIC limit on deposit insurance. The repo product provides them with collateral for their funds held by the Company.

The following information is presented concerning these transactions:

(dollars in thousands)	Repurchase Agreements Years Ended December 31,						Fed Funds Purchased Years Ended December 31,
	2005		2004		2003		2005		2004		2003
Weighted average interest rate at year-end		3.71%		2.04%		0.88%		4.19%		2.20%		0.85%
Weighted average interest rate for the year		3.21%		1.22%		0.65%		2.97%		1.34%		1.26%
Average outstanding for the year	$	100,070	$	20,188	$	16,510	$	86,637	$	100,229	$	50,489
Maximum outstanding at any month-end during the year	$	228,824	$	31,254	$	20,601	$	446,300	$	186,600	$	328,000
Amount outstanding at end of year	$	219,642	$	20,941	$	14,139	$	227,000	$	158,100	$	44,200
Interest expense	$	3,211	$	246	$	107	$	2,570	$	1,343	$	636

In the third Quarter of 2005, the Company issued several longer-term repos totaling $125 million with other financial institutions. These borrowings have a variable rate of interest for an initial period and then may either be called by the other institution or will have their price reset for the remainder of their term. In each case, the initial variable rate is 80 basis points less than the three-month LIBOR rate. The following table provides a summary of the terms of these borrowings:

Amount ($ in 000s)	Initial Rate		Call Date	Fixed Reset Rate		Final Maturity
$50,000	2.88	%	7/29/08	4.440	%	7/29/15
$25,000	3.04	%	8/25/07	4.110	%	8/25/15
$25,000	3.04	%	2/25/08	4.185	%	8/25/15
$25,000	3.07	%	3/15/09	4.380	%	9/15/15

14.    LONG-TERM DEBT AND OTHER BORROWINGS

Long-term debt and other borrowings include the following items:

(dollars in thousands)	December 31,
	2005		2004
Long term debt and other borrowings:
Federal Home Loan Bank advances	$	587,999	$	619,143
Treasury Tax & Loan amounts due to Federal Reserve Bank		8,814		14,888
Subordinated debt issued by the Bank		121,000		121,000
Senior debt issued by the Bancorp		37,000		37,000
Subordinated debt issued by the Bancorp		39,082		31,091
Total Long term debt and other borrowings		793,895		823,122
Obligation under capital lease		9,317		9,130
Total long term debt and other borrowing and obligations under capital lease	$	803,212	$	832,252

To supplement deposits when loan demand is high and as part of the Company’s asset and liability management strategy, fixed rate term advances are borrowed from the FHLB. As of December 31, 2005, total outstanding balances to the FHLB were $588.0 million. There were $228.4 million in

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scheduled maturities of the advances of 1 year or less, $243.2 million in 1 to 3 years, and $116.4 million in more than 3 years.

The Treasury tax and loan amounts are payroll deposits made by employers to PCBNA for eventual payment to the IRS. PCBNA may hold these deposits and pay interest on them until called by the Treasury Department.

In July 2001, SBB&T issued $36 million in subordinated debt, bearing an interest rate of 9.22%, payable semi-annually and maturing in July 2011. In December 2003, PCBNA issued $35 million in subordinated debt. The debt was issued as part of a pool of debt issued by a number of financial institutions. The notes mature in December 2013 and are priced at a floating rate of 2.60% over the 90 day LIBOR rate. At issuance, LIBOR was 1.17% resulting in a note rate of 3.77%. As of December 31, 2005 the rate on these notes was 7.10%. The notes are callable at par after 5 years. The proceeds of the debt were used as part of the funding of the acquisition of PCCI. In December 2004, PCBNA issued $50 million in subordinated debt. The note matures in 2015. The note bears a fixed interest rate of 5.42% for the first five years when it becomes callable by the Company. During the next five years the debt reprices every three months to 1.75% over the three-month LIBOR rate. All of the subordinated debt qualifies as Tier 2 capital for PCBNA and the Company in the computation of capital ratios discussed in Note 20.

The Company issued $40 million in senior notes bearing an interest rate of 7.54%, payable semi-annually and maturing in July 2006. Of this amount, $3 million was held by PCCI at the time of its acquisition by the Company. Therefore the obligation is reported at $37 million in the table above.

The subordinated debt issued by Bancorp was assumed in connection with the PCCI acquisition and the FBSLO acquisition. The difference between these four amounts and the amount shown in the table above represents the fair value adjustment related to the debt that was recorded at the acquisitions of PCCI and FBSLO, less subsequent amortization. The following table shows the terms of the four notes.

Owed to	Amount Owed (in $000)		Initial Fixed Rate		Maturity	Call Date	Spread over LIBOR if not called
PCC Trust I	$	13,750	6.335	%	2033	2008	3.25	%
PCC Trust II		6,190	6.580	%	2033	2008	3.15	%
PCC Trust III		10,310	6.800	%	2033	2008	3.10	%
FBSLO Trust		8,000	6.718	%	2032	2007	3.45	%

The obligation under capital lease was incurred at the beginning of 2004 when the Company assumed the master lease on a shopping center in which one of its branch offices is located. Based on the payments and term of the lease, the net present value of the portion of the payments related to the buildings is recorded as a capital lease. The lease calls for monthly payments through 2038. The implied interest rate is 5.89%. The amortization of these buildings is included with depreciation expense. Rather than providing for contingent adjustments based on the consumer price index, the lease provides for specific increases during its term. The amount of lease payments for 2005 was $344,000. As of December 31, 2005, the total minimum sublease rent to be received under non-cancelable subleases is $2.5 million. The Company also leases the land under an operating lease.

With respect to each of the above debt instruments, there are no significant restrictive covenants as to the issuance of other debt or that would require payment in full prior to the scheduled maturity and are considered the general obligation of the Company. There are no specific triggering events associated with this debt other than defaulted payments that cause the total amounts to become due and payable prior to the contractual maturity.

During the course of 2005, 2004, and 2003, the Company occasionally borrowed funds for liquidity purposes from the discount window at the FRB.

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15.    OTHER POSTRETIREMENT BENEFITS

All eligible retirees may obtain health insurance coverage through the Company’s Retiree Health Plan (“the Plan”). The coverage is provided through the basic coverage plan provided for current employees. Based on a formula involving date of retirement, age at retirement, and years of service prior to retirement, the Plan provides that the Company will pay a portion of the health insurance premium for the retiree. The portion varies from 60% to 100% of the premium amount paid for current employees. Though the premiums for a retiree’s health coverage are not paid until after the employee retires, the Company is required to recognize the cost of those benefits as they are earned rather than when paid.

The Accumulated Postretirement Benefit Obligation

The commitment the Company has made to provide these benefits results in an obligation that must be recognized in the financial statements. This obligation, termed the accumulated postretirement benefit obligation (“APBO”), is the actuarial net present value of the obligation for: (1) already retired employees’ expected postretirement benefits; and (2) the portion of the expected postretirement benefit obligation earned to date by current employees. The net present value is that amount which if compounded at an assumed interest rate would equal the amount expected to be paid in the future.

This obligation must be re-measured each year because it changes with each of the following factors: (1) the number of employees working for the Company; (2) the average age of the employees working for the Company as this impacts how soon it would be expected that the Company will begin making payments; (3) increases in expected health care costs; and (4) prevailing interest rates. In addition, because the obligation is measured on a net present value basis, the passage of each year brings the eventual payment of benefits closer, and therefore, like the compounding of interest, causes the obligation to increase. The following tables disclose the reconciliation of the beginning and ending balances of the APBO; the reconciliation of beginning and ending balances of the fair value of the plan assets; and the funding status of the Plan as of December 31, 2005, 2004, and 2003.

(in thousands)	Years Ended December 31,
	2005			2004			2003
Benefit obligation, beginning of year	$	(15,755	)	$	(13,243	)	$	(9,857	)
Service cost		(1,732	)		(1,462	)		(991	)
Interest cost		(910	)		(795	)		(666	)
Amendments		5,107			—			—
New participants		(238	)		(275	)		(160	)
Medicare prescription subsidy		1,983			—			—
Actuarial losses		(8,274	)		(199	)		(1,768	)
Benefits paid		287			219			199
Benefit obligation, end of year		(19,532	)		(15,755	)		(13,243	)
Fair value of Plan assets, beginning of year		8,553			6,085			3,465
Actual return on Plan assets		617			627			1,191
Employer contribution		1,500			2,000			1,543
Benefits paid		(204	)		(159	)		(114	)
Fair value of Plan assets, end of year		10,466			8,553			6,085
Funded Status		(9,066	)		(7,202	)		(7,158	)
Unrecognized net actuarial loss		12,500			4,568			4,777
Unrecognized prior service cost		(6,603	)		275			160
Accrued benefit cost	$	(3,169	)	$	(2,359	)	$	(2,221	)

Accrued benefit costs of $3.2 million for December 31, 2005, and $2.4 million for December 31, 2004, are included within the category for accrued interest payable and other liabilities in the consolidated balance sheets.

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The Plan provides for graduated levels of benefits based on length of service. During 2005, the Company amended the Plan to require additional years of service time to achieve a specified level of benefits. This had the effect of lowering the projected cost of the benefits as both fewer employees would become eligible and future retirees would be eligible to lower levels of benefits.

The Components of the Net Periodic Postretirement Benefit Cost

Each year the Company recognizes a portion of the change in the APBO as an expense. This portion is called the net periodic postretirement benefit cost (the “NPPBC”). The NPPBC, is made up of several components:

·       Service cost	Each year employees earn a portion of their eventual benefit. This component is the net present value of that portion.
·       Interest cost	Each year the benefit obligation for each employee is one year closer to being paid and therefore increases in amount closer to the eventual benefit payment amount. This component represents that increase resulting from the passage of another year.
·       Return on assets	Income is earned on any investments that have been set aside to fund the eventual benefit payments. This component is an offset to the first two components.
·       Amortization cost	Significant estimates and assumptions about interest rates, trends in health care costs, plan changes, employee turnover, and earnings on assets are used in measuring the APBO each year. Actual experience may differ from the estimates and assumptions may change. Differences will result in what are termed experience gains and losses. These may cause increases or decreases in the APBO or in the value of plan assets. This component recognizes a portion of the experience gains and losses.
·       Prior service cost	At the adoption of the Plan, the Company fully recognized the net present value of the benefits credited to employees for service provided prior to the adoption of the plan. Had the Company not recognized this amount, a portion of it would be included as a fifth component.

The following table shows the amounts for each of the components of the NPPBC. The total amount is included with the cost of other employee benefits in the Consolidated Statements of Income under Salaries and Benefits.

(in thousands)	Years Ended December 31,
	2005			2004			2003
Service cost	$	1,732		$	1,462		$	991
Interest cost		910			795			666
Return on assets		(547	)		(389	)		(291	)
Amortization cost		297			330			267
Net periodic postretirement cost	$	2,392		$	2,198		$	1,633

The Use of Estimates and the Amortization of Experience Gains and Losses

The following table discloses the assumed rates that have been used for the factors that may have a significant impact on the APBO.

	December 31,
	2005	2004	2003
Discount rate	5.53%	5.84%	6.07%
Expected return on plan assets	6.50%	6.50%	6.50%
Health care inflation rate	Graded rates	Graded rates	Graded rates

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The discount rate is used to compute the present value of the APBO. It is selected each year by reference to the current rates of investment grade corporate bonds, specifically Moody’s Aa corporate bond yield as of November 30. Higher discount rates result in a lower APBO at the end of the year and the NPPBC to be recognized for the following year, while lower rates raise both.

The Company uses 6.50% as its estimate of the long-term rate of return on plan assets. The APBO is a long-term liability of 30 years or more. The 6.50% rate is the assumed average earning rate over an equally long investment horizon. If the rate of return in any year is greater than this estimate, the Company will have an experience gain, and an experience loss if the rate of return is less. Earnings on the plan’s assets were 28.50%, 9.00% and 6.78%, for the years ended December 31, 2003, 2004, and 2005, respectively.

The Medicare Prescription Drug, Improvement and Modernization Act was enacted in 2003. Beginning with 2005, the APBO disclosed in the above tables reflect the expected federal subsidy provided by the act because the Company has been able to conclude that the benefits provided by the Plan are equivalent to those provided by the act.

Increases in health insurance costs impact the portion of the APBO because such increases result in higher health insurance premiums paid by the Company. If costs rise at a higher rate than assumed by the Company, there will be an experience loss. If they rise at a lesser rate, there will be an experience gain.

For the health care inflation rate for current employees, the Company has assumed 9% for 2006 with rates gradually decreasing each year to 5% in 2010 and thereafter.

Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects:

	1-Percentage-Point Increase		As Estimated		1-Percentage-Point Decrease
Effect on total of service and interest cost components	$	3,615	$	2,771	$	2,312
Effect on postretirement benefit obligation	$	24,209	$	19,532	$	16,814

Rather than recognizing the whole amount of the experience gains or losses in the year after they arise, under GAAP they are recognized through amortization over the average remaining service lives of the employees. Amortization over time is used because many of these changes may be partially or fully reversed in subsequent years as further changes in experience and/or assumptions occur.

Plan Assets

The Company established a Voluntary Employees’ Beneficiary Association (“VEBA”) to hold the assets that will be used to pay the benefits for participants of the plan other than key executive officers. As a separate benefit trust, the VEBA assets are not reported in the assets of the Company. Most of the plan assets have been invested in insurance policies on the lives of various employees of the Company. In turn, the premiums paid on these policies in excess of the mortality costs of the insurance and the administrative costs are invested in mutual funds. This investment practice is followed in order to accumulate assets that can earn a nontaxable return because the mutual funds are “wrapped” in the insurance policies. The following table shows the weighted-average allocation of VEBA plan assets by asset category:

	As of December 31,
	2005		2004
Asset category:
Equity securities	98	%	96	%
Debt securities	2	%	4	%
Total	100	%	100	%

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Funded Status

If the assets of the VEBA are more than the APBO related to employees of the Company not defined as key employees, the VEBA is overfunded. If the assets of the VEBA are less than the APBO related to employees of the Company not defined as key employees, the VEBA is underfunded. The funded status of the plan is shown in the first table in this note as the amount by which the plan assets are more or less than the APBO. As of December 31, 2005, the VEBA was underfunded by $6,473,000. The APBO related to the key employees of $2,593,000 is fully unfunded.

Employers are allowed wide discretion as to whether and how they set aside funds to meet the obligation they are recognizing. However, while GAAP requires assumed increases in the rate of future health care costs to be used in computing the amount of APBO and the funded status of the such plans, the Internal Revenue Code (“IRC”) does not permit the Company to deduct the portion of the NPPBC for non-key employees that relates to assumed increases in the rate of future health care costs. Consequently, so long as future health care costs are projected to increase, the Company could not deduct a contribution of the whole amount necessary to fully fund the non-key employee obligation. In addition, the IRC specifically prohibits funding of the obligation relating to the key employees.

Cash Flows

Contributions:  The current funding policy of the Company with respect to the non-key employee plan is to contribute assets to the VEBA at least sufficient to pay the costs of current medical premiums of retirees. In some years the Company also contributes assets to pay the costs of the life insurance premiums and to provide additional earning assets for the VEBA to reduce any underfunded condition. Generally, these additional contributions will not exceed the amount that can be deducted in the Company’s current income tax return, but if they do, the tax effect of the amount in excess of deductible amount will be recognized as a deferred tax asset (See Note 16). In those years that the Company does not contribute assets for the payment of the life insurance premiums, assets in the VEBA are used to pay the premiums. Proceeds from the life insurance policy payoffs will fund benefits and premiums in the future. Such proceeds are included in the assumed 6.5% rate of return on the assets of the plan. If the Company’s Employee Benefits Advisory Committee has made a formal decision on the contribution to be made for the year prior to year-end, the contribution will be recognized as a receivable in the plan assets of the VEBA. The decision on the amount of the contribution for 2003 was not made prior to year-end. Subsequent to year-end, the committee decided to contribute $1 million to the VEBA in 2004 for 2003. This contribution was made in the first quarter of 2004. Another $1 million was contributed during the remainder of 2004. The 2005 contribution of $1.5 million was made in 2005. Management estimates that it will make contributions in the range of $1.0 to $2.0 million in 2006.

Estimated Future Benefit Payments:  The Company has estimated that it will make the following benefit payments. These estimates reflect expected future service as appropriate.

	Health Benefits
2006	$	536
2007		583
2008		675
2009		741
2010		871
Years 2011-2015		5,894

16.    INCOME TAXES

The provisions (benefits) for income taxes related to operations and the tax benefit related to stock options that is credited directly to shareholders’ equity are disclosed in the next table.

Current tax expense is the amount that is estimated to be due to taxing authorities for the current year. Some of this amount was paid during each year in the form of estimated payments. Deferred tax expense or benefit represents the tax effect of changes in the temporary differences due to an

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item of income or expense being recognized for financial statement purposes in a different period than it is recognized in the Company’s tax return.

The total current provision for income taxes includes a net credit of $307,000 for securities losses realized in 2005, a credit of $849,000 for securities losses realized in 2004, and a debit of $849,000 for securities gains realized in 2003. It also includes net operating losses of $16.5 million for Federal and $15.7 million for State purposes, generated by the final return of PCCI that expire in 2024 and 2014, respectively.

(in thousands)	Year Ended December 31,
	2005			2004			2003
Federal:
Current	$	42,524		$	35,540		$	28,211
Deferred		(112	)		1,462			1,782
Total Federal		42,412			37,002			29,993
State:
Current		17,479			13,909			12,062
Deferred		(879	)		1,035			287
Total State		16,600			14,944			12,349
Total tax provision	$	59,012		$	51,946		$	42,342
Reduction in taxes payable associated with exercises of stock options	$	(2,399	)	$	(2,851	)	$	(1,637	)
Tax credits included in the computation of the tax provision	$	(2,253	)	$	(2,382	)	$	(2,648	)

Although not affecting the total provision, actual income tax payments may differ from the amounts shown as current provision as a result of the final determination made during the preparation of the Company’s tax returns as to the timing of certain deductions and credits. The total tax provision differs from the Federal statutory rate of 35 percent for the reasons shown in the following table.

	Year Ended December 31
	2005		2004		2003
Tax provision at Federal statutory rate	35.0	%	35.0	%	35.0	%
Interest on securities and loans exempt from Federal taxation	(2.6	)	(2.8	)	(3.2	)
State income taxes, net of Federal income tax benefit	6.8		6.9		6.9
ESOP dividends deductible as an expense for tax purposes	(0.3	)	(0.3	)	(0.4	)
Tax Credits	(1.4	)	(1.6	)	(1.6	)
Other, net	(0.2	)	(0.1	)	(0.8	)
Actual tax provision	37.3	%	37.1	%	35.9	%

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The following table shows the amount of deferred tax asset or liability related to the major temporary differences as of December 31, 2005, 2004, and 2003. As disclosed in the following table, net deferred tax assets as of December 31, 2005 and 2004, totaled $18.2 million and $12.2 million, respectively. These amounts are included within other assets on the balance sheet.

The net unrealized gain or loss on securities that are available-for-sale is included as a component of equity. This amount is reported net of the related tax effect. The tax effect is a deferred tax asset if there is a net unrealized loss because the Company would have received a deduction for the loss had the securities been sold as of the end of the year. The tax effect would be a deferred tax liability if there were a net unrealized gain because the Company would owe additional taxes had the securities been sold as of the end of the year. However, changes in the unrealized gains or losses are not recognized either in net income or in taxable income, and therefore they do not represent temporary differences between reported financial statement income and taxable income reported on the Company’s tax return. Consequently, the change in the tax effect of the net unrealized gain or loss is not included as a component of deferred tax expense or benefit, but is disclosed separately in the table below.

(in thousands)	December 31,
	2005			2004			2003
Deferred tax assets:
Allowance for credit losses	$	25,998		$	24,743		$	22,888
State taxes		4,533			4,630			4,032
Accrued salary continuation plan		1,706			1,274			1,400
Deferred Compensation		4,440			3,290			2,971
Premium on Acquired Liabilities		2,025			1,138			—
Other		2,366			3,513			3,093
Total deferred tax assets		41,068			38,588			34,384
Deferred tax liabilities:
Loan costs		2,257			3,098			2,755
FHLB Stock		2,311			1,550			573
Fixed Assets		12,030			9,331			6,810
Premium on Acquired Loans		1,645			2,159			—
Federal effect of state tax asset		1,715			1,407			1,756
Other		2,156			3,080			2,028
Total deferred tax liabilities		22,114			20,625			13,922
Net deferred tax asset before unrealized gains and losses on securities		18,954			17,963			20,462
Unrealized (gains) and losses on securities		(716	)		(5,782	)		(6,896	)
Net deferred tax asset	$	18,238		$	12,181		$	13,566

The Company is permitted to recognize deferred tax assets only to the extent that they are expected to be used to reduce amounts that have been paid or will be paid to tax authorities. Management reviews this each year by comparing the amount of the deferred tax assets with amounts paid in the past that might be recovered by carryback provisions in the tax code and with anticipated taxable income expected to be generated from operations in the future. If it does not appear that the deferred tax assets are usable, a valuation allowance would be established to acknowledge their uncertain benefit. Management believes a valuation allowance is not needed to reduce any deferred tax asset because there is sufficient taxable income within the carryback periods to realize all material amounts.

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17.    EMPLOYEE BENEFIT PLANS

The Company’s Employee Stock Ownership Plan (“ESOP”) was initiated in January 1985. As of December 31, 2005, the ESOP held 1,884,746 shares.

The Company’s profit-sharing plan has two components. The Salary Savings Plan component is authorized under Section 401(k) of the Internal Revenue Code. An employee may defer up to 80% of pre-tax salary in the plan up to a maximum dollar amount set each year by the Internal Revenue Service. The Company matches 100% of the first 3% of the employee’s compensation that the employee elects to defer and 50% of the next 3%, but not more than 4.5% of the employee’s total compensation. In 2005, 2004, and 2003, the employer’s matching contributions were $2.7 million, $2.4 million and $2.2 million, respectively. The other component is the Incentive & Investment Plan (“I&I Plan”) which permits contributions by the Company to be invested in various mutual funds chosen by the employees.

After providing for the Company’s contribution to the Retiree Health Plan discussed in Note 15 and the matching contribution to the Salary Savings Plan, the remaining contribution may be made either to the ESOP or to the Incentive & Investment Plan.

Total contributions by the Company to the above profit-sharing plans were $4,837,000 in 2005, $4,901,000 in 2004, and $4,371,000 in 2003. Only a portion of the contributions for 2003 and 2004 were actually paid within the respective calendar years so that the ESOP would not be competing against the Company in the market during a period when the Company was repurchasing stock for retirement. Accordingly, the balance of the 2003 contribution was paid in 2004 and the balance of the 2004 contribution was paid in 2005. The contribution for 2005 will be paid in 2006. Aside from the employer’s matching contribution to the Salary Savings Plan or 401(k) component of the profit-sharing plan, the contributions went to the ESOP in 2005, 2004, and 2003. The expenses of these plans are borne by the Company.

18.    COMMITMENTS AND CONTINGENCIES

Table of Contractual Lease Obligations

The following table shows the contractual lease obligations the Company is committed to make. The nature, business purpose, and significance of the items are discussed in separate sections below the table.

(dollars in thousands)	As of December 31, 2005										As of December 31, 2004
	Less than one year		One to three years		Three to five years		More than five years		Total
Non-cancelable leases	$	10,285	$	16,725	$	8,407	$	10,558	$	45,975	$	45,426
Capital leases		344		1,140		906		24,262		26,652		26,995
Total	$	10,629	$	17,865	$	9,313	$	34,820	$	72,627	$	72,421

Leasing of Premises:  The Company leases most of its office locations and substantially all of these office leases contain multiple five-year renewal options and provisions for increased rentals, principally for property taxes and maintenance. As of December 31, 2005, the minimum rentals under non-cancelable leases for the next five years and thereafter are shown in the above table. The amounts in the table for minimum rentals are not reported net of the contractual obligations of sub-tenants. Sub-tenants leasing space from the Company under these operating leases are contractually obligated to the Company for approximately $2.9 million. Approximately 64% of these payments are due to the Company over the next three years. Total rental expense, net of sublease income, for premises included in operating expenses are $8.7 million in 2005, $8.2 million in 2004, and $7.0 million in 2003.

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Legal

The Company has been a defendant in a class action lawsuit brought on behalf of persons who entered into a refund anticipation loan application and agreement (the “RAL Agreement”) with the Company from whose tax refund the Company deducted a debt owed by the applicant to another RAL lender. The lawsuit was filed on March 18, 2003 in the Superior Court in San Francisco, California as Canieva Hood and Congress of California Seniors v. Santa Barbara Bank & Trust, Pacific Capital Bank, N.A., and Jackson-Hewitt, Inc. The Company is a party to a separate cross-collection agreement with each of the other RAL lenders by which it agrees to collect sums due to those other lenders on delinquent RALs by deducting those sums from tax refunds due to its RAL customers and remitting those funds to the RAL lender to whom the debt is owed. This cross-collection procedure is disclosed in the RAL Agreement with the RAL customer and is specifically authorized and agreed to by the customer. The plaintiff does not contest the validity of the debt, but contends that the cross-collection is illegal and requests damages on behalf of the class, injunctive relief against the Company, restitution of sums collected, punitive damages and attorneys’ fees. Venue for this suit was changed to Santa Barbara. The Company filed an answer to the complaint and a cross complaint for indemnification against the other RAL lenders. On May 4, 2005, a superior court judge in Santa Barbara granted a motion filed by the Company and the other RAL lenders, which resulted in the entry of a judgment in favor of the Company dismissing the suit. The plaintiffs have filed an appeal.

The Company is a defendant in a class action lawsuit brought on behalf of persons who entered into a refund transfer application and agreement (the “RT Agreement”) with the Company from whose tax refund the Company deducted a debt owed by the applicant to another RAL lender. The lawsuit was filed on May 13, 2003 in the Superior Court in San Francisco, California as Alana Clark, Judith Silverstine, and David Shelton v. Santa Barbara Bank & Trust. The cross-collection procedures mentioned in the description above of the Hood case is also disclosed in the RT Agreement with each RT customer and is specifically authorized and agreed to by the customers. The plaintiffs do not contest the validity of the debt, but contend that the cross-collection is illegal and request damages on behalf of the class, injunctive relief against the Company, restitution of sums collected, punitive damages and attorneys’ fees. The Company filed a motion for a change in venue from San Francisco to Santa Barbara. The plaintiffs’ legal counsel stipulated to the change in venue. Thereafter, the plaintiffs dismissed the complaint without prejudice. The plaintiffs filed a new complaint in San Francisco limited to a single cause of action alleging a violation of the California Consumer Legal Remedies Act. The Company filed an answer to the complaint and a cross complaint for indemnification against the other RAL lenders. Discovery is continuing.

The Company is a defendant in a class action lawsuit brought on behalf of residents of the State of New York who engaged Jackson Hewitt, Inc (“JHI”) to provide tax preparation services and who through JHI entered into an agreement with the Company to receive a RAL. JHI is also a defendant. The lawsuit was filed on June 18, 2004, in the Supreme Court of the State of New York, County of New York as Myron Benton v. Jackson Hewitt, Inc. and Santa Barbara Bank & Trust Co. As part of the RAL documentation, the customer receives and signs a disclosure form which discloses that the Company may share a portion of the federal refund processing fee and finance charge with JHI. The plaintiffs allege that the failure of JHI and the Company to disclose the specific amount of the fee that JHI receives is unlawful and request damages on behalf of the class, injunctive relief, punitive damages and attorneys’ fees. The Company filed a motion to dismiss the complaint. In response to the complaint, on December 22, 2004, the plaintiffs filed an amended complaint. The amended complaint added three new causes of action: 1) a cause of action for an alleged violation of California Business and Professions Code Sections 17200 and 17500, et seq, as a result of alleged deceptive business practices and false advertising; 2) a cause of action for an alleged violation of California Consumer Legal Remedies Act, California Civil Code Section 1750, et seq; and 3) a cause of action for alleged negligent misrepresentation. The Company has filed a motion for summary judgment. The plaintiff has filed a motion for partial summary judgment. Following a court hearing on December 6, 2005, the judge took the matter under submission.

The Company believes that there is no merit to the above three claims and intends to vigorously defend itself.

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The Company is also involved in various litigation of a routine nature that is being handled and defended in the ordinary course of the Company’s business. Expenses are being incurred in connection with defending the Company, but in the opinion of Management, based in part on consultation with legal counsel, the resolution of this litigation including the three specific cases described above will not have a material impact on the Company’s financial position, results of operations, or cash flows.

19.    SHAREHOLDERS’ EQUITY

Stock Repurchases

In early 2003, the Company repurchased 284,000 shares with $6.8 million remaining from $20 million authorized by the Board of Directors in 2002. During 2003, the Board authorized an additional $40 million of repurchases. Approximately $21.4 million of this was spent during the remainder of 2003 to repurchase 640,000 shares. With the growth in assets from the PCCI acquisition and because no stock was issued as consideration, Management elected not to repurchase any shares in 2004, aside from fractional shares arising from a stock split.

There were no repurchases of shares in 2005.

Stock Issuance

During 2003 and 2004, there were no shares issued except in connection with the exercise of stock options.

During 2005, the Board of Directors authorized the awarding of approximately 225,000 restricted shares to employees and directors. The restricted shares issued to employees have graduated vesting over a five year period. The restricted shares issued to directors vest in one year. The shares are added to capital as the service time is recognized through compensation expense. Compensation expense totaling $1.3 million related to approximately 90,000 shares was recognized in 2005.

During 2005, the Company established a Dividend Reinvestment and Direct Stock Purchase Plan. The dividend reinvestment provision allows shareholders to have the Company’s transfer agent purchase new shares of stock with their dividends. The direct stock purchase plan allows the Company to sell shares directly to shareholders and others as it deems advisable. Dividend reinvestment was minimal in 2005. Approximately 490,000 shares were issued with proceeds of $21.6 million received by the Company.

Stock Splits

In June 2004, the Company’s Board of Directors approved another 4 for 3 stock split. The additional stock was distributed in June 2004. All share and per share amounts appearing in these notes and in the Consolidated Financial Statements which these notes accompany have been restated to reflect this split.

The Company paid cash for fractional shares resulting from the stock split.

Stock Option Plans

The Company’s stock option plans offer key employees and directors an opportunity to purchase shares of the Company’s common stock. The Company has four stock option plans all of which have been approved by its shareholders. Options are granted from only two of these. The remaining two plans are active now only for the exercise of options held by employees and directors.

The first of the plans from which awards are granted is the Directors Stock Option Plan established in 1996. Only non-qualified options may be granted under this plan. The second is the 2002 Stock Plan for employees established in January 2002. Either incentive or non-qualified options may be granted under this plan. Under the original provisions of the Directors plan, stock acquired by the exercise of options granted under the plans could not be sold for five years after the date of the grant

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or for two years after the date options are exercised, whichever was later. In 1998, the Board of Directors of the Company eliminated this restriction.

All options outstanding in these plans were granted with an option price set at 100% of the market value of the Company’s common stock on the date of the grant. The grants for most of the employee options specify that they are exercisable in cumulative 20% annual installments and will expire ten years from the date of grant. The options granted under the directors’ plan are exercisable after six months.

The option plans permit employees and directors to pay the exercise price of options they are exercising and the related tax liability with shares of Company stock they already own. The owned shares are surrendered to the Company at current market value. Shares with a current market value of $2,644,000, $4,338,000, and $3,230,000 were surrendered in the years ended December 31, 2005, 2004, and 2003, respectively. These surrendered shares are netted against the new shares issued for the exercise of stock options in the Consolidated Statements of Changes in Shareholders’ Equity.

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The following table presents information relating to all of the stock option plans as of December 31, 2005, 2004, and 2003 (adjusted for stock splits and stock dividends).

	Options	Per Share Price Ranges		Weighted Average Price		Weighted Average Expiration in Years
2005
Granted	111,220	$	27.42 to $37.90	$	33.59
Exercised	412,590	$	6.49 to $29.78	$	19.13
Cancelled and expired	68,125	$	15.41 to $29.63	$	26.22
Outstanding at end of year	12,552	$	7.02 to $10.02	$	8.27	1.22
	153,658	$	10.03 to $14.02	$	11.13	1.75
	595,661	$	14.03 to $21.02	$	16.04	4.84
	900,453	$	21.03 to $31.02	$	28.05	7.43
	89,759	$	31.03 to $37.90	$	35.00	5.91
Total outstanding at end of year	1,752,083
Exercisable at end of year	1,083,396	$	7.02 to $34.02	$	20.03
Shares available for future grant	3,955,170
2004
Granted	1,034,698	$	23.16 to $33.02	$	28.79
Exercised	597,118	$	4.77 to $28.19	$	17.11
Cancelled and expired	35,282	$	15.41 to $30.22	$	26.22
Outstanding at end of year	15,220	$	6.49 to $  9.49	$	8.04	2.06
	192,421	$	9.50 to $13.49	$	11.18	2.72
	831,162	$	13.50 to $20.49	$	15.91	5.13
	1,074,031	$	20.50 to $30.49	$	27.77	7.92
	8,744	$	30.50 to $33.02	$	32.94	5.81
Total outstanding at end of year	2,121,578
Exercisable at end of year	1,099,639	$	6.49 to $30.49	$	18.06
2003
Granted	158,244	$	19.46 to $27.29	$	23.51
Exercised	584,432	$	3.71 to $20.54	$	14.17
Cancelled and expired	20,735	$	14.93 to $19.31	$	15.50
Outstanding at end of year	6,124	$	4.77 to $  7.02	$	5.65	1.53
	14,211	$	7.03 to $10.02	$	8.48	3.30
	369,972	$	10.03 to $15.27	$	12.66	2.71
	1,218,850	$	15.28 to $22.77	$	16.47	5.06
	110,123	$	22.78 to $27.29	$	24.62	4.08
Total outstanding at end of year	1,719,280
Exercisable at end of year	1,158,241	$	4.77 to $23.52	$	15.20

20.    REGULATORY CAPITAL REQUIREMENTS

The Company and PCBNA are subject to various regulatory capital requirements administered by the Federal banking agencies. Failure to meet minimum capital requirements as specified by the regulatory framework for prompt corrective action could cause the regulators to initiate certain mandatory or discretionary actions that, if undertaken, could have a direct material effect on the Company’s financial statements.

The table below sets forth the actual capital amounts and ratios for the Company as of December 31, 2005 and 2004. It also shows the minimum amounts and ratios that it must maintain

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under the regulatory requirements to meet the standard of “adequately capitalized” and the minimum amounts and ratios required to meet the regulatory standards of “well capitalized.”

For the Company, Tier I capital consists of common stock, surplus, and retained earnings. Tier II capital includes a portion of the allowance for credit losses and the subordinated debt mentioned in Note 14. The capital benefit of the subordinated debt is reduced 20% per year in the last five years of its term. The first such reduction on the Company’s subordinated debt will occur in the third quarter of 2006.

Risk-weighted assets are computed by applying a weighting factor from 0% to 100% to the carrying amount of the assets as reported in the balance sheet and to a portion of off-balance sheet items such as loan commitments and letters of credit. The definitions and weighting factors are all contained in the regulations. However, the capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

(dollars in thousands)	Pacific Capital Bancorp Actual			Minimums for Capital Adequacy Purposes			Minimums to be Well-Capitalized
	Amount		Ratio	Amount		Ratio	Amount		Ratio
As of December 31, 2005
Total Tier I & Tier II Capital (to Risk Weighted Assets)	$	611,679	11.3%	$	432,066	8.0%	$	540,082	10.0%
Tier I Capital (to Risk Weighted Assets)	$	433,396	8.0%	$	216,033	4.0%	$	324,049	6.0%
Tier I Capital (to Average Tangible Assets)	$	433,396	6.6%	$	263,809	4.0%	$	329,761	5.0%
Risk Weighted Assets	$	5,400,822
Average Tangible Assets	$	6,595,214
As of December 31, 2004
Total Tier I & Tier II Capital (to Risk Weighted Assets)	$	543,696	12.1%	$	359,472	8.0%	$	449,341	10.0%
Tier I Capital (to Risk Weighted Assets)	$	367,487	8.2%	$	179,736	4.0%	$	269,604	6.0%
Tier I Capital (to Average Tangible Assets)	$	367,487	6.3%	$	232,108	4.0%	$	290,135	5.0%
Risk Weighted Assets	$	4,493,406
Average Tangible Assets	$	5,802,708

As of December 31, 2005, both PCBNA and the Company met the requirements as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, an institution must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the above table.

The following table shows the three capital ratios for PCBNA at December 31, 2005 and 2004. There are no conditions or events since December 31, 2005 that Management believes have changed or will change PCBNA’s category for other than temporary conditions related to the RAL program.

As of December 31,	Total Tier I and Tier II Capital to Risk Weighted Assets		Tier I Capital to Risk Weighted Assets		Tier I Capital to Average Tangible Assets
2005	11.18	%	7.87	%	6.46	%
2004	12.50	%	8.57	%	6.64	%

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Bancorp is the parent company and sole owner of PCBNA. However, there are legal limitations on the amount of dividends which may be paid by PCBNA to Bancorp. The amounts which may be paid as dividends by a bank are determined based on the bank’s capital accounts and earnings in prior years. As of December 31, 2005, PCBNA would have been permitted to pay up to $234.4 million to Bancorp.

21.    NONINTEREST REVENUE

The major grouping of noninterest revenue on the consolidated income statements includes several specific items: service charges on deposits accounts, trust fees, refund transfer fees, gains on sale of tax refund loans, and gain or loss on sales and calls of securities.

The refund transfer fees are earned from the companion program of the Company’s refund loan program described in Note 6. When customers do not choose or do not qualify for the loan product, they may still benefit from an expedited payment of their income tax refund. After receiving the customer’s refund from the IRS, the Company either authorizes the tax preparer to provide a check directly to the customer or the Company deposits the check in the customer’s account. There is no loan involved with this product, and consequently the income is not classified as interest income.

The Company recorded a net gain on sale of tax refund loans of $26.0 million in 2005 and $2.9 million in 2004. These gains relate to the sale of RALs through the securitization vehicle discussed in Note 11 on page 104.

Noninterest revenue also includes several general categories: other service charges, commissions, and fees and other income. Other service charges, commissions, and fees include a variety of revenues earned by providing services to customers.

(in thousands)	December 31,
	2005			2004			2003
Included in other service charges, commissions and fees:
Merchant bankcard fees	$	1,277		$	1,182		$	1,027
Standby letter of credit fees		1,332			1,288			556
Real estate loan broker fees		889			1,460			2,700
Debit card fees		3,323			2,318			1,495
Collection fees		5,617			4,781			4,244
Included in other income:
Loss on tax credit partnerships	$	(1,849	)	$	(3,644	)	$	(1,513	)
Earnings on cash surrender value of bank owned life insurance		1,994			818			978
Interest/dividends on other securities		1,906			2,100			1,268
Gain on sale of SBA loans		2,724			2,069			415
Gain on sale of residential real estate loans		73			263			1,424

The loss on tax credit partnerships result from the Company’s investments in limited partnerships that are set up to build or renovate low-income housing. Given the generally higher income demographics in the Company’s market areas, the Company does not have many opportunities to make the direct investments in low-income housing that are required for the Company to comply with the provisions of the Community Reinvestment Act. These partnerships operate at a loss but generate Federal and state income tax credits in excess of the after-tax impact of the losses.

The interest/dividends on other securities represent the income from the FHLB and FRB stock held by the Company.

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22.    OTHER OPERATING EXPENSE

The table below discloses the largest items included in other operating expense. Consultant expense includes the Company’s independent accountants, attorneys, and other management consultants used for special projects.

(in thousands)	December 31,
	2005		2004		2003
Noninterest expense
Software expense	$	14,727	$	9,814	$	8,205
Consultants—other		9,665		4,731		4,600
Consultants—accounting		2,402		3,872		2,214
Telephone		3,166		2,870		2,628
Postage and freight		2,886		2,251		1,957
Developers performance fees		3,016		2,233		2,413
Off-balance sheet contingency loss		571		50		4,624
Workers compensation insurance		1,063		1,667		1,895

23.    DERIVATIVE INSTRUMENTS

The Company has established policies and procedures to permit limited use of off-balance sheet derivatives to help manage interest rate risk.

Interest Rate Swaps to Manage the Company’s Interest Rate Risk

At various times, the Company has entered into several interest rate swaps to mitigate interest rate risk. Under the terms of these swaps, the Company pays a fixed rate of interest to the counterparty and receives a floating rate of interest. Such swaps have the effect of converting fixed rate financial instruments into variable or floating rate instruments. Such swaps may be related to specific instruments or pools of instruments—loans, securities, or deposits with similar interest rate characteristics or terms. Other types of derivatives are permitted by the Company’s policies, but have not been utilized.

There was one such swap in place at the end of 2004. The notional amount of this hedge at December 31, 2004 was $9.6 million with a fair value loss of approximately $30,000. This swap agreement expired in February of 2005.

Matching Interest Rate Swaps with Customers

The Company has entered into interest rate swaps with some of its customers to assist them in managing their interest rate risks. As of December 31, 2005, there were swaps with a notional amount of $53.1 million. To avoid increasing its own interest rate risk by entering into these swap agreements, the Company enters into offsetting swap agreements with other larger financial institutions. The effect of the offsetting swaps to the Company is to neutralize its position. A fee is charged to the Company’s customer that is in excess of the fee paid by the Company to the other financial institution.

24.    DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS

There are several factors that users of these financial statements should keep in mind regarding the fair values disclosed in this note. First, there are uncertainties inherent in the process of estimating the fair value of certain financial instruments. Second, the Company must exclude from its estimate of the fair value of deposit liabilities any consideration of its on-going customer relationships that provide stable sources of investable funds.

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Cash and Cash Equivalents

The face values of cash, Federal funds sold, and securities purchased under agreements to resell are their fair value.

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Securities and Money Market Instruments

For securities and commercial paper, fair value equals quoted market price, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. Because all securities are classified as available-for-sale, they are all carried at fair value.

Loans

The fair value of loans is estimated by discounting the future contractual cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. These contractual cash flows are adjusted to reflect estimates of uncollectible amounts.

Mortgage Servicing Rights

Mortgage servicing rights are carried at the lower of cost or estimated fair value. The method of estimating fair value for these assets is described in Note 1 on page 82.

Deposit Liabilities

The fair value of demand deposits, money market accounts, and savings accounts is the amount payable on demand as of December 31 of each year. The fair value of fixed-maturity certificates of deposit is estimated by discounting the interest and principal payments using the rates currently offered for deposits of similar remaining maturities.

Long-term Debt and Other Borrowings

For FHLB advances, the fair value is estimated using rates currently quoted by the FHLB for advances of similar remaining maturities. For the senior and subordinated debt issues, the fair value is estimated by discounting the interest and principal payments using approximately the same interest rate spread to treasury securities of comparable term as the notes had when issued. For treasury tax and loan obligations, carrying amount is a reasonable estimate of their fair value.

Repurchase Agreements and Federal Funds Purchased

For Federal funds purchased and treasury tax and loan instruments, the carrying amount is a reasonable estimate of their fair value. The fair value of repurchase agreements is determined by reference to rates in the wholesale repurchase market. The rates paid to the Company’s customers are slightly lower than rates in the wholesale market and, consequently, the fair value will generally be less than the carrying amount. The fair value of the long-term repo agreements is determined in the same manner as for the senior and subordinated debt described above.

Derivatives

Fair values for derivative financial instruments are based upon quoted market prices where available, except in the case of certain options and swaps where pricing models are used.

Financial Guarantees, Commitments, and Other Off-balance-sheet Instruments

The fair value of guarantees and letters of credit is based on fees currently charged for similar agreements. The Company does not believe that the fair value of any of its loan commitments to be material within the context of this note because generally fees have not been charged, the use of the commitment is at the option of the potential borrower, the commitments are being written at rates comparable to current market rates, and the committed rate floats to an index that makes the eventual borrowing rate comparable to then current market rates.

Fair values for off-balance-sheet, credit related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. The fair value of these instruments is immaterial and consequently they are omitted from the table.

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The carrying amount and estimated fair values of the Company’s financial instruments as of December 31, 2005 and 2004 are as follows:

(dollars in thousands)	As of December 31, 2005				As of December 31, 2004
	Carrying Amount		Fair Value		Carrying Amount		Fair Value
Financial assets:
Cash and due from banks	$	158,880	$	158,880	$	133,116	$	133,116
Securities available-for-sale		1,369,549		1,369,549		1,524,874		1,524,874
Net loans		4,841,688		4,829,453		4,008,317		3,969,200
Mortgage servicing rights		1,566		1,566		1,679		1,679
Derivatives		490		490		501		501
Financial liabilities:
Deposits	$	5,017,866	$	5,005,202	$	4,512,290	$	4,508,135
Long-term debt and other borrowings		803,212		781,522		832,252		807,081
Repurchase agreements and Federal funds purchased		446,642		451,756		179,041		193,927
Derivatives		497		497		531		531

25.    SEGMENT REPORTING

While the Company’s products and services are all of the nature of commercial banking, the Company has five reportable segments. There are four specific segments: Community Banking, Commercial Banking, Tax Refund Programs and Fiduciary. The remaining activities of the Company are reported in a segment titled “All Other.”

Factors Used to Identify Reportable Segments

The Company uses a combination of internal reporting structures, products, services provided, and customers served to determine its reportable segments. The segments also reflect the specific management structure in which loan and deposit products are handled by different organizational units.

Types of Customers and Services from Which Revenues are Derived

Community Banking:  Business units in this segment engage in small business lending (including Small Business Administration guaranteed loans) and leasing, consumer installment loans, home equity lines, and 1-4 family residential mortgages. The segment also includes all of the activities carried out in the Company’s branches. In addition to deposit-related services, these include safe deposit box rentals, foreign exchange, electronic fund transfers, and other ancillary services to businesses and individuals.

Commercial Banking:  Business units in this segment make loans to medium-sized businesses and their owners. Loans are made for the purchase of business assets, working capital lines, investment, and the development and construction of nonresidential or multi-family residential property. Letters of credit are also offered to customers both to facilitate commercial transactions and as performance bonds.

Fiduciary:  This segment provides trust and investment services to its customers. The Trust and Investment Services Division may act as both custodian and manager of trust accounts as directed by the client. In addition to securities and other liquid assets, the division manages real estate held in trust. The division also sells third-party mutual funds and annuities to customers.

Refund Programs:  The loan products provided in this segment are described in Note 6 on page 98. The other product, refund transfers, consists of receipt of tax refunds from the Internal Revenue Service on behalf of individual taxpayers and authorizing the local issuance of checks to the taxpayers so that they do not need a mailing address or to wait for the refund check to be mailed to them. Both of these businesses relate to the filing of income tax returns and consequently are highly seasonal. Approximately 90% of the activity occurs in the first quarter of each year.

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All Other:  This segment consists of other business lines and support units. The administrative support units include the Company’s executive administration, data processing, marketing, credit administration, human resources, legal and benefits, treasury, and finance and accounting. The primary revenues are from PCBNA’s securities portfolios.

Change to the Reportable Segments

In connection with the PCCI acquisition, the operations of the three branches acquired were included in the “Community Banking” segment along with the other branch activities of the Company. During 2004, the operations of PCCI’s commercial real estate and SBA lending areas reported to the former CEO of PCCI, who reported to the CEO of the Company and, consequently, they had been identified as a reportable segment during 2004. As of the beginning of 2005, these lending areas reported to the Manager of Retail and Small Business Lending with the Community Banking segment. The following tables disclose segment performance for the periods ended December 31, 2005 and 2004 with these lending activities included in the Community Banking segment.

In connection with the FBSLO acquisition, the operations of the two branches acquired were included in the “Community Banking segment along with the other branch activities of the Company. The operations of FBSLO’s commercial and commercial real estate lending areas report to the Company’s Commercial Lending Manager and consequently are included in the “Commercial Banking” segment. FBSLO’s small business and consumer lending operations now report to the Company’s Manager of Retail and Small Business Lending and consequently are included with other such lending operations in the “Community Banking” segment.

Charges and Credits for Funds and Income from the Investment Portfolios

For the Company, the process of disaggregating its businesses into these segments is somewhat arbitrary. Many of the Company’s customers do business with more than one segment. In these cases, the Company may use relationship pricing, whereby customers may be given a favorable price on one product because the other products they use are very profitable for the Company. As a fiscal intermediary, a large proportion of the Company’s business consists of borrowing from some customers—depositors and other financial institutions or bankers—and lending the funds to other customers—borrowers and securities issuers. The interest expense paid on the borrowings is charged to the segment that does the borrowing—Community Banking for deposits and Treasury (in All Other) for non-deposit borrowing. The interest earned on loans and securities is credited to the segments that do the lending or investing—Community Banking, Commercial Banking for loans and Treasury for investments.

If results of operations for the segments were reported on that basis, i.e. simply based on the products handled by the assigned staff, it would appear that the lending units were all highly profitable because they had only interest income while the deposit units incurred the interest expense. If they were not part of a depository institution, lending units would have to borrow the funds they lend and pay interest expense. In addition to the interest expense, the cost of servicing deposit customers is also borne by Branch Activities section of the Community Banking segment. To give a fair picture of profitability at the segment level, it is therefore necessary to charge the lending units for the cost of the funds they use while crediting the branch units in the Community Banking segment for the funds they provide.

Similarly, the Treasury Department included within the All Other segment uses deposit funds to purchase securities and other investments. It also needs to be charged for this use of funds. The Treasury Department also borrows funds as needed to supplement deposit growth and manage interest rate risk. A credit for these funds is assigned to the Treasury Department.

The securities portfolios provide liquidity to the Company and earn income from funds received from depositors that are in excess of the amounts lent to borrowers. The interest rates applicable to securities are lower than for loans because there is little or no credit risk. Foregoing the higher rates earned by loans is, in a sense, a cost of maintaining the necessary liquidity, and may be an opportunity cost for being unable to generate sufficient loans to make full use of the available funds. However, there is no one lending unit to which it is appropriate to charge the liquidity and opportunity costs related to the investment portfolios. Consequently, the liquidity and opportunity costs remain with the Treasury Department. Each segment that uses funds through lending or investing is charged for its funds at the same rates based solely on the maturity terms or repricing characteristics

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of the assets funded, while the Community Banking and All Other segments are credited for the funds they provide based on the maturity term or repricing characteristics of those funds.

The process of crediting or charging segments for the benefits they provide to or receive from other segments is termed transfer pricing. The Company transfer prices funds, but does not attempt to transfer price services provided from one segment to another in determining each segment’s profit or loss, e.g. there is no allocation of administration overhead to the operating units.

To better measure the profitability of the consumer lending and treasury activities and to reflect that the funds used and provided are not of the same maturity, the charges and credits for funds within the Community Banking and All Other segments are not netted.

Measure of Profit or Loss

In assessing the performance of each segment, the chief executive officer reviews the segment’s contribution before tax. Taxes are excluded because the Company has permanent tax differences (see Note 16) that do not apply equally to all segments. In addition, if segments were measured by their net-of-tax contribution, they would be advantaged or disadvantaged by any enacted changes in tax rates even though such changes are not reflective of the performance of the segments.

Interest Income and Revenues from External Customers

In the All Other segment, interest income exceeds revenues from external customers. This occurs because there are a number of negative amounts, specifically losses on securities and the tax credit partnerships, that originate with external customers that offset the interest income received from other external customers.

Intersegment Revenues and Internal Charge for Funds

Intersegment revenues consist of transfer pricing for the funds provided by the “Community Banking,” “Refund Programs,” and “Fiduciary” segments, and through the borrowings incurred by the Company’s Treasury department included in “All Other.” Internal charges for funds consist of the transfer pricing for the funds used for lending activities by “Community Banking” and “Commercial Banking” and for the purchases of investments by the Treasury department. The totals for intersegment revenues and charges for funds will equal each other because the Company’s Treasury unit acts as the net seller or buyer of funds and hence receives the difference between intersegment revenues earned by the other units and charges for funds assessed against the other units. Charges for funds to the lending and Treasury units are reduced because a portion of each segment’s assets are assumed to be funded by capital rather than borrowed funds. A charge for capital is not included in the pre-tax profitability for each segment.

The charge and credit for funds is computed by reference to external market rates. The charge for funds used for a specific loan or security is calculated by reference to the rate the Company would be charged by the FHLB to borrow money for the same term as the loan or security. While loans may have specific maturities, a portion of them will be paid off prior to maturity. The Company includes estimates of prepayments in determining the average term of the hypothetical borrowing. The credit for funds is computed by reference to a risk free rate of return on an investment of similar maturity as the deposit. Because among deposit types, only CDs have a specific maturity, the Company includes an estimate of how long the deposit relationship is likely to last in determining the term of the hypothetical investment. The process of funds transfer pricing also involves the interpolation of rates when quoted prices are not available for the reference item for the term of the asset or liability being transfer priced.

Intersegment revenues and internal charges for funds will generally be higher when interest rates are higher and lower when rates are low. Short-term interest rates were generally higher in 2005 than in the corresponding period of 2004. The commercial loans in the Commercial Banking segment usually have short maturities or reprice frequently and therefore this segment is charged for funds by reference to the short-term rates. Intermediate-term rates were generally lower than the first quarter of 2004. The consumer and small business loans in the Community Banking segment are usually fixed or have infrequent repricings and therefore this segment is charged for funds by reference to intermediate-term rates. The amount of charges and credits for funds will also be impacted as the estimates for prepayments of loans or early withdrawal of deposits are impacted by changes in interest rates.

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As indicated above, the Company’s Treasury unit functions as a “money center” balancing the funding uses and sources. The changes in its intersegment revenues and charges for funds from one year to the next are primarily the result of changes in the relative amounts used and provided by the other segments.

Other Segment Disclosure

With respect to the disclosure of total assets for the individual segments, fixed assets used by the other segments are all nonetheless recorded as assets of the All Other segment that manages most of them. Depreciation expense for these assets is charged to the segment that uses them.

The Company has no operations in foreign countries to require disclosure by geographical area. The Company has no single customer generating 10% or more of total revenues.

The Company records provision expense for all loans other than RALs in its Credit Administration Department, which is included in the “All Other” segment.

Specific Segment Disclosure

The following table presents information for each specific segment regarding assets, profit or loss, and specific items of revenue and expense that are included in that measure of segment profit or loss as reviewed by the chief executive officer. Also included is the sum of the other operating and support units in the All Other column.

(dollars in thousands)	Community Banking		Commercial Banking		Refund Programs		Fiduciary		All Other			Total
Year Ended December 31, 2005
Revenues from external customers	$	203,067	$	121,029	$	121,903	$	17,003	$	81,080		$	544,082
Intersegment revenues		144,141		—		7,020		2,470		55,465			209,096
Total revenues	$	347,208	$	121,029	$	128,923	$	19,473	$	136,545		$	753,178
Profit (Loss)	$	161,388	$	57,911	$	66,332	$	13,015	$	(134,347	)	$	164,299
Interest income		169,823		119,240		64,747		—		78,349			432,159
Interest expense		56,390		—		3,107		—		52,008			111,505
Internal charge for funds		67,482		56,161		2,929		4		82,521			209,096
Depreciation		4,918		123		800		62		6,882			12,785
Total assets		2,636,523		1,846,150		174		1,265		2,392,047			6,876,159
Capital expenditures		—		—		—		—		25,480			25,480
Year Ended December 31, 2004
Revenues from external customers	$	156,092	$	97,393	$	65,541	$	15,665	$	73,472		$	408,163
Intersegment revenues		101,443		—		4,704		1,519		19,541			127,207
Total revenues	$	257,535	$	97,393	$	70,245	$	17,184	$	93,013		$	535,370
Profit (Loss)	$	121,615	$	66,780	$	45,548	$	10,643	$	(98,349	)	$	146,237
Interest income		125,778		94,871		36,674		—		75,205			332,528
Interest expense		33,552		—		1,119		369		34,171			69,211
Internal charge for funds		42,986		23,248		—		9		60,964			127,207
Depreciation		4,198		149		731		76		5,428			10,582
Total assets		2,264,525		1,695,544		133,511		2,199		1,929,006			6,024,785
Capital expenditures		—		—		—		—		25,362			25,362
Year Ended December 31, 2003
Revenues from external customers	$	124,152	$	96,544	$	64,117	$	14,682	$	61,018		$	360,513
Intersegment revenues		70,850		—		1,824		1,416		34,380			108,470
Total revenues	$	195,002	$	96,544	$	65,941	$	16,098	$	95,398		$	468,983
Profit (Loss)	$	87,744	$	60,221	$	40,440	$	9,540	$	(73,353	)	$	124,592
Interest income		95,875		94,559		31,984		—		56,350			278,768
Interest expense		31,997		—		814		467		20,655			53,933
Internal charge for funds		30,788		27,650		2,684		10		47,338			108,470
Depreciation		3,665		169		547		106		5,433			9,920
Total assets		1,529,344		1,595,788		24,008		1,206		1,709,284			4,859,630
Capital expenditures		—		—		—		—		15,662			15,662

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The following table reconciles total revenues and profit for the segments to total revenues and pre-tax income, respectively, in the Consolidated Financial Statements. For purposes of performance measurement and therefore for the segment disclosure above, income from tax-exempt securities, loans, and leases is reported on a fully taxable equivalent basis. Under this method of disclosure, the income disclosed is increased to that amount which, if taxed, would result in the amount included in the financial statements. While useful to management, this increase to recognize the tax-exempt nature of these instruments is not in accordance with GAAP. Consequently, the table below includes the tax equivalent adjustment as a reconciling item between total revenues and pre-tax profit or loss for the segments and the corresponding amounts reported in the Consolidated Statements of Income.

(dollars in thousands)	Year ended December 31,
	2005			2004			2003
Total revenues for reportable segments	$	753,178		$	535,370		$	468,983
Elimination of intersegment revenues		(209,096	)		(127,207	)		(108,470	)
Elimination of taxable equivalent adjustment		(6,002	)		(6,347	)		(6,579	)
Total consolidated revenues	$	538,080		$	401,816		$	353,934
Total profit or loss for reportable segments	$	164,299		$	146,237		$	124,592
Elimination of taxable equivalent adjustment		(6,002	)		(6,347	)		(6,579	)
Income before income taxes	$	158,297		$	139,890		$	118,013

26.    FOURTH QUARTER 2004 ADJUSTMENTS

The Company identified three accounting errors that it corrected in the fourth quarter of 2004. These errors are described in the succeeding paragraphs. The portions of these adjustments that relate to any prior period financial statements were immaterial.

On February 7, 2005, the Chief Accountant of the SEC sent a letter to the American Institute of Certified Public Accountants calling attention to several issues in the accounting for leases. One of the issues is the requirement to recognize minimum or fixed rent increases on a straight-line basis. When the Company reviewed its lease accounting in response to the letter, it discovered that it had not followed the straight-line recognition in all cases. The Company determined that it had under-recognized lease expense over the terms of these leases going back as far as 1993 by a cumulative amount of $885,000.

During the fourth quarter of 2004, the Company recognized that it had not posted all of the losses on its low income housing tax credit partnerships. The cumulative amount of the unrecognized losses was $1.4 million. Most of this amount relates to the years prior to 2002 and in no case would adjustment for any prior period financial statements be material.

During the fourth quarter of 2004, the Company recognized $1.4 million in stay put payments, of which $980,000 was attributable to prior quarters in 2004. Adjustment to the financial statements for these prior quarters is not material.

These adjustments had an impact on net income for the fourth quarter of 2004 of $2.2 million or 5 cents per diluted share. For the year 2004, the impact on net income was $1.3 million or 3 cents per diluted share.

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27.    PACIFIC CAPITAL BANCORP

The condensed financial statements of the Bancorp are presented on the following three pages.

PACIFIC CAPITAL BANCORP

(Parent Company Only)

Balance Sheets

(in thousands)

	December 31,
	2005		2004
Assets
Cash	$	23,911	$	2,549
Investment in and advances to subsidiaries		575,221		506,772
Premises and equipment, net		1,070		747
Other assets		34,239		28,921
Total assets	$	634,441	$	538,989
Liabilities
Senior and subordinated debentures	$	76,082	$	68,091
Other liabilities		13,103		11,216
Total liabilities		89,185		79,307
Equity
Common stock		11,662		11,434
Surplus		107,829		78,903
Accumulated other comprehensive income		987		7,970
Retained earnings		424,778		361,375
Total shareholders’ equity		545,256		459,682
Total liabilities and shareholders’ equity	$	634,441	$	538,989

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PACIFIC CAPITAL BANCORP

(Parent Company Only)

Income Statements

(in thousands)

	Years Ended December 31,
	2005			2004			2003
Equity in earnings of subsidiaries:
Undistributed	$	75,429		$	73,060		$	48,244
Dividends		27,240			17,500			29,000
Interest income		—			(2	)		—
Interest expense		(4,766	)		(4,368	)		(3,016	)
Other income		67			134			35
Other operating expense		(2,249	)		(1,288	)		(705	)
Income tax benefit		3,564			2,908			2,113
Net income	$	99,285		$	87,944		$	75,671

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PACIFIC CAPITAL BANCORP

(Parent Company Only)

Statements of Cash Flows

(in thousands)

	Years Ended December 31,
	2005			2004			2003
Increase (decrease) in cash and cash equivalents:
Cash flows from operating activities:
Net income	$	99,285		$	87,944		$	75,671
Adjustments to reconcile net income to net cash used in operations:
Equity in undistributed net income of subsidiaries		(102,669	)		(90,560	)		(77,244	)
Additional investment in subsidiary		—			(13,008	)		—
Depreciation expense		33			58			126
Increase in other assets		(5,320	)		(14,267	)		(3,390	)
Increase in other liabilities		1,887			4,297			231
Net cash used in operating activities		(6,784	)		(25,536	)		(4,606	)
Cash flows from investing activities:
Net decrease in loans		—			26			55
Capital (expenditures) and dispositions		(356	)		1,680			2,172
Distributed earnings of subsidiaries		27,240			17,500			29,000
Net cash provided by investing activities		26,884			19,206			31,227
Cash flows from financing activities:
Proceeds from other borrowing		7,991			28,091			—
Proceeds from issuance of common stock		29,154			8,927			6,663
Payments to retire common stock		—			—			(28,208	)
Dividends paid		(35,883	)		(31,400	)		(27,399	)
Net cash provided by (used in) financing activities		1,262			5,618			(48,944	)
Net (decrease) increase in cash and cash equivalents		21,362			(712	)		(22,323	)
Cash and cash equivalents at beginning of period		2,549			3,261			25,584
Cash and cash equivalents at end of period	$	23,911		$	2,549		$	3,261

Supplemental disclosures: none

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QUARTERLY FINANCIAL DATA (UNAUDITED)

(amounts in thousands except per share amounts)	2005 Quarters								2004 Quarters
	4th		3rd		2nd		1st		4th		3rd		2nd		1st
Interest income	$	101,476	$	93,107	$	86,308	$	145,266	$	77,404	$	76,583	$	71,429	$	100,765
Interest expense		34,389		29,622		24,611		22,883		19,894		18,424		15,996		14,897
Net interest income		67,087		63,485		61,697		122,383		57,510		58,159		55,433		85,868
Provision for credit losses		4,993		1,967		7,901		39,012		1,748		2,740		737		7,584
Noninterest revenue		13,972		14,814		17,979		65,158		12,393		11,241		15,380		36,621
Operating expense		58,750		53,814		48,333		53,508		45,398		43,349		44,043		47,116
Income before income taxes		17,316		22,518		23,442		95,021		22,757		23,311		26,033		67,789
Income taxes		6,248		8,150		8,999		35,615		8,510		8,752		9,486		25,198
Net Income	$	11,068	$	14,368	$	14,443	$	59,406	$	14,247	$	14,559	$	16,547	$	42,591
Net earnings per share:
Basic	$	0.24	$	0.31	$	0.32	$	1.30	$	0.31	$	0.32	$	0.36	$	0.94
Diluted	$	0.24	$	0.31	$	0.31	$	1.29	$	0.31	$	0.32	$	0.36	$	0.93

ITEM 9.    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

On June 21, 2005, the Company filed a Current Report on Form 8-K announcing that the Audit Committee of the Board of Directors dismissed PricewaterhouseCoopers LLP (“PwC”) on June 15, 2005 as the Company’s independent registered public accounting firm for the year ended December 31, 2005. The decision came after the Audit Committee adopted in March 2005 a policy to solicit proposals for the auditing engagement at least every three years. The Committee received proposals for the engagement from three firms including PwC. Based on the proposals, the July 13, 2005, the Committee determined that it was in the best interests of the Company to select another firm. On July 13, 2005, the Company filed a Current Report on Form 8-K announcing that its Audit Committee had engaged Ernst & Young, LLP as its independent registered public accounting firm for the year ended December 31, 2005.

As described in the Company’s Current Report on Form 8-K dated June 15, 2005, the PwC’s reports on the consolidated financial statements of the Company as of and for the year ended December 31, 2004 did not contain any adverse opinion or disclaimer of opinion, and were not qualified or modified as to uncertainty, audit scope or accounting principle. PwC’s integrated report for the year ended December 31, 2004 did include the conclusion that the Company had not maintained effective internal control over financial reporting as of that date because of the effect of two material weaknesses identified by the Company’s management during its assessment of the Company’s internal control over financial reporting. A description of the material weaknesses is included in the Current Report on Form 8-K dated June 21, 2005.

Except for the material weaknesses mentioned above, there are no reportable events under Item 304(a)(1)(v) of Regulation S-K that occurred during the year ended December 31, 2004 and through June 15, 2005. During the year ended December 31, 2004 and through June 15, 2005, there were no disagreements with PwC on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure which disagreements, if not resolved to the satisfaction of PwC, would cause PwC to make reference thereto in its report on the Company’s financial statements for such year.

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ITEM 9A.    CONTROLS AND PROCEDURES

Disclosure controls and procedures are the controls and other procedures that are designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Securities Exchange Act of 1934 (Exchange Act) is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s (SEC) rules and forms. Disclosure controls and procedures include, among other processes, controls and procedures designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

As of December 31, 2005 the Company carried out an evaluation, under the supervision and management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures were effective as of December 31, 2005.

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

Management is responsible for establishing and maintaining adequate internal control over financial reporting at the Company. Our internal control over financial reporting is a process designed under the supervision of the Chief Executive Officer and Chief Financial Officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s financial statements for external reporting purposes in accordance with accounting principles generally accepted in the United States of America. A company’s internal control over financial reporting includes policies and procedures that (1) pertain to the maintenance of records that accurately and fairly reflect, in reasonable detail, transactions and dispositions of the company’s assets, (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America and that receipts and expenditures are being made only in accordance with authorizations of management and the directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the company’s financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

As of December 31, 2005, the Company carried out an evaluation, 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 Company’s internal control over financial reporting pursuant to Rule 13a-15(c), as adopted by the SEC under the Exchange Act. In evaluating the effectiveness of the Company’s internal control over financial reporting, management used the framework established in “Internal Control—Integrated Framework,” issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”).

Management excluded certain elements of internal control over financial reporting of the activities of First Bancshares, Inc. of San Luis Obispo (FBSLO) from its evaluation of internal control over financial reporting as of December 31, 2005 because FBSLO was acquired by the Company in a purchase business combination during 2005. FBSLO’s loans and deposits represented $232 million and $231 million, respectively, of the Company’s related consolidated financial statement amounts as of December 31, 2005, and FBSLO contributed net income of $2.9 million for the year ended December 31, 2005. FBSLO’s investment portfolio and long-term debt was integrated with the Company’s investment portfolio at the time of the closing of the acquisition and was included in Managements evaluation of internal controls. Interest income and expense from these portfolios is excluded from the net income figure above.

132

Based on this evaluation, Management concluded that as of December 31, 2005, the Company internal control over financial reporting was effective.

Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005, has been audited by Ernst & Young LLP, an independent registered public accounting firm as stated in their report which is included on pages 74-75.

CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING

In 2004, Management had conducted a similar evaluation of internal controls over financial reporting and had concluded that there were two material weaknesses in those internal controls. Steps were taken in 2005 to remediate those weaknesses. These remediation steps included enhancements to the Company’s reconciliation processes and more formal review of the application of Generally Accepted Accounting Principles to leasing transactions and other non-routine transactions.

133

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information required by Item 10 is incorporated herein by reference to the sections titled “The Board of Directors” and “Named Officers” in the Company’s definitive Proxy Statement for the annual meeting to be held May 23, 2006 that will be filed within 120 days following the fiscal year end December 31, 2005 (“Proxy Statement”).

ITEM 11. EXECUTIVE COMPENSATION

The information required by Item 11 is incorporated herein by reference to the section titled “Executive Compensation” in the Company’s Proxy Statement.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The information required by Item 12 is incorporated herein by reference to the section titled “Beneficial Ownership Chart” in the Company’s Proxy Statement.

ITEM 13. CERTAIN BUSINESS RELATIONSHIPS

The information required by Item 13 is incorporated herein by reference to the section titled “Certain Business Relationships” in the Company’s Proxy Statement.

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

The information required by Item 14 is incorporated herein by reference to the section titled “Audit Committee Report” in the Company’s Proxy Statement.

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PART IV

ITEM 15. EXHIBITS, FINANCIAL STATEMENTS, AND REPORTS ON FORM 8-K

(a)1. FINANCIAL STATEMENTS

The listing of financial statements required by this item is set forth in the index for Item 8 of this report.

(a)2. FINANCIAL STATEMENTS SCHEDULES

The listing of supplementary financial statement schedules required by this item is set forth in the index for Item 8 of this report.

(a)3. EXHIBITS

The listing of exhibits required by this item is set forth in the Exhibit Index beginning on page 137 of this report. Each management contract or compensatory plan or arrangement required to be filed as an exhibit to this report is listed under Item 10.1 “Compensation Plans and Agreements,” in the Exhibit Index.

(b) REPORTS ON FORM 8-K

The following current reports on Form 8-K were filed with the Securities and Exchange Commission during the fourth quarter of 2005.

Subject		Filing Date
Item 8.01	Other Events	October 26, 2005
	Press release announcing earnings for the third quarter of 2005.
Item 8.01	Other Events	November 14, 2005
	On November 10, 2005, the Company announced that its Executive Vice President and CFO, Donald Lafler intends to retire in 2006.

(c) EXHIBITS

See exhibits listed in “Exhibit Index” on page 137 of this report.

(d) FINANCIAL STATEMENT SCHEDULES

There are no financial statement schedules required by Regulation S-X that have been excluded from the annual report to shareholders.

135

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed by the undersigned, thereunto duly authorized.

Pacific Capital Bancorp

By /s/ William S. Thomas. Jr.	March 15, 2006
William S. Thomas, Jr.	Date
President and Chief Executive Officer
Director

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities and on the dates indicated.

/s/ Edward E. Birch	March 15, 2006	/s/ William S. Thomas, Jr.	March 15, 2006
Edward E. Birch	Date	William S. Thomas, Jr.	Date
Chairman of the Board		President
		Chief Executive Officer
		(Principal Executive Officer)
/s/ Richard M. Davis	March 15, 2006	/s/ Richard S. Hambleton, Jr.	March 15, 2006
Richard M. Davis	Date	Richard S. Hambleton, Jr.	Date
Director		Director
/s/ D. Vernon Horton	March 15, 2006	/s/ Roger C. Knopf	March 15, 2006
D. Vernon Horton	Date	Roger C. Knopf	Date
Vice Chairman		Director
/s/ Robert W. Kummer, Jr.	March 15, 2006	/s/ Donald Lafler	March 15, 2006
Robert W. Kummer, Jr.	Date	Donald Lafler	Date
Director		Executive Vice President
		Chief Financial Officer
		(Principal Financial and Accounting Officer)
/s/ Clayton C. Larson	March 15, 2006	/s/ John Mackall	March 15, 2006
Clayton C. Larson	Date	John Mackall	Date
Vice Chairman		Director
/s/ Gerald T. McCullough	March 15, 2006	/s/ Richard A. Nightingale	March 15, 2006
Gerald T. McCullough	Date	Richard A. Nightingale	Date
Director		Director
/s/ Kathy J. Odell	March 15, 2006
Kathy J. Odell	Date
Director

136

EXHIBIT INDEX TO PACIFIC CAPITAL BANCORP FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 2005

Exhibit

Number        Description *

3.	Articles of Incorporation and Bylaws:
	3.1	Certificate of Restatement of Articles of Incorporation of Pacific Capital Bancorp dated June 10, 2005. (1)
	3.2	Certificate of Amendment of Articles of Incorporation dated August 8, 2005. (2)
	3.3	Amended and Restated Bylaws of Pacific Capital Bancorp effective February 17, 2006. (3)
4.	Instruments Defining the Rights of Security Holders, including indentures
	4.1	Amended and Restated Stockholders Rights Agreements, dated as of April 22, 2003, between Pacific Capital Bancorp and Mellon Investor Services LLC, as Rights Agent. (4)
		Note: No long-term debt instruments issued by the Company or any of its consolidated subsidiaries exceeds 10% of the consolidated total assets of the Company and its subsidiaries. In accordance with paragraph 4(iii) of Item 601 of Regulation S-K, the Company will furnish to the Commission upon request copies of long-term debt instruments and related agreements.
10.	Material contracts:
	10.1	Compensation Plans and Agreements:
		10.1.1	Pacific Capital Bancorp 2002 Stock Plan. (5)
		10.1.2	Pacific Capital Bancorp Directors Stock Option Plan. (6)
		10.1.3	Pacific Capital Bancorp Incentive & Investment and Salary Savings Plan, as amended and restated effective January 1, 2001. (5)
			10.1.3.1	First Amendment to Pacific Capital Bancorp Amended and Restated Incentive and Investment and Salary Savings Plan. (5)
			10.1.3.2	Second Amendment to Pacific Capital Bancorp Amended and Restated Incentive and Investment and Salary Savings Plan. (5)
			10.1.3.3	Third Amendment to Pacific Capital Bancorp Amended and Restated Incentive and Investment and Salary Savings Plan. (5)
			10.1.3.4	Addendum Incorporating EGTRAA Compliance Amendment to Pacific Capital Bancorp Incentive and Investment and Salary Savings Plan. (5)
		10.1.4	Pacific Capital Bancorp Employee Stock Ownership Plan and Trust, as amended and restated effective January 1, 2001. (5)
			10.1.4.1	First Amendment to Pacific Capital Bancorp Amended and Restated Employee Stock Ownership Plan and Trust. (5)
			10.1.4.2	Addendum Incorporating EGTRAA Compliance Amendment to Pacific Capital Bancorp Employee Stock Ownership Plan and Trust. (5)
		10.1.5	Pacific Capital Bancorp Amended and Restated Key Employee Retiree Health Plan dated December 30,1998. (5)
		10.1.6	Pacific Capital Bancorp Amended and Restated Retiree Health Plan (Non-Key Employees) dated December 30, 1998. (5)
		10.1.7	Trust Agreement of Santa Barbara Bank & Trust Voluntary Beneficiary Association. (7)
			10.1.7.1	First Amendment to Trust Agreement of Santa Barbara Bank & Trust Voluntary Beneficiary Association. (8)

137

		10.1.8	Pacific Capital Bancorp, Amended and Restated, 1996 Directors Stock Plan, as dated February 22, 2000 as amended July 21, 2004. (5)
			10.1.8.1	Pacific Capital Bancorp 1996 Directors Stock Option Agreement. (5)
			10.1.8.2	Pacific Capital Bancorp 1996 Directors Stock Option Agreement (Reload Option). (5)
		10.1.9	Pacific Capital Bancorp Directors’ Stock Option Plan and Form of Stock Option Agreement. (9)
		10.1.10	Pacific Capital Bancorp 1984 Amended and Restated Stock Option Plan and Forms of Agreements as amended to date. (5)
		10.1.11	Pacific Capital Bancorp 1994 Stock Option Plan, as amended, and Forms of Incentive and Non-Qualified Stock Option Agreements. (5)
		10.1.12	Amended and Restated Pacific Capital Bancorp Management Retention Plan. (10)
		10.1.13	Pacific Capital Bancorp First Amended and Restated Deferred Compensation Plan dated October 1, 2000. (5)
			10.1.13.1	First Amended and Restated Trust Agreement under Pacific Capital Bancorp Deferred Compensation Plan dated October 1, 2000. (5)
		10.1.14	Pacific Capital Bancorp Non-Employee Director Compensation Plan Effective January 1, 2006. (13)
		10.1.15	Pacific Capital Bancorp Deferred Compensation Plan, effective January 1, 2005.**
		10.1.16	Pacific Capital Bancorp 2005 High Performance Compensation Plan, effective January 1, 2005.**
		10.1.17	Amended and Restated Executive Salary Continuation Benefits Agreement between Clayton C. Larson and Pacific Capital Bancorp dated September 23, 1997. (14)
		10.1.18	Employment Offer Letter dated February 21, 2006 between Pacific Capital Bancorp and Joyce Clinton.**
		10.1.19	Employment Offer Letter dated March 3, 2006 between Pacific Capital Bancorp and George Leis.**
		10.1.20	Pacific Capital Bancorp 2005 Directors’ Stock Plan. (12)
		10.1.21	Form of Stock Option Agreement. (12)
		10.1.22	Form of Restricted Stock Agreement. (12)
	16.1	Letter regarding change in certifying accountant**
21.	Subsidiaries of the registrant**
23.	Consents of Experts and Counsel
	23.1	Consent of Ernst & Young LLP with respect to financial statements of the Registrant. **
	23.2	Consent of PricewaterhouseCoopers LLP with respect to financial statements of the Registrant.**
31.	Certifications pursuant to Section 302 of Sarbanes-Oxley Act of 2002
	31.1	Certification of William S. Thomas, Jr.**
	31.2	Certification of Donald Lafler**
32.	Certification pursuant to Section 906 of Sarbanes-Oxley Act of 2002**

138

Shareholders may obtain a copy of any exhibit by writing to:

Carol Zepke, Corporate Secretary

Pacific Capital Bancorp

P.O. Box 60839

Santa Barbara, CA 93160

* Effective December 30, 1998, Santa Barbara Bancorp and Pacific Capital Bancorp merged and, contemporaneously with effectiveness of the merger, Santa Barbara Bancorp, the surviving entity, changed its corporate name to Pacific Capital Bancorp. Documents identified as filed by Santa Barbara Bancorp prior to December 30, 1998 were filed by Santa Barbara Bancorp (File 0-11113). Documents identified as filed by Pacific Capital Bancorp prior to December 30, 1998 were filed by Pacific Capital Bancorp as it existed prior to the merger (File No. 0-13528).

** Filed herewith.

The Exhibits listed below are incorporated by reference to the specified filing.

(1) Filed as Exhibit 3(i)(B) to the Current Report on Form 8-K Pacific Capital Bancorp (File No. 0-11113) filed June 17, 2005.

(2) Filed as Exhibit 3(i)(B) to the Quarterly Report on Form 10-Q of Pacific Capital Bancorp (File No. 0-11113) for the quarter ended September 30, 2005.

(3) Filed as Exhibit 3.1 to the Current Report on Form 8-K of Pacific Capital Bancorp (File No. 0-11113) filed on February 23, 2006.

(4) Filed as Exhibit 4.1 to the Quarterly Report on Form 10-Q of Pacific Capital Bancorp (File No. 0-11113) for the quarter ended March 31, 2003.

(5) Filed as an exhibit with the same number to the Annual Report on Form 10-K of Pacific Capital Bancorp (File No. 0-01113) for the fiscal year ended December 31, 2004.

(6) Filed as Exhibit 4.2 to the Amendment No. 1 to Form S-8 of Santa Barbara Bancorp (Registration No. 33-48724) filed on June 13, 1995.

(7) Filed as Exhibit 10.1.8 to Annual Report on Form 10-K of Santa Barbara Bancorp (File No.0-11113) for the fiscal year ended December 31, 1997.

(8) Filed as an Exhibit to Annual Report on Form 10-K of Santa Barbara Bancorp (File No.0-11113) for fiscal year ended December 31, 1995.

(9) Filed as Exhibit 10.25 to Annual Report on Form 10-K of Pacific Capital Bancorp (File No. 0-13528) for the fiscal year ended December 31, 1991.

(10) Filed as Exhibit 10.1 to Current Report on Form 8-K (File No. 0-11113) filed October 25, 2004.

(11) Filed as Exhibit 99.1 to Current Report on Form 8-K of Pacific Capital Bancorp (File No. 0-11113) filed January 31, 2006.

(12) Filed as Exhibit to Form S-8 of Pacific Capital Bancorp (Registration No. 333-127982) filed on August 31, 2005.

(13) Filed as Exhibit 99.1 to the Current Report on Form 8-K Pacific Capital Bancorp (File No. 0-11113) filed January 24, 2006.

(14) Filed as Exhibit 10.58 to the Quarter Report on Form 10-Q (File No. 0-13528) for the quarter ended September 30, 1997.

139

EX-10.1.15

Exhibit 10.1.15

PACIFIC CAPITAL BANCORP

DEFERRED COMPENSATION PLAN

Effective January 1, 2005

TABLE OF CONTENTS[.1]

		Page
ARTICLE 1	Definitions	1
ARTICLE 2	Selection, Enrollment, Eligibility	6
2.1	Selection by Committee	6
2.2	Enrollment and Eligibility Requirements; Commencement of Participation.	6
ARTICLE 3	Deferral Commitments/Company Contribution Amounts/ Company Restoration Matching Amounts/ Vesting/Crediting/Taxes	7
3.1	Minimum Deferrals	7
3.2	Maximum Deferral	8
3.3	Election to Defer; Effect of Election Form	8
3.4	Withholding and Crediting of Annual Deferral Amounts	9
3.5	Company Contribution Amount	9
3.6	Company Restoration Matching Amount	9
3.7	Crediting of Amounts after Benefit Distribution	10
3.8	Vesting	10
3.9	Crediting/Debiting of Account Balances	11
3.1	FICA and Other Taxes	12
ARTICLE 4	Scheduled Distribution; Unforeseeable Financial Emergencies; Withdrawal Payout Upon Income Inclusion Under Code Section 409A	13
4.1	Scheduled Distribution	13
4.2	Postponing Scheduled Distributions	13
4.3	Other Benefits Take Precedence Over Scheduled Distributions	14
4.4	Withdrawal Payout/Suspensions for Unforeseeable Financial Emergencies	14
4.5	Withdrawal Payout Upon Income Inclusion Under Code Section 409A	15
ARTICLE 5	Retirement Benefit	15
5.1	Retirement Benefit	15
5.2	Payment of Retirement Benefit	15
ARTICLE 6	Termination Benefit	16
6.1	Termination Benefit	16
6.2	Payment of Termination Benefit	16
ARTICLE 7	Disability Benefit	16
7.1	Disability Benefit	16
7.2	Payment of Disability Benefit	16
ARTICLE 8	Death Benefit	16
8.1	Death Benefit	16
8.2	Payment of Death Benefit	17

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ARTICLE 9	Beneficiary Designation	17
9.1	Beneficiary	17
9.2	Beneficiary Designation; Change; Spousal Consent	17
9.3	Acknowledgment	17
9.4	No Beneficiary Designation	17
9.5	Doubt as to Beneficiary	17
9.6	Discharge of Obligations	17
ARTICLE 10	Leave of Absence	18
10.1	Paid Leave of Absence	18
10.2	Unpaid Leave of Absence	18
ARTICLE 11	Termination of Plan, Amendment or Modification	18
11.1	Termination of Plan	18
11.2	Amendment	19
11.3	Plan Agreement	19
11.4	Effect of Payment	19
ARTICLE 12	Administration	19
12.1	Committee Duties	19
12.2	Administration Upon Change In Control	19
12.3	Agents	20
12.4	Binding Effect of Decisions	20
12.5	Indemnity of Committee	20
12.6	Employer Information	20
ARTICLE 13	Other Benefits and Agreements	20
13.1	Coordination with Other Benefits	20
ARTICLE 14	Claims Procedures	21
14.1	Presentation of Claim	21
14.2	Notification of Decision	21
14.3	Review of a Denied Claim	21
14.4	Decision on Review	22
14.5	Legal Action	22
ARTICLE 15	Trust	22
15.1	Establishment of the Trust	22
15.2	Interrelationship of the Plan and the Trust	22
15.3	Distributions From the Trust	23
ARTICLE 16	Miscellaneous	23
16.1	Status of Plan	23
16.2	Unsecured General Creditor	23
16.3	Employer’s Liability	23
16.4	Nonassignability	23
16.5	Not a Contract of Employment	23

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16.6	Furnishing Information	24
16.7	Terms	24
16.8	Captions	24
16.9	Governing Law	24
16.10	Notice	24
16.11	Successors	24
16.12	Spouse’s Interest	24
16.13	Validity	25
16.14	Incompetent	25
16.15	Court Order	25
16.16	Insurance	25

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PACIFIC CAPITAL BANCORP

DEFERRED COMPENSATION PLAN

Effective January 1, 2005

Purpose

The purpose of this Plan is to provide specified benefits to Directors and a select group of management or highly compensated Employees who contribute materially to the continued growth, development and future business success of Pacific Capital Bancorp, a California corporation, and its subsidiaries, if any, that sponsor this Plan. This Plan shall be unfunded for tax purposes and for purposes of Title I of ERISA.

ARTICLE 1

Definitions

For the purposes of this Plan, unless otherwise clearly apparent from the context, the following phrases or terms shall have the following indicated meanings:

1.1 “Account Balance” shall mean, with respect to a Participant, an entry on the records of the Employer equal to the sum of (i) the Deferral Account balance, (ii) the Company Contribution Account balance, and (iii) the Company Restoration Matching Account balance. The Account Balance shall be a bookkeeping entry only and shall be utilized solely as a device for the measurement and determination of the amounts to be paid to a Participant, or his or her designated Beneficiary, pursuant to this Plan.

1.2 “Annual Deferral Amount” shall mean that portion of a Participant’s Base Salary, Bonus, Commissions, Director Fees and LTIP Amount that a Participant defers in accordance with Article 3 for any one Plan Year, without regard to whether such amounts are withheld and credited during such Plan Year. In the event of a Participant’s Retirement, Disability, death or Termination of Employment prior to the end of a Plan Year, such year’s Annual Deferral Amount shall be the actual amount withheld prior to such event.

1.3 “Annual Installment Method” shall be an annual installment payment over the number of years selected by the Participant in accordance with this Plan, calculated as follows: (i) for the first annual installment, the Participant’s vested Account Balance shall be calculated as of the close of business on or around the Participant’s Benefit Distribution Date, as determined by the Committee in its sole discretion, and (ii) for remaining annual installments, the Participant’s vested Account Balance shall be calculated on every anniversary of such calculation date, as applicable. Each annual installment shall be calculated by multiplying this balance by a fraction, the numerator of which is one and the denominator of which is the remaining number of annual payments due the Participant. By way of example, if the Participant elects a ten (10) year Annual Installment Method for the Retirement Benefit, the first payment shall be 1/10 of the vested Account Balance, calculated as described in this definition. The following year, the payment shall be 1/9 of the vested Account Balance, calculated as described in this definition.

1.4 “Base Salary” shall mean the annual cash compensation relating to services performed during any calendar year, excluding distributions from nonqualified deferred compensation plans, bonuses, commissions, overtime, fringe benefits, stock options, relocation expenses, incentive payments, non-monetary awards, director fees and other fees, and automobile and other

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allowances paid to a Participant for employment services rendered (whether or not such allowances are included in the Employee’s gross income). Base Salary shall be calculated before reduction for compensation voluntarily deferred or contributed by the Participant pursuant to all qualified or nonqualified plans of any Employer and shall be calculated to include amounts not otherwise included in the Participant’s gross income under Code Sections 125, 402(e)(3), 402(h), or 403(b) pursuant to plans established by any Employer; provided, however, that all such amounts will be included in compensation only to the extent that had there been no such plan, the amount would have been payable in cash to the Employee.

1.5 “Beneficiary” shall mean one or more persons, trusts, estates or other entities, designated in accordance with Article 9, that are entitled to receive benefits under this Plan upon the death of a Participant.

1.6 “Beneficiary Designation Form” shall mean the form established from time to time by the Committee that a Participant completes, signs and returns to the Committee to designate one or more Beneficiaries.

1.7 “Benefit Distribution Date” shall mean the date that triggers distribution of a Participant’s vested Account Balance. A Participant’s Benefit Distribution Date shall be determined upon the occurrence of any one of the following:

(a) If the Participant Retires, his or her Benefit Distribution Date shall be the last day of the six-month period immediately following the date on which the Participant Retires unless the Committee determines in its sole and absolute discretion that Participant does not qualify as a “specified employee” as defined in accordance with Treasury guidance and Regulations related to Code Section 409A, including but not limited to Notice 2005-1, Proposed Treasury Regulations Section 1.409A and such other Treasury guidance or Regulations issued after the effective date of this plan, where in such case the Benefit Distribution Date shall be the date on which the Participant Retires; provided, however, in the event the Participant changes his or her Retirement Benefit election in accordance with Section 5.1(b), his or her Benefit Distribution Date shall be postponed in accordance with Section 5.1(b);

(b) If the Participant experiences a Termination of Employment, his or her Benefit Distribution Date shall be the last day of the six-month period immediately following the date on which the Participant experiences a Termination of Employment unless the Committee determines in its sole and absolute discretion that Participant does not qualify as a “specified employee” as defined in accordance with Treasury guidance and Regulations related to Code Section 409A, including but not limited to Notice 2005-1, Proposed Treasury Regulations Section 1.409A and such other Treasury guidance or Regulations issued after the effective date of this plan, where in such case the Benefit Distribution Date shall be the date on which the Participant experiences a Termination of Employment; provided, however, in the event the Participant changes his or her Termination Benefit election in accordance with Section 6.1(b), his or her Benefit Distribution Date shall be postponed in accordance with Section 6.1(b);

(c) The date on which the Committee is provided with proof that is satisfactory to the Committee of the Participant’s death, if the Participant dies prior to the complete distribution of his or her vested Account Balance; or

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(d) The date on which the Participant becomes Disabled.

1.8 “Board” shall mean the board of directors of Pacific Capital Bancorp.

1.9 “Bonus” shall mean any compensation, in addition to Base Salary, Commissions and LTIP Amounts, earned by a Participant for services rendered during a Plan Year, under any Employer’s cash bonus and cash incentive plans.

1.10 “Change in Control” shall mean any “change in control event” as defined in accordance with Treasury guidance and Regulations related to Code Section 409A, including but not limited to Notice 2005-1, Proposed Treasury Regulations Section 1.409A and such other Treasury guidance or Regulations issued after the effective date of this Plan.

1.11 “Claimant” shall have the meaning set forth in Section 14.1.

1.12 “Code” shall mean the Internal Revenue Code of 1986, as it may be amended from time to time.

1.13 “Commissions” shall mean compensation earned by a Participant where (i) a substantial portion of the services provided consist of the direct sale of a product or service to a customer, (ii) the compensation consists either of a portion of the purchase price or amount calculated solely by reference to the volume sales, and (iii) payment of the compensation is contingent on the employer receiving payment from an unrelated customer for the product or services. Notwithstanding the foregoing, Commissions shall not include Bonus or LTIP Amounts or other additional incentives or awards earned by the Participant.

1.14 “Committee” shall mean the committee described in Article 12.

1.15 “Company” shall mean (i) Pacific Capital Bancorp, a California corporation, and (ii) each and any successor to all or substantially all of the Company’s assets or business.

1.16 “Company Contribution Account” shall mean (i) the sum of the Participant’s Company Contribution Amounts, plus (ii) amounts credited or debited to the Participant’s Company Contribution Account in accordance with this Plan, less (iii) all distributions made to the Participant or his or her Beneficiary pursuant to this Plan that relate to the Participant’s Company Contribution Account.

1.17 “Company Contribution Amount” shall mean, for any one Plan Year, the amount determined in accordance with Section 3.5.

1.18 “Company Restoration Matching Account” shall mean (i) the sum of all of a Participant’s Company Restoration Matching Amounts, plus (ii) amounts credited or debited to the Participant’s Company Restoration Matching Account in accordance with this Plan, less (iii) all distributions made to the Participant or his or her Beneficiary pursuant to this Plan that relate to the Participant’s Company Restoration Matching Account.

1.19 “Company Restoration Matching Amount” shall mean, for any one Plan Year, the amount determined in accordance with Section 3.6.

1.20 “Death Benefit” shall mean the benefit set forth in Article 8.

1.21 “Deferral Account” shall mean (i) the sum of all of a Participant’s Annual Deferral Amounts, plus (ii) amounts credited or debited to the Participant’s Deferral Account in accordance with this Plan, less (iii) all distributions made to the Participant or his or her Beneficiary pursuant to this Plan that relate to his or her Deferral Account.

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1.22 “Director” shall mean any member of the board of Pacific Capital Bancorp.

1.23 “Director Fees” shall mean the annual fees earned by a Director from Pacific Capital Bancorp, including retainer fees and meetings fees, as compensation for serving on the board of directors.

1.24 “Disability” or “Disabled” shall mean that a Participant is (i) unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or can be expected to last for a continuous period of not less than 12 months, or (ii) by reason of any medically determinable physical or mental impairment which can be expected to result in death or can be expected to last for a continuous period of not less than 12 months, receiving income replacement benefits for a period of not less than 3 months under an accident or health plan covering employees of the Participant’s Employer.

1.25 “Disability Benefit” shall mean the benefit set forth in Article 7.

1.26 “Election Form” shall mean the form, which may be in electronic format, established from time to time by the Committee that a Participant completes, signs and returns to the Committee to make an election under the Plan.

1.27 “Employee” shall mean a person who is an employee of any Employer.

1.28 “Employer(s)” shall mean the Company and/or any of its subsidiaries (now in existence or hereafter formed or acquired) that has been selected by the Board to participate in the Plan and has adopted the Plan as a sponsor.

1.29 “ERISA” shall mean the Employee Retirement Income Security Act of 1974, as it may be amended from time to time.

1.30 “401(k) Plan” shall mean, with respect to an Employer, a plan qualified under Code Section 401(a) that contains a cash or deferral arrangement described in Code Section 401(k), adopted by the Employer, as it may be amended from time to time, or any successor thereto.

1.31 “LTIP Amounts” shall mean any portion of cash compensation payments attributable to a Plan Year that is earned by a Participant as an Employee under any Employer’s long-term incentive plan or any other long-term incentive arrangement designated by the Committee. Stock payments under any such long-term incentive plan or arrangement do not constitute LTIP Amounts.

1.32 “Participant” shall mean any Employee or Director (i) who is selected to participate in the Plan, (ii) who submits an executed Plan Agreement, Election Form and Beneficiary Designation Form, which are accepted by the Committee, and (iii) whose Plan Agreement has not terminated.

1.33 “Plan” shall mean the Pacific Capital Bancorp Deferred Compensation Plan, which shall be evidenced by this instrument and by each Plan Agreement, as they may be amended from time to time.

1.34 “Plan Agreement” shall mean a written agreement, as may be amended from time to time, which is entered into by and between an Employer and a Participant. Each Plan Agreement executed by a Participant and the Participant’s Employer shall provide for the entire benefit to which such Participant is entitled under the Plan; should there be more than one Plan Agreement, the Plan Agreement bearing the latest date of acceptance by the Employer shall supersede all previous Plan Agreements in their entirety and shall govern such entitlement. The terms of any Plan Agreement may be different for any Participant, and any Plan Agreement may provide additional

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benefits not set forth in the Plan or limit the benefits otherwise provided under the Plan; provided, however, that any such additional benefits or benefit limitations must be agreed to by both the Employer and the Participant.

1.35 “Plan Year” shall mean a period beginning on January 1 of each calendar year and continuing through December 31 of such calendar year.

1.36 “Retirement,” “Retire(s)” or “Retired” shall mean with respect to an Employee, unless otherwise specified by the Committee in the Plan Agreement, separation from service with any and all Employers for any reason other than a leave of absence, death or Disability, as determined in accordance with Code Section 409A and related Treasury guidance and Regulations, following the first date as of which (a) the Employee has attained at least age fifty-five (55) and has completed at least ten (10) Years of Service, and (b) the sum of Employee’s age plus Years of Service is at least equal to seventy-five (75); and shall mean with respect to a Director who is not an Employee, separation from service as a Director with all Employers on or after the attainment of age seventy-two (72). If a Participant is both an Employee and a Director, Retirement shall not occur until he or she Retires as both an Employee and a Director.

1.37 “Retirement Benefit” shall mean the benefit set forth in Article 5.

1.38 “Scheduled Distribution” shall mean the distribution set forth in Section 4.1.

1.39 “Terminate the Plan,” “Termination of the Plan” shall mean a determination by an Employer’s board of directors that (i) all of its Participants shall no longer be eligible to participate in the Plan, (ii) all deferral elections for such Participants shall terminate, and (iii) such Participants shall no longer be eligible to receive company contributions under this Plan.

1.40 “Termination Benefit” shall mean the benefit set forth in Article 6.

1.41 “Termination of Employment” shall mean the separation from service with all Employers, voluntarily or involuntarily, for any reason other than Retirement, Disability, death or an authorized leave of absence, as determined in accordance with Code Section 409A and related Treasury guidance and Regulations. If a Participant is both an Employee and a Director, a Termination of Employment shall occur only upon the termination of the last position held.

1.42 “Trust” shall mean one or more trusts established by the Company in accordance with Article 15.

1.43 “Unforeseeable Financial Emergency” shall mean an unforeseeable emergency that is caused by an event beyond the control of the Participant that would result in severe financial hardship to the Participant or Beneficiary resulting from (i) a sudden and unexpected illness or accident of the Participant or Beneficiary, the Participant’s or Beneficiary’s spouse, or the Participant’s or Beneficiary’s dependent (as defined in Code Section 152(a)), (ii) a loss of the Participant’s or Beneficiary’s property due to casualty, or (iii) such other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the Participant or Beneficiary, all as determined in the sole discretion of the Committee.

1.44 “Years of Plan Participation” shall mean the total number of full Plan Years a Participant has been a Participant in the Plan prior to his or her Termination of Employment (determined without regard to whether deferral elections have been made by the Participant for any Plan Year). Any partial year shall not be counted. Notwithstanding the previous sentence, a Participant’s first Plan Year of participation shall be treated as a full Plan Year for purposes of this definition, even if it is only a partial Plan Year of participation.

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1.45 “Years of Service” shall mean the total number of full years in which a Participant has been employed by one or more Employers. For purposes of this definition, a year of employment shall be a 365 day period (or 366 day period in the case of a leap year) that, for the first year of employment, commences on the Employee’s date of hiring and that, for any subsequent year, commences on an anniversary of that hiring date. The Committee shall make a determination as to whether any partial year of employment shall be counted as a Year of Service.

ARTICLE 2

Selection, Enrollment, Eligibility

2.1 Selection by Committee    Participation in the Plan shall be limited to Directors and, as determined by the Committee in its sole discretion, a select group of management or highly compensated Employees. From that group, the Committee shall select, in its sole discretion, those individuals who may actually participate in this Plan.

2.2 Enrollment and Eligibility Requirements; Commencement of Participation.

(a) As a condition to participation, each Director or selected Employee who is eligible to participate in the Plan effective as of the first day of a Plan Year shall complete, execute and return to the Committee a Plan Agreement, an Election Form and a Beneficiary Designation Form, prior to the first day of such Plan Year, or such other earlier deadline as may be established by the Committee in its sole discretion. In addition, the Committee shall establish from time to time such other enrollment requirements as it determines, in its sole discretion, are necessary.

(b) A Director or selected Employee who first becomes eligible to participate in this Plan after the first day of a Plan Year must complete these requirements within thirty (30) days after he or she first becomes eligible to participate in the Plan, or within such other earlier deadline as may be established by the Committee, in its sole discretion, in order to participate for that Plan Year. In such event, such person’s participation in this Plan shall not commence earlier than the date determined by the Committee pursuant to Section 2.2(c) and such person shall not be permitted to defer under this Plan any portion of his or her Base Salary, Bonus, LTIP Amounts, Commissions and/or Director Fees that are paid with respect to services performed prior to his or her participation commencement date, except to the extent permissible under Code Section 409A and related Treasury guidance or Regulations.

(c) Each Director or selected Employee who is eligible to participate in the Plan shall commence participation in the Plan on the date that the Committee determines, in its sole discretion, that the Director or Employee has met all enrollment requirements set forth in this Plan and required by the Committee, including returning all required documents to the Committee within the specified time period. Notwithstanding the foregoing, the Committee shall process such Participant’s deferral election as soon as administratively practicable after such deferral election is submitted to and accepted by the Committee.

(d) If a Director or an Employee fails to meet all requirements contained in this Section 2.2 within the period required, that Director or Employee shall not be eligible to participate in the Plan during such Plan Year.

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ARTICLE 3

Deferral Commitments/Company Contribution Amounts/

Company Restoration Matching Amounts/ Vesting/Crediting/Taxes

3.1 Minimum Deferrals.

(a) Annual Deferral Amount. For each Plan Year, a Participant may elect to defer, as his or her Annual Deferral Amount, Base Salary, Bonus, Commissions, LTIP Amounts and/or Director Fees in the following minimum amounts for each deferral elected:

Deferral	Minimum Amount
Base Salary, Bonus, Commissions and/or LTIP Amounts	$5,000 aggregate
Director Fees	$0

If the Committee determines, in its sole discretion, prior to the beginning of a Plan Year that a Participant has made an election for less than the stated minimum amounts, or if no election is made, the amount deferred shall be zero. If the Committee determines, in its sole discretion, at any time after the beginning of a Plan Year that a Participant has deferred less than the stated minimum amounts for that Plan Year, any amount credited to the Participant’s Account Balance as the Annual Deferral Amount for that Plan Year shall be distributed to the Participant within sixty (60) days after the last day of the Plan Year in which the Committee determination was made.

(b) Short Plan Year. Notwithstanding the foregoing, if a Participant first becomes a Participant after the first day of a Plan Year, the minimum Annual Deferral Amount shall be an amount equal to the minimum set forth above, multiplied by a fraction, the numerator of which is the number of complete months remaining in the Plan Year and the denominator of which is 12.

3.2 Maximum Deferral.

(a) Annual Deferral Amount. For each Plan Year, a Participant may elect to defer, as his or her Annual Deferral Amount, Base Salary, Bonus, Commissions, LTIP Amounts and/or Director Fees up to the following maximum percentages for each deferral elected:

Deferral	Maximum Percentage
Base Salary	90%
Bonus	100%
Commissions	100%
LTIP Amounts	100%
Director Fees	100%

(b) Short Plan Year. Notwithstanding the foregoing, if a Participant first becomes a Participant after the first day of a Plan Year, the maximum Annual Deferral Amount shall be limited to the amount of compensation not yet earned by the Participant as of the date

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the Participant submits a Plan Agreement and Election Form to the Committee for acceptance, except to the extent permissible under Code Section 409A and related Treasury guidance or Regulations.

3.3 Election to Defer; Effect of Election Form.

(a) First Plan Year. In connection with a Participant’s commencement of participation in the Plan, the Participant shall make an irrevocable deferral election for the Plan Year in which the Participant commences participation in the Plan, along with such other elections as the Committee deems necessary or desirable under the Plan. For these elections to be valid, the Election Form must be completed and signed by the Participant, timely delivered to the Committee (in accordance with Section 2.2 above) and accepted by the Committee.

(b) Subsequent Plan Years. For each succeeding Plan Year, an irrevocable deferral election for that Plan Year, and such other elections as the Committee deems necessary or desirable under the Plan, shall be made by timely delivering a new Election Form to the Committee, in accordance with its rules and procedures, before the end of the Plan Year preceding the Plan Year for which the election is made. If no such Election Form is timely delivered for a Plan Year, the Annual Deferral Amount shall be zero for that Plan Year.

(c) Performance-Based Compensation. Notwithstanding the foregoing, the Committee may, in its sole discretion, determine that an irrevocable deferral election pertaining to performance-based compensation may be made by timely delivering an Election Form to the Committee, in accordance with its rules and procedures, no later than six (6) months before the end of the performance service period. “Performance-based compensation” shall be compensation based on services performed over a period of at least twelve (12) months, in accordance with Code Section 409A and related Treasury guidance or Regulations. Until such time as Treasury guidance provides the requirements for an amount to qualify as “performance-based compensation” under Code Section 409A, the Committee may utilize the definition of “performance-based compensation” provided in Proposed Treasury Regulations Section 1.409A-1(e) in determining which amounts may be deferred by delivering an Election Form to the Committee, in accordance with its rules and procedures, no later than six (6) months before the end of the performance service period.

3.4 Withholding and Crediting of Annual Deferral Amounts. For each Plan Year, the Base Salary portion of the Annual Deferral Amount shall be withheld from each regularly scheduled Base Salary payroll in equal amounts, as adjusted from time to time for increases and decreases in Base Salary. The Bonus, Commissions, LTIP Amounts and/or Director Fees portion of the Annual Deferral Amount shall be withheld at the time the Bonus, Commissions, LTIP Amounts or Director Fees are or otherwise would be paid to the Participant, whether or not this occurs during the Plan Year itself. Annual Deferral Amounts shall be credited to a Participant’s Deferral Account at the time such amounts would otherwise have been paid to the Participant.

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3.5 Company Contribution Amount

(a) For each Plan Year, an Employer may be required to credit amounts to a Participant’s Company Contribution Account in accordance with employment or other agreements entered into between the Participant and the Employer. Such amounts shall be credited on the date or dates prescribed by such agreements.

(b) For each Plan Year, an Employer, in its sole discretion, may, but is not required to, credit any amount it desires to any Participant’s Company Contribution Account under this Plan, which amount shall be for that Participant the Company Contribution Amount for that Plan Year. The amount so credited to a Participant may be smaller or larger than the amount credited to any other Participant, and the amount credited to any Participant for a Plan Year may be zero, even though one or more other Participants receive a Company Contribution Amount for that Plan Year. The Company Contribution Amount described in this Section 3.5(b), if any, shall be credited on a date or dates to be determined by the Committee, in its sole discretion.

3.6 Company Restoration Matching Amount. A Participant’s Company Restoration Matching Amount for any Plan Year shall be an amount determined by the Committee, in its sole discretion, to make up for certain limits applicable to the 401(k) Plan or other qualified plan for such Plan Year, as identified by the Committee, or for such other purposes as determined by the Committee in its sole discretion. The amount so credited to a Participant under this Plan for any Plan Year (i) may be smaller or larger than the amount credited to any other Participant, and (ii) may differ from the amount credited to such Participant in the preceding Plan Year. The Participant’s Company Restoration Matching Amount, if any, shall be credited on a date or dates to be determined by the Committee, in its sole discretion.

3.7 Crediting of Amounts after Benefit Distribution. Notwithstanding any provision in this Plan to the contrary, should the complete distribution of a Participant’s vested Account Balance occur prior to the date on which any portion of (i) the Annual Deferral Amount that a Participant has elected to defer in accordance with Section 3.3, (ii) the Company Contribution Amount, or (iii) the Company Restoration Matching Amount, would otherwise be credited to the Participant’s Account Balance, such amounts shall not be credited to the Participant’s Account Balance, but shall be paid to the Participant in a manner determined by the Committee, in its sole discretion.

3.8 Vesting.

(a) A Participant shall at all times be 100% vested in his or her Deferral Account.

(b) A Participant shall be vested in his or her Company Contribution Account in accordance with the same vesting schedule set forth in the Company’s 401(k) Plan that applies to Company contributions, unless otherwise specified by the Committee in the Plan Agreement.

(c) A Participant shall be vested in his or her Company Restoration Matching Account only to the extent that the Participant would be vested in such amounts under the provisions of the 401(k) Plan, as determined by the Committee in its sole discretion.

(d) Notwithstanding anything to the contrary contained in this Section 3.8, the Committee may, in its sole discretion, at any time provide for accelerated vesting, in whole or in part,

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of a Participant’s Company Contribution Account and Company Restoration Matching Account upon a Participant’s Retirement, death while employed by an Employer, Disability, or in the event of a Change in Control.

(e) Notwithstanding subsection 3.8(d) above, the vesting schedule for a Participant’s Company Contribution Account and Company Restoration Matching Account shall not be accelerated upon a Change in Control to the extent that the Committee determines that such acceleration would cause the deduction limitations of Section 280G of the Code to become effective. In the event that all of a Participant’s Company Contribution Account and/or Company Restoration Matching Account is not vested pursuant to such a determination, the Participant may request independent verification of the Committee’s calculations with respect to the application of Section 280G. In such case, the Committee must provide to the Participant within ninety (90) days of such a request an opinion from a nationally recognized accounting firm selected by the Participant (the “Accounting Firm”). The opinion shall state the Accounting Firm’s opinion that any limitation in the vested percentage hereunder is necessary to avoid the limits of Section 280G and contain supporting calculations. The cost of such opinion shall be paid for by the Company.

(f) Section 3.8(e) shall not prevent the acceleration of the vesting schedule applicable to a Participant’s Company Contribution Account and/or Company Restoration Matching Account if such Participant is entitled to a “gross-up” payment, to eliminate the effect of the Code section 4999 excise tax, pursuant to his or her employment agreement or other agreement entered into between such Participant and the Employer.

3.9 Crediting/Debiting of Account Balances. In accordance with, and subject to, the rules and procedures that are established from time to time by the Committee, in its sole discretion, amounts shall be credited or debited to a Participant’s Account Balance in accordance with the following rules:

(a) Measurement Funds. The Participant may elect one or more of the measurement funds selected by the Committee, in its sole discretion, which are based on certain mutual funds (the “Measurement Funds”), for the purpose of crediting or debiting additional amounts to his or her Account Balance. As necessary, the Committee may, in its sole discretion, discontinue, substitute or add a Measurement Fund. Each such action will take effect as of the first day of the first calendar quarter that begins at least thirty (30) days after the day on which the Committee gives Participants advance written notice of such change.

(b) Election of Measurement Funds. A Participant, in connection with his or her initial deferral election in accordance with Section 3.3(a) above, shall elect, on the Election Form, one or more Measurement Fund(s) (as described in Section 3.9(a) above) to be used to determine the amounts to be credited or debited to his or her Account Balance. If a Participant does not elect any of the Measurement Funds as described in the previous sentence, the Participant’s Account Balance shall automatically be allocated into the lowest-risk Measurement Fund, as determined by the Committee, in its sole discretion. The Participant may (but is not required to) elect, by submitting an Election Form to the Committee that is accepted by the Committee, to add or delete one or more Measurement Fund(s) to be used to determine the amounts to be credited or debited to his or her Account Balance, or to change the portion of his or her Account Balance allocated to each previously or newly elected Measurement Fund. If an election is made in accordance

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with the previous sentence, it shall apply as of the first business day deemed reasonably practicable by the Committee, in its sole discretion, and shall continue thereafter for each subsequent day in which the Participant participates in the Plan, unless changed in accordance with the previous sentence. Notwithstanding the foregoing, the Committee, in its sole discretion, may impose limitations on the frequency with which one or more of the Measurement Funds elected in accordance with this Section may be added or deleted by such Participant; furthermore, the Committee, in its sole discretion, may impose limitations on the frequency with which the Participant may change the portion of his or her Account Balance allocated to each previously or newly elected Measurement Fund.

(c) Proportionate Allocation. In making any election described in Section 3.9(b) above, the Participant shall specify on the Election Form, in increments of one percent (1%), the percentage of his or her Account Balance or Measurement Fund, as applicable, to be allocated/reallocated.

(d) Crediting or Debiting Method. The performance of each Measurement Fund (either positive or negative) will be determined on a daily basis based on the manner in which such Participant’s Account Balance has been hypothetically allocated among the Measurement Funds by the Participant.

(e) No Actual Investment. Notwithstanding any other provision of this Plan that may be interpreted to the contrary, the Measurement Funds are to be used for measurement purposes only, and a Participant’s election of any such Measurement Fund, the allocation of his or her Account Balance thereto, the calculation of additional amounts and the crediting or debiting of such amounts to a Participant’s Account Balance shall not be considered or construed in any manner as an actual investment of his or her Account Balance in any such Measurement Fund. In the event that the Company or the Trustee (as that term is defined in the Trust), in its own discretion, decides to invest funds in any or all of the investments on which the Measurement Funds are based, no Participant shall have any rights in or to such investments themselves. Without limiting the foregoing, a Participant’s Account Balance shall at all times be a bookkeeping entry only and shall not represent any investment made on his or her behalf by the Company or the Trust; the Participant shall at all times remain an unsecured creditor of the Company.

3.10 FICA and Other Taxes.

(a) Annual Deferral Amounts. For each Plan Year in which an Annual Deferral Amount is being withheld from a Participant, the Participant’s Employer(s) shall withhold from that portion of the Participant’s Base Salary, Bonus, Commissions and/or LTIP Amounts that is not being deferred, in a manner determined by the Employer(s), the Participant’s share of FICA and other employment taxes on such Annual Deferral Amount. If necessary, the Committee may reduce the Annual Deferral Amount in order to comply with this Section 3.10.

(b) Company Restoration Matching Account and Company Contribution Account. When a Participant becomes vested in a portion of his or her Company Restoration Matching Account and/or Company Contribution Account, the Participant’s Employer(s) shall withhold from that portion of the Participant’s Base Salary, Bonus, Commissions and/or LTIP Amounts that is not deferred, in a manner determined by the Employer(s),

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the Participant’s share of FICA and other employment taxes on such Company Restoration Matching Amount and/or Company Contribution Amount. If necessary, the Committee may reduce the vested portion of the Participant’s Company Restoration Matching Account or Company Contribution Account, as applicable, in order to comply with this Section 3.10.

(c) Distributions. The Participant’s Employer(s), or the trustee of the Trust, shall withhold from any payments made to a Participant under this Plan all federal, state and local income, employment and other taxes required to be withheld by the Employer(s), or the trustee of the Trust, in connection with such payments, in amounts and in a manner to be determined in the sole discretion of the Employer(s) and the trustee of the Trust.

ARTICLE 4

Scheduled Distribution; Unforeseeable Financial Emergencies;

Withdrawal Payout Upon Income Inclusion Under Code Section 409A

4.1 Scheduled Distribution. In connection with each election to defer an Annual Deferral Amount, a Participant may irrevocably elect to receive a Scheduled Distribution, in the form of a lump sum payment, from the Plan with respect to all or a portion of the Annual Deferral Amount. The Scheduled Distribution shall be a lump sum payment in an amount that is equal to the portion of the Annual Deferral Amount the Participant elected to have distributed as a Scheduled Distribution, plus amounts credited or debited in the manner provided in Section 3.9 above on that amount, calculated as of the close of business on or around the date on which the Scheduled Distribution becomes payable, as determined by the Committee in its sole discretion. Subject to the other terms and conditions of this Plan, each Scheduled Distribution elected shall be paid out during a sixty (60) day period commencing immediately after the first day of any Plan Year designated by the Participant (the “Scheduled Distribution Date”). The Plan Year designated by the Participant must be at least three (3) Plan Years after the end of the Plan Year to which the Participant’s deferral election described in Section 3.3 relates. By way of example, if a Scheduled Distribution is elected for Annual Deferral Amounts that are earned in the Plan Year commencing January 1, 2006, the earliest Scheduled Distribution Date that may be designated by a Participant would be January 1, 2010, and the Scheduled Distribution would become payable during the sixty (60) day period commencing immediately after such Scheduled Distribution Date. Notwithstanding the foregoing, to the extent the Committee reasonable anticipates that the Company’s deduction for payment of a Scheduled Distribution would be limited or eliminated as a result of application of Code Section 162(m), such Scheduled Distribution shall be delayed to the earliest date where the Committee reasonably anticipates that the deduction of the payment of the Scheduled Distribution will not be limited or eliminated by application of Code Section 162(m) or the calendar year in which Participant separates from service.

4.2 Postponing Scheduled Distributions. A Participant may elect to postpone a Scheduled Distribution described in Section 4.1 above, and have such amount paid out during a sixty (60) day period commencing immediately after an allowable alternative distribution date designated by the Participant in accordance with this Section 4.2. In order to make this election, the Participant must submit a new Scheduled Distribution Election Form to the Committee in accordance with the following criteria:

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(a) Such Scheduled Distribution Election Form must be submitted to and accepted by the Committee in its sole discretion at least twelve (12) months prior to the Participant’s previously designated Scheduled Distribution Date;

(b) The new Scheduled Distribution Date selected by the Participant must be the first day of a Plan Year, and must be at least five years after the previously designated Scheduled Distribution Date; and

(c) The election of the new Scheduled Distribution Date shall have no effect until at least twelve (12) months after the date on which the election is made.

4.3 Other Benefits Take Precedence Over Scheduled Distributions. Should a Benefit Distribution Date occur that triggers a benefit under Articles 5, 6, 7 or 8, any Annual Deferral Amount that is subject to a Scheduled Distribution election under Section 4.1 shall not be paid in accordance with Section 4.1, but shall be paid in accordance with the other applicable Article. Notwithstanding the foregoing, the Committee shall interpret this Section 4.3 in a manner that is consistent with Code Section 409A and other applicable tax law, including but not limited to Notice 2005-1, Proposed Treasury Regulations Section 1.409A and such other Treasury guidance or Regulations issued after the effective date of this Plan.

4.4 Withdrawal Payout/Suspensions for Unforeseeable Financial Emergencies.

(a) If the Participant experiences an Unforeseeable Financial Emergency, the Participant may petition the Committee to suspend deferrals of Base Salary, Bonus, Commissions, Director Fees, and LTIP Amounts to the extent deemed necessary by the Committee to satisfy the Unforeseeable Financial Emergency. If suspension of deferrals is not sufficient to satisfy the Participant’s Unforeseeable Financial Emergency, or if suspension of deferrals is not required under Code Section 409A and other applicable tax law, the Participant may further petition the Committee to receive a partial or full payout from the Plan. The Participant shall only receive a payout from the Plan to the extent such payout is deemed necessary by the Committee to satisfy the Participant’s Unforeseeable Financial Emergency, plus amounts necessary to pay taxes reasonably anticipated as a result of the distribution.

(b) The payout shall not exceed the lesser of (i) the Participant’s vested Account Balance, calculated as of the close of business on or around the date on which the amount becomes payable, as determined by the Committee in its sole discretion, or (ii) the amount necessary to satisfy the Unforeseeable Financial Emergency, plus amounts necessary to pay taxes reasonably anticipated as a result of the distribution. Notwithstanding the foregoing, a Participant may not receive a payout from the Plan to the extent that the Unforeseeable Financial Emergency is or may be relieved (A) through reimbursement or compensation by insurance or otherwise, (B) by liquidation of the Participant’s assets, to the extent the liquidation of such assets would not itself cause severe financial hardship or (C) by suspension of deferrals under this Plan, if the Committee, in its sole discretion, determines that suspension is required by Code Section 409A and other applicable tax law.

(c) If the Committee, in its sole discretion, approves a Participant’s petition for suspension, the Participant’s deferrals under this Plan shall be suspended as of the date of such

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approval. If the Committee, in its sole discretion, approves a Participant’s petition for suspension and payout, the Participant’s deferrals under this Plan shall be suspended as of the date of such approval and the Participant shall receive a payout from the Plan within sixty (60) days of the date of such approval.

(d) Notwithstanding the foregoing, the Committee shall interpret all provisions relating to suspension and/or payout under this Section 4.4 in a manner that is consistent with Code Section 409A and other applicable tax law, including but not limited to Notice 2005-1, Proposed Treasury Regulations Section 1.409A and such other Treasury guidance or Regulations issued after the effective date of this Plan.

4.5 Withdrawal Payout Upon Income Inclusion Under Code Section 409A. If at any time any portion of a Participant’s Account Balance fails to meet the requirements of Code Section 409A, Notice 2005-1, Proposed Treasury Regulations Section 1.409A and such other Treasury guidance or Regulations issued after the effective date of this Plan, the Participant may petition the Committee to receive a payout from the Plan equal in value to the amount that is includable in income under Code Section 409A; provided, however, such payment may not exceed the amount required to be included in income as a result of the failure to comply with the requirements of Code Section 409A.

ARTICLE 5 Retirement Benefit

5.1 Retirement Benefit. A Participant who Retires shall receive, as a Retirement Benefit, his or her vested Account Balance, calculated as of the close of business on or around the Participant’s Benefit Distribution Date, as determined by the Committee in its sole discretion.

5.2 Payment of Retirement Benefit.

(a) A Participant, in connection with his or her commencement of participation in the Plan, shall elect on an Election Form to receive the Retirement Benefit in a lump sum or pursuant to an Annual Installment Method of up to ten (10) years. If a Participant does not make any election with respect to the payment of the Retirement Benefit, then such Participant shall be deemed to have elected to receive the Retirement Benefit in a lump sum. Notwithstanding the foregoing, if the value of Participant’s Account Balance is less than $50,000 on the Benefit Distribution Date, the Participant shall receive the Retirement Benefit in a lump sum payment in accordance with Section 6.2(c) regardless of whether Participant’s election specifies an Annual Install Method.

(b) A Participant may change the form of payment of the Retirement Benefit by submitting an Election Form to the Committee in accordance with the following criteria:

(i) The election to modify the Retirement Benefit shall have no effect until at least twelve (12) months after the date on which the election is made; and

(ii) The first Retirement Benefit payment shall be delayed at least five (5) years from the Participant’s originally scheduled Benefit Distribution Date described in Section 1.7(a).

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However, if the value of Participant’s Account Balance is less than $50,000 on the Benefit Distribution Date, the Participant shall receive the Retirement Benefit in a lump sum payment in accordance with Section 6.2(c) regardless of whether Participant made a change to the form of payment under this Section 6.2(b) to specify payment under the Annual Installment Method. Notwithstanding the foregoing, the Committee shall interpret all provisions relating to changing the Retirement Benefit election under this Section 5.1 in a manner that is consistent with Code Section 409A and other applicable tax law, including but not limited to Notice 2005-1, Proposed Treasury Regulations Section 1.409A and such other Treasury guidance or Regulations issued after the effective date of this Plan.

The Election Form most recently accepted by the Committee shall govern the payout of the Retirement Benefit.

(c) The lump sum payment shall be made, or installment payments shall commence, no later than sixty (60) days after the Participant’s Benefit Distribution Date. Remaining installments, if any, shall be paid no later than sixty (60) days after each anniversary of the Participant’s Benefit Distribution Date.

ARTICLE 6

Termination Benefit

6.1 Termination Benefit. A Participant who experiences a Termination of Employment shall receive, as a Termination Benefit, his or her vested Account Balance, calculated as of the close of business on or around the Participant’s Benefit Distribution Date, as determined by the Committee in its sole discretion.

6.2 Payment of Termination Benefit. The Termination Benefit shall be paid to the Participant in a lump sum payment no later than sixty (60) days after the Participant’s Benefit Distribution Date.

ARTICLE 7

Disability Benefit

7.1 Disability Benefit. Upon a Participant’s Disability, the Participant shall receive a Disability Benefit, which shall be equal to the Participant’s vested Account Balance, calculated as of the close of business on or around the Participant’s Benefit Distribution Date, as selected by the Committee in its sole discretion.

7.2 Payment of Disability Benefit. The Disability Benefit shall be paid to the Participant in a lump sum payment no later than sixty (60) days after the Participant’s Benefit Distribution Date.

ARTICLE 8

Death Benefit

8.1 Death Benefit. The Participant’s Beneficiary(ies) shall receive a Death Benefit upon the Participant’s death which will be equal to the Participant’s vested Account Balance, calculated as

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of the close of business on or around the Participant’s Benefit Distribution Date, as selected by the Committee in its sole discretion.

8.2 Payment of Death Benefit. The Death Benefit shall be paid to the Participant’s Beneficiary(ies) in a lump sum payment no later than sixty (60) days after the Participant’s Benefit Distribution Date.

ARTICLE 9

Beneficiary Designation

9.1 Beneficiary. Each Participant shall have the right, at any time, to designate his or her Beneficiary(ies) (both primary as well as contingent) to receive any benefits payable under the Plan to a beneficiary upon the death of a Participant. The Beneficiary designated under this Plan may be the same as or different from the Beneficiary designation under any other plan of an Employer in which the Participant participates.

9.2 Beneficiary Designation; Change; Spousal Consent. A Participant shall designate his or her Beneficiary by completing and signing the Beneficiary Designation Form, and returning it to the Committee or its designated agent. A Participant shall have the right to change a Beneficiary by completing, signing and otherwise complying with the terms of the Beneficiary Designation Form and the Committee’s rules and procedures, as in effect from time to time. If the Participant names someone other than his or her spouse as a Beneficiary, the Committee may, in its sole discretion, determine that spousal consent is required to be provided in a form designated by the Committee, executed by such Participant’s spouse and returned to the Committee. Upon the acceptance by the Committee of a new Beneficiary Designation Form, all Beneficiary designations previously filed shall be canceled. The Committee shall be entitled to rely on the last Beneficiary Designation Form filed by the Participant and accepted by the Committee prior to his or her death.

9.3 Acknowledgment. No designation or change in designation of a Beneficiary shall be effective until received and acknowledged in writing by the Committee or its designated agent.

9.4 No Beneficiary Designation. If a Participant fails to designate a Beneficiary as provided in Sections 9.1, 9.2 and 9.3 above or, if all designated Beneficiaries predecease the Participant or die prior to complete distribution of the Participant’s benefits, then the Participant’s designated Beneficiary shall be deemed to be his or her surviving spouse. If the Participant has no surviving spouse, the benefits remaining under the Plan to be paid to a Beneficiary shall be payable to the executor or personal representative of the Participant’s estate.

9.5 Doubt as to Beneficiary. If the Committee has any doubt as to the proper Beneficiary to receive payments pursuant to this Plan, the Committee shall have the right, exercisable in its discretion, to cause the Participant’s Employer to withhold such payments until this matter is resolved to the Committee’s satisfaction.

9.6 Discharge of Obligations. The payment of benefits under the Plan to a Beneficiary shall fully and completely discharge all Employers and the Committee from all further obligations under this Plan with respect to the Participant, and that Participant’s Plan Agreement shall terminate upon such full payment of benefits.

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ARTICLE 10

Leave of Absence

10.1 Paid Leave of Absence. If a Participant is authorized by the Participant’s Employer to take a paid leave of absence from the employment of the Employer, (i) the Participant shall continue to be considered eligible for the benefits provided in Articles 4, 5, 6, 7 or 8 in accordance with the provisions of those Articles, and (ii) the Annual Deferral Amount shall continue to be withheld during such paid leave of absence in accordance with Section 3.3.

10.2 Unpaid Leave of Absence. If a Participant is authorized by the Participant’s Employer to take an unpaid leave of absence from the employment of the Employer for any reason, such Participant shall continue to be eligible for the benefits provided in Articles 4, 5, 6, 7 or 8 in accordance with the provisions of those Articles. However, the Participant shall be excused from fulfilling his or her Annual Deferral Amount commitment that would otherwise have been withheld during the remainder of the Plan Year in which the unpaid leave of absence is taken. During the unpaid leave of absence, the Participant shall not be allowed to make any additional deferral elections. However, if the Participant returns to employment, the Participant may elect to defer an Annual Deferral Amount for the Plan Year following his or her return to employment and for every Plan Year thereafter while a Participant in the Plan, provided such deferral elections are otherwise allowed and an Election Form is delivered to and accepted by the Committee for each such election in accordance with Section 3.3 above.

ARTICLE 11

Termination of Plan, Amendment or Modification

11.1 Termination of Plan. Although each Employer anticipates that it will continue the Plan for an indefinite period of time, there is no guarantee that any Employer will continue the Plan or will not terminate the Plan at any time in the future. Accordingly, each Employer reserves the right to Terminate the Plan . In the event of a Termination of the Plan, the Measurement Funds available to Participants following the Termination of the Plan shall be comparable in number and type to those Measurement Funds available to Participants in the Plan Year preceding the Plan Year in which the Termination of the Plan is effective. Following a Termination of the Plan, Participant Account Balances shall remain in the Plan until the Participant becomes eligible for the benefits provided in Articles 4, 5, 6, 7 or 8 in accordance with the provisions of those Articles. The Termination of the Plan shall not adversely affect any Participant or Beneficiary who has become entitled to the payment of any benefits under the Plan as of the date of termination. Notwithstanding the foregoing, to the extent permissible under Code Section 409A and other applicable tax law, including but not limited to Notice 2005-1, Proposed Treasury Regulations Section 1.409A and such other Treasury guidance or Regulations issued after the effective date of this Plan, following a Change in Control the Employer shall be permitted to (i) terminate the Plan by action of its board of directors, and (ii) distribute the vested Account Balances to Participants in a lump sum no later than twelve (12) months after the Change in Control.

11.2 Amendment.

(a) Any Employer may, at any time, amend or modify the Plan in whole or in part with respect to that Employer. Notwithstanding the foregoing, (i) no amendment or

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modification shall be effective to decrease the value of a Participant’s vested Account Balance in existence at the time the amendment or modification is made, and (ii) no amendment or modification of this Section 11.2 or Section 12.2 of the Plan shall be effective unless and until two-thirds (2/3) of Participants with an Account Balance in the Plan as of the date of such proposed amendment or modification provide prior written consent in a time and manner determined by the Committee.

(b) Notwithstanding any provision of the Plan to the contrary, in the event that the Company determines that any provision of the Plan may cause amounts deferred under the Plan to become immediately taxable to any Participant under Code Section 409A, and related Treasury guidance or Regulations, the Company may (i) adopt such amendments to the Plan and appropriate policies and procedures, including amendments and policies with retroactive effect, that the Company determines necessary or appropriate to preserve the intended tax treatment of the Plan benefits provided by the Plan and/or (ii) take such other actions as the Company determines necessary or appropriate to comply with the requirements of Code Section 409A, and related Treasury guidance or Regulations.

11.3 Plan Agreement. Despite the provisions of Sections 11.1 and 11.2 above, if a Participant’s Plan Agreement contains benefits or limitations that are not in this Plan document, the Employer may only amend or terminate such provisions with the written consent of the Participant.

11.4 Effect of Payment. The full payment of the Participant’s vested Account Balance under Articles 4, 5, 6, 7 or 8 of the Plan shall completely discharge all obligations to a Participant and his or her designated Beneficiaries under this Plan, and the Participant’s Plan Agreement shall terminate.

ARTICLE 12

Administration

12.1 Committee Duties. Except as otherwise provided in this Article 12, this Plan shall be administered by a Committee, which shall consist of the Board, or such committee as the Board shall appoint. Members of the Committee may be Participants under this Plan. The Committee shall also have the discretion and authority to (i) make, amend, interpret, and enforce all appropriate rules and regulations for the administration of this Plan, and (ii) decide or resolve any and all questions, including benefit entitlement determinations and interpretations of this Plan, as may arise in connection with the Plan. Any individual serving on the Committee who is a Participant shall not vote or act on any matter relating solely to himself or herself. When making a determination or calculation, the Committee shall be entitled to rely on information furnished by a Participant or the Company.

12.2 Administration Upon Change In Control. The Participant’s Account Balance shall remain in the Plan upon a Change in Control and shall be subject to the terms and conditions of the Plan. Within one hundred and twenty (120) days following a Change in Control, the individuals who comprised the Committee immediately prior to the Change in Control (whether or not such individuals are members of the Committee following the Change in Control) may, by written consent of the majority of such individuals, appoint an independent third party administrator (the “Administrator”) to perform any or all of the Committee’s duties described in Section 12.1 above, including without limitation, the power to determine any questions arising in connection

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with the administration or interpretation of the Plan, and the power to make benefit entitlement determinations. Upon and after the effective date of such appointment, (i) the Company must pay all reasonable administrative expenses and fees of the Administrator, and (ii) the Administrator may only be terminated with the written consent of the majority of Participants with an Account Balance in the Plan as of the date of such proposed termination.

12.3 Agents. In the administration of this Plan, the Committee or the Administrator, as applicable, may, from time to time, employ agents and delegate to them such administrative duties as it sees fit (including acting through a duly appointed representative) and may from time to time consult with counsel.

12.4 Binding Effect of Decisions. The decision or action of the Committee or Administrator, as applicable, with respect to any question arising out of or in connection with the administration, interpretation and application of the Plan and the rules and regulations promulgated hereunder shall be final and conclusive and binding upon all persons having any interest in the Plan.

12.5 Indemnity of Committee. All Employers shall indemnify and hold harmless the members of the Committee, any Employee to whom the duties of the Committee may be delegated, and the Administrator against any and all claims, losses, damages, expenses or liabilities arising from any action or failure to act with respect to this Plan, except in the case of willful misconduct by the Committee, any of its members, any such Employee or the Administrator.

12.6 Employer Information. To enable the Committee and/or Administrator to perform its functions, the Company and each Employer shall supply full and timely information to the Committee and/or Administrator, as the case may be, on all matters relating to the Plan, the Trust, the Participants and their Beneficiaries, the Account Balances of the Participants, the compensation of its Participants, the date and circumstances of the Retirement, Disability, death or Termination of Employment of its Participants, and such other pertinent information as the Committee or Administrator may reasonably require.

ARTICLE 13

Other Benefits and Agreements

13.1 Coordination with Other Benefits. The benefits provided for a Participant and Participant’s Beneficiary under the Plan are in addition to any other benefits available to such Participant under any other plan or program for employees of the Participant’s Employer. The Plan shall supplement and shall not supersede, modify or amend any other such plan or program except as may otherwise be expressly provided.

ARTICLE 14

Claims Procedures

14.1 Presentation of Claim. Any Participant or Beneficiary of a deceased Participant (such Participant or Beneficiary being referred to below as a “Claimant”) may deliver to the Committee a written claim for a determination with respect to the amounts distributable to such Claimant from the Plan. If such a claim relates to the contents of a notice received by the Claimant, the claim must be made within sixty (60) days after such notice was received by the Claimant. All other claims must be made within 180 days of the date on which the event that caused the claim

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to arise occurred. The claim must state with particularity the determination desired by the Claimant.

14.2 Notification of Decision. The Committee shall consider a Claimant’s claim within a reasonable time, but no later than ninety (90) days after receiving the claim. If the Committee determines that special circumstances require an extension of time for processing the claim, written notice of the extension shall be furnished to the Claimant prior to the termination of the initial ninety (90) day period. In no event shall such extension exceed a period of ninety (90) days from the end of the initial period. The extension notice shall indicate the special circumstances requiring an extension of time and the date by which the Committee expects to render the benefit determination. The Committee shall notify the Claimant in writing:

(a) that the Claimant’s requested determination has been made, and that the claim has been allowed in full; or

(b) that the Committee has reached a conclusion contrary, in whole or in part, to the Claimant’s requested determination, and such notice must set forth in a manner calculated to be understood by the Claimant:

(i) the specific reason(s) for the denial of the claim, or any part of it;

(ii) specific reference(s) to pertinent provisions of the Plan upon which such denial was based;

(iii) a description of any additional material or information necessary for the Claimant to perfect the claim, and an explanation of why such material or information is necessary;

(iv) an explanation of the claim review procedure set forth in Section 14.3 below; and

(v) a statement of the Claimant’s right to bring a civil action under ERISA Section 502(a) following an adverse benefit determination on review.

14.3 Review of a Denied Claim. On or before sixty (60) days after receiving a notice from the Committee that a claim has been denied, in whole or in part, a Claimant (or the Claimant’s duly authorized representative) may file with the Committee a written request for a review of the denial of the claim. The Claimant (or the Claimant’s duly authorized representative):

(a) may, upon request and free of charge, have reasonable access to, and copies of, all documents, records and other information relevant (as defined in applicable ERISA regulations) to the claim for benefits;

(b) may submit written comments or other documents; and/or

(c) may request a hearing, which the Committee, in its sole discretion, may grant.

14.4 Decision on Review. The Committee shall render its decision on review promptly, and no later than sixty (60) days after the Committee receives the Claimant’s written request for a review of the denial of the claim. If the Committee determines that special circumstances require an extension of time for processing the claim, written notice of the extension shall be furnished to the Claimant prior to the termination of the initial sixty (60) day period. In no event shall such extension exceed a period of sixty (60) days from the end of the initial period. The extension notice shall indicate the special circumstances requiring an extension of time and the date by

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which the Committee expects to render the benefit determination. In rendering its decision, the Committee shall take into account all comments, documents, records and other information submitted by the Claimant relating to the claim, without regard to whether such information was submitted or considered in the initial benefit determination. The decision must be written in a manner calculated to be understood by the Claimant, and it must contain:

(a) specific reasons for the decision;

(b) specific reference(s) to the pertinent Plan provisions upon which the decision was based;

(c) a statement that the Claimant is entitled to receive, upon request and free of charge, reasonable access to and copies of, all documents, records and other information relevant (as defined in applicable ERISA regulations) to the Claimant’s claim for benefits; and

(d) a statement of the Claimant’s right to bring a civil action under ERISA Section 502(a).

14.5 Legal Action. A Claimant’s compliance with the foregoing provisions of this Article 14 is a mandatory prerequisite to a Claimant’s right to commence any legal action with respect to any claim for benefits under this Plan.

ARTICLE 15

Trust

15.1 Establishment of the Trust. In order to provide assets from which to fulfill the obligations of the Participants and their beneficiaries under the Plan, the Company may establish a trust by a trust agreement with a third party, the trustee, to which each Employer may, in its discretion, contribute cash or other property, including securities issued by the Company, to provide for the benefit payments under the Plan, (the “Trust”).

15.2 Interrelationship of the Plan and the Trust. The provisions of the Plan and the Plan Agreement shall govern the rights of a Participant to receive distributions pursuant to the Plan. The provisions of the Trust shall govern the rights of the Employers, Participants and the creditors of the Employers to the assets transferred to the Trust. Each Employer shall at all times remain liable to carry out its obligations under the Plan.

15.3 Distributions From the Trust. Each Employer’s obligations under the Plan may be satisfied with Trust assets distributed pursuant to the terms of the Trust, and any such distribution shall reduce the Employer’s obligations under this Plan.

ARTICLE 16

Miscellaneous

16.1 Status of Plan. The Plan is intended to be a plan that is not qualified within the meaning of Code Section 401(a) and that “is unfunded and is maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees” within the meaning of ERISA Sections 201(2), 301(a)(3) and 401(a)(1). The Plan shall be administered and interpreted (i) in a manner consistent with that intent, and (ii) in accordance with Code Section 409A and related Treasury guidance and Regulations.

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16.2 Unsecured General Creditor. Participants and their Beneficiaries, heirs, successors and assigns shall have no legal or equitable rights, interests or claims in any property or assets of an Employer. For purposes of the payment of benefits under this Plan, any and all of an Employer’s assets shall be, and remain, the general, unpledged unrestricted assets of the Employer. An Employer’s obligation under the Plan shall be merely that of an unfunded and unsecured promise to pay money in the future.

16.3 Employer’s Liability. An Employer’s liability for the payment of benefits shall be defined only by the Plan and the Plan Agreement, as entered into between the Employer and a Participant. An Employer shall have no obligation to a Participant under the Plan except as expressly provided in the Plan and his or her Plan Agreement.

16.4 Nonassignability. Neither a Participant nor any other person shall have any right to commute, sell, assign, transfer, pledge, anticipate, mortgage or otherwise encumber, transfer, hypothecate, alienate or convey in advance of actual receipt, the amounts, if any, payable hereunder, or any part thereof, which are, and all rights to which are expressly declared to be, unassignable and non-transferable. No part of the amounts payable shall, prior to actual payment, be subject to seizure, attachment, garnishment or sequestration for the payment of any debts, judgments, alimony or separate maintenance owed by a Participant or any other person, be transferable by operation of law in the event of a Participant’s or any other person’s bankruptcy or insolvency or be transferable to a spouse as a result of a property settlement or otherwise.

16.5 Not a Contract of Employment. The terms and conditions of this Plan shall not be deemed to constitute a contract of employment between any Employer and the Participant. Such employment is hereby acknowledged to be an “at will” employment relationship that can be terminated at any time for any reason, or no reason, with or without cause, and with or without notice, unless expressly provided in a written employment agreement. Nothing in this Plan shall be deemed to give a Participant the right to be retained in the service of any Employer, either as an Employee or a Director, or to interfere with the right of any Employer to discipline or discharge the Participant at any time.

16.6 Furnishing Information. A Participant or his or her Beneficiary will cooperate with the Committee by furnishing any and all information requested by the Committee and take such other actions as may be requested in order to facilitate the administration of the Plan and the payments of benefits hereunder, including but not limited to taking such physical examinations as the Committee may deem necessary.

16.7 Terms. Whenever any words are used herein in the masculine, they shall be construed as though they were in the feminine in all cases where they would so apply; and whenever any words are used herein in the singular or in the plural, they shall be construed as though they were used in the plural or the singular, as the case may be, in all cases where they would so apply.

16.8 Captions. The captions of the articles, sections and paragraphs of this Plan are for convenience only and shall not control or affect the meaning or construction of any of its provisions.

16.9 Governing Law. Subject to ERISA, the provisions of this Plan shall be construed and interpreted according to the internal laws of the State of California without regard to its conflicts of laws principles.

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16.10 Notice. Any notice or filing required or permitted to be given to the Committee under this Plan shall be sufficient if in writing and hand-delivered, or sent by registered or certified mail, to the address below:

Pacific Capital Bancorp

Attn: General Counsel or

Director of Human Resources

1021 Anacapa Street, 3rd Floor

Santa Barbara, CA 93160-0839

Such notice shall be deemed given as of the date of delivery or, if delivery is made by mail, as of the date shown on the postmark on the receipt for registration or certification.

Any notice or filing required or permitted to be given to a Participant under this Plan shall be sufficient if in writing and hand-delivered, or sent by mail, to the last known address of the Participant.

16.11 Successors. The provisions of this Plan shall bind and inure to the benefit of the Participant’s Employer and its successors and assigns and the Participant and the Participant’s designated Beneficiaries.

16.12 Spouse’s Interest. The interest in the benefits hereunder of a spouse of a Participant who has predeceased the Participant shall automatically pass to the Participant and shall not be transferable by such spouse in any manner, including but not limited to such spouse’s will, nor shall such interest pass under the laws of intestate succession.

16.13 Validity. In case any provision of this Plan shall be illegal or invalid for any reason, said illegality or invalidity shall not affect the remaining parts hereof, but this Plan shall be construed and enforced as if such illegal or invalid provision had never been inserted herein.

16.14 Incompetent. If the Committee determines in its discretion that a benefit under this Plan is to be paid to a minor, a person declared incompetent or to a person incapable of handling the disposition of that person’s property, the Committee may direct payment of such benefit to the guardian, legal representative or person having the care and custody of such minor, incompetent or incapable person. The Committee may require proof of minority, incompetence, incapacity or guardianship, as it may deem appropriate prior to distribution of the benefit. Any payment of a benefit shall be a payment for the account of the Participant and the Participant’s Beneficiary, as the case may be, and shall be a complete discharge of any liability under the Plan for such payment amount.

16.15 Court Order. The Committee is authorized to comply with any court order in any action in which the Plan or the Committee has been named as a party, including any action involving a determination of the rights or interests in a Participant’s benefits under the Plan. Notwithstanding the foregoing, the Committee shall interpret this provision in a manner that is consistent with Code Section 409A and other applicable tax law, including but not limited to guidance issued after the effective date of this Plan.

16.16 Insurance. The Employers, on their own behalf or on behalf of the trustee of the Trust, and, in their sole discretion, may apply for and procure insurance on the life of the Participant, in such amounts and in such forms as the Trust may choose. The Employers or the trustee of the Trust,

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as the case may be, shall be the sole owner and beneficiary of any such insurance. The Participant shall have no interest whatsoever in any such policy or policies, and at the request of the Employers shall submit to medical examinations and supply such information and execute such documents as may be required by the insurance company or companies to whom the Employers have applied for insurance.

IN WITNESS WHEREOF, the Company has signed this Plan document as of December 28, 2005.

Pacific Capital Bancorp, a California corporation
By:	/s/    Sherrell Reefer
Title:	Sr. VP, Director of Human Resources

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EX-10.1.16

Exhibit 10.1.16

[GRAPHIC APPEARS HERE]

2005

HIGH PERFORMANCE INCENTIVE PROGRAM

The High Performance Incentive Program (HPIP) is designed to recognize and reward those employees of Pacific Capital Bancorp (the Company) who have contributed meaningfully to the increase in shareholder value, profitability and customer centricity of the Company. Additionally, the plan’s objectives include the following:

• Create greater alignment with the Core Bank Performance*

• Encourage teamwork within departments and across business units

• Ensure that our total compensation is competitive

The High Performance Incentive Program is linked directly to achieving the company’s annual Core Bank Net Income goal. Every employee is important in achieving our goal.

*Does not include revenue and expenses from Refund Anticipation Loan and Refund Transfer business.

KEY ELEMENTS

Success Factors

Three Success Factors determine an annual Incentive award:

• Bank Performance

• Department Performance

• Individual Performance

Ø Bank Performance

The Company’s annual business planning and budgeting process outlines the objectives to be achieved for the year. Our goal for 2005 is Core Bank Net Income at or above plan.

Ø Department Performance

The performance of each department is dependent upon the combined efforts and focus of all its employees. To ensure that there is a common framework, the following metrics will apply to all departments:

• Revenue Generation

• Expense Management

• Customer Value Added

• Risk Management (e.g. Regulatory and Governance Compliance)

Departments may have different components for these metrics depending upon their function. It is important that all employees understand their role in achieving the department goals.

Ø Individual Performance

In addition to the responsibilities each individual has in performing his or her job, individual goals will be established that contribute directly to the Company’s annual business goals. The individual’s goals will support the Department’s metrics, must be significant, and directly support the profitability or contribution of the business unit’s achievement of the annual business plan, compliance and risk mitigation, and the leadership and development of employees if the individual is in a leadership role.

1

Goals and Weightings

To ensure that all employees are aligned toward the Bank Performance, every employee will have a minimum of 15% weighting in this goal category. Positions in higher grade levels generally have the responsibility to guide a business unit and to more directly impact the overall Bank performance. The goals in the higher grade levels, therefore, will be weighted more heavily to the overall Bank performance. The goal setting process and weighting should correlate directly to the individual’s responsibility level and ability to measure his or her impact on company performance. It is recommended that not more than three to four goals are established to ensure that the employee has the right focus.

Plan Funding

Our ability to fund incentive payouts is dependent upon our overall success in achieving the Core Bank’s net income goal. Funding levels will reflect the degree of success in attaining the Core Bank’s net income goal and in turn, will establish the dollar level of the incentive pool. If the Bank does not achieve the Threshold level, there will be no payout of incentives even if a Department and/or Individual has met or exceeded his or her goals.

Levels	Bank Goal Achievement	Funding Level of Pool
Below Threshold	< 95% of Goal	No funding
Threshold	95% - 99% of Goal	75% funded
Target	100% -110% of Goal	100% funded
Stretch	110% - 120% of goal	120%
Super Stretch Bank level only	> 120% of goal	Funded up to a cap of 150%

2

Guidelines for Determining Individual Award

The department leader is responsible for recommending the appropriate incentive awards based upon the individual contributions of each eligible employee. Award percentages will differ based upon the level of goal achievement and performance of the employee. An individual must have achieved an “Expectations Achieved” overall PACE rating for the past 12 months to be considered for any award. Base compensation rewards the employee for performing his or her responsibilities; the HPIP incentive recognizes the “above and beyond” contributions of the employee.

Grade	Below Threshold	Threshold	Target	Stretch
18-19, T6	0%	Up to 18.75%	Up to 25%	Up to 31.25%
17, T5	0%	Up to 15%	Up to 20%	Up to 25%
15-16, T3-T4	0%	Up to 11.25%	Up to 15%	Up to 18.75%
13-14, T2	0%	Up to 9%	Up to 12%	Up to 15%
7-12, T1, D1-3	0%	Up to 3.75%	Up to 5%	Up to 6.25%

An Adjustment Factor can be used that takes into consideration the employee’s contribution to Individual, Department and Bank goals relative to other employees in the department. It also should take into account other factors such as overall PACE rating, pro-ration for new employees, risk management and leadership.

TERMS AND CONDITIONS

Eligible Participants

All regular status employees of Pacific Capital Bancorp who are paid on a 100% salaried basis through the program year and who are actively employed at the time of distribution are eligible for consideration. Eligibility, however, does not guarantee payment. Employees who participate in variable or commission pay programs or the RAL department incentive program are not eligible for the HPIP Program.

3

Employees who are hired during the year but prior to October 1, 2005, will be eligible on a prorated basis. Employees who change from a 100% salaried position to a variable or commission pay plan during the business year may be eligible for HPIP on a prorated basis. Employees who retire from the Company (in accordance with the Company’s retirement criteria) after the first quarter of the year will also be eligible on a prorated basis.

When an employee transfers to a new business unit during the year, it is important that the new leader collaborates with the former leader to document accomplishment level for the previously set individual goals and business unit goals. The new leader and employee will then determine and document new individual and department goals for the balance of the year.

Program Year

The HPIP is effective January 1, 2005 and will be in effect during the plan year defined as January 1 through December 31, 2005. The Program will be reviewed and updated annually to ensure alignment with the Bank’s strategic plan and business goals.

Program Administrator

The Program Administrator is the Director of Human Resources of Pacific Capital Bancorp. The Program Administrator reviews all recommendations prior to submission to the Compensation Committee of the Board of Directors and has responsibility to ensure fair and consistent consideration of participants. The Program Administrator may recommend modifications in the program design and review the effectiveness of the plan on an annual basis.

Payment

Funding of the program and payments are subject to approval by the Compensation Committee of the Board of Directors, and if approved, payment will be made in February 2006.

Termination of Employment

To encourage employees to remain in the employment of the Company, a participant must be employed on the date of the actual incentive payout. Any termination (except by reason of death or official company retirement), prior to the incentive payment date will serve as a forfeiture of any award.

Disability or Death

If a participant is disabled by an accident or illness, and is disabled long enough to be placed on long-term disability as defined by the Company’s LTD plan, his or her incentive award for the Program period shall be pro-rated so that no award will be earned during the period of long-term disability.

In the event of death, the Company will pay to the participant’s estate the pro-rata portion of the award that the participant would have received if he or she had lived to the end of the Program year.

Miscellaneous

The Program will not be deemed to give any participant the right to be retained in the employ of the Company, nor will the Program interfere with the right of the Company to discharge any participant at any time.

Pacific Capital Bancorp reserves the right to modify this program at any time.

4

EX-10.1.18

Exhibit 10.1.18

February 21, 2006

Joyce Clinton

Dear Joyce,

I am pleased to confirm our offer and your acceptance to commence employment on March 16, 2006. You will be employed as the Executive Vice President-Chief Financial Officer of both Pacific Capital Bancorp (the “Company”) and its subsidiary Pacific Capital Bank, N.A. (the “Bank”). You will be reporting to William S. Thomas, Jr., CEO and President. You will be compensated at a bi-weekly rate of $9,230.77. Additionally, you will receive a $50,000.00 sign-on bonus subject to the normal payroll deductions in four installments. The first $20,000.00 will be paid to you upon hire (on the first payroll following your start date), or you may elect to take this portion of your bonus after 90 days of employment, to take advantage of participation in the Bank’s 401(k) plan; $10,000.00 will be paid upon completion of 6 months of employment, $10,000.00 will be paid upon completion of 12 months of employment, and $10,000.00 will be paid upon 18 months of employment. This bonus will be paid only if you are still employed on these dates. You may also elect to have these amounts contributed to your Deferred Compensation Plan if you are a participant.

To support your interim relocation, you will be reimbursed for travel expenses up to $10,000.00. Additionally, we will work with you regarding your interim housing needs (Bank’s corporate apartment/other lodging). To support your relocation to the Santa Barbara area, the Bank will provide you with a non-preferential loan of $100,000.00, secured by your new residence, on terms that comply with Federal Reserve Regulation O. At the time of your permanent relocation, the Bank will provide reasonable relocation with a reputable moving company.

For each year you remain with the Bank, up to ten years, you will receive a retention bonus of $10,000.00, subject to normal payroll deductions, on the anniversary date of your employment.

At the next meeting of the Compensation Committee of the Board of Directors after you have commenced employment, you will be granted a Non-Qualified Stock Option for 10,000 shares of the Company’s stock, which is exercisable over the next ten years, per the terms and conditions of the Stock Option Grant. These options will be at the current market price on the date of the Grant. You will also be granted a Restricted Stock grant of 5,000 shares of the Company’s stock, which has a staggered vesting period, per the terms and conditions of the Restricted Stock Agreement. These options will be at the current market price on the date of the Grant. You will also be eligible to participate in the Management Retention Plan (Change in Control) at 200%, and our Deferred Compensation program. You will receive separate documents related to these plans. As a member of the Senior Leadership Council, you will also be eligible to participate in our Retiree Health Program.

You will be eligible to participate in the Bank’s 2006 High Performance Incentive Program (HPIP) prorated to your date of employment. The HPIP will likely be paid in late February, 2007, based upon 2006 performance. Mr. Thomas will discuss with you the Incentive Award Guidelines and help you to establish your individual goals.

You will be eligible for four weeks of vacation per year, prorated according to your date of hire. Your eligibility for other benefit programs, such as our flexible Benefits Plan and 401(k) Salary Savings Plan will commence on the first of the month following completion of 90 days of employment.

Employment at Pacific Capital Bancorp and Pacific Capital Bank, N. A. is at will. Employees are not hired for any specified term. The Company and Bank hope that the working relationship will be mutually satisfactory and challenging. However we recognize that this is not always the case, and as such you may wish to resign your position with or without cause upon oral or written notice. Similarly, the Company or Bank may end or change the employment relationship or status at any time with or without cause, upon oral or written notice. All of the terms and conditions of the employment offer from the Company and the Bank are fully and completely set forth in this letter. Unless specifically set forth herein, no other term or condition of employment shall be included in this offer of employment.

Joyce, we are so pleased that you are joining us and feel you will make an important contribution to the growth of the Company. To confirm your acceptance of this offer, please sign and return this copy to me.

Sincerely,

Sherrell E. Reefer

Senior Vice President

Director of Human Resources

I hereby accept the offer of employment as outlined above:

Joyce Clinton (Date)

EX-10.1.19

Exhibit 10.1.19

March 3, 2006

George Leis

Dear George,

I am pleased to confirm our offer and your acceptance to commence employment March 13, 2006. You will be employed as the Executive Vice President-Wealth Management/Enterprise Sales at both Pacific Capital Bancorp (the Company) and its subsidiary Pacific Capital Bank, N.A. You will be reporting to Tom Thomas, CEO and President. You will be compensated at a bi-weekly rate of $7692.31. Additionally, you will receive a $100,000.00 sign on bonus subject to the normal payroll deductions to be paid upon hire or you may elect to take this portion of your bonus after 90 days of employment, to take advantage of participation in the Bank’s 401(k) plan. You may also elect to have these amounts contributed to your Deferred Compensation Plan if you are a participant.

To support your relocation to the Santa Barbara area, the Bank will provide you with a non-preferential loan of $100,000.00, to be secured by your new residence on terms that comply with Federal Reserve Regulation O. Upon your relocation, you will also receive a relocation allowance (moving costs, meals, gas, motel, etc.) of up to $10,000.00. You will be reimbursed after you provide appropriate receipts. If your employment is terminated within the first year after relocation, a prorated amount of the relocation bonus will be due to Pacific Capital Bank, N.A. You will also have the opportunity to utilize the company apartment for one month to assist with your transition.

For each year you remain with the Bank, up to 10 years, you will receive a retention bonus of $10,000.00, subject to normal payroll deductions, on the anniversary date of your employment.

At the next meeting of the Compensation Committee of the Board of Directors after you have commenced employment, you will be granted a Non-Qualified Stock Option for 10,000 shares of the Company’s stock, which is exercisable over the next ten years, per the terms and conditions of the Stock Option Grant. These options will be at the current market price on the date of the Grant. You will also be granted a Restricted Stock grant of 5,000 shares of the Company’s stock, which has a staggered vesting period, per the terms and conditions of the Restricted Stock Agreement. These shares will be current market price on the date of the Grant. You will also be eligible to participate in the Management Retention Plan (Change in Control) at 200%, and our Deferred Compensation program. You will receive separate documents related to these plans. As a member of the Senior Leadership Council, you will also be eligible to participate in our Retiree Health Program.

You will be eligible to participate in the Bank’s 2006 High Performance Incentive Program (HPIP) prorated to your date of employment. The HPIP is normally paid in late February, 2007, based upon 2006 performance. Mr. Thomas will discuss with you the Incentive Award Guidelines and help you to establish your individual goals.

You will be eligible for four weeks of vacation per year, prorated according to your date of hire. Your eligibility for other benefit programs, such as our flexible Benefits Plan and 401(k) Salary Savings Plan will commence on the first of the month following completion of 90 days of employment.

Employment at Pacific Capital Bancorp and Pacific Capital Bank, N. A. is at will. Employees are not hired for any specified term. The Company and Bank hope that the working relationship will be mutually satisfactory and challenging. However we recognize that this is not always the case, and as such you may wish to resign your position with or without cause upon oral or written notice. Similarly, the Company or Bank may end or change the employment relationship or status at any time with or without cause, upon oral or written notice. All of the terms and conditions of the employment offer from the Company and Pacific Capital Bank, N. A. are fully and completely set forth in this letter. Unless specifically set forth herein, no other term or condition of employment shall be included in this offer of employment.

George, we are so pleased that you are joining us and feel you will make an important contribution to the growth of the Company. To confirm your acceptance of this offer, please sign and return this copy to me.

Sincerely,

Sherrell E. Reefer

Senior Vice President

Director of Human Resources

I hereby accept the offer of employment as outlined above:

George Leis (Date)

EX-16.1

Exhibit 16.1

March 15, 2006

Securities and Exchange Commission

100 F Street, N.E.

Washington, DC 20549

Commissioners:

We have read the statements made by Pacific Capital Bancorp (copy attached), which we understand will be filed with the United States Securities and Exchange Commission, pursuant to Item 304 of Regulation S-K, as part of Item 9 of Pacific Capital Bancorp’s Form 10-K to be filed on or about March 15, 2006. We agree with the statements concerning our Firm in such Item 9 of Form 10-K. However, we make no comment whatsoever regarding the following: (i) the current status of material weaknesses disclosed in Item 4.01 of the Form 8-K filed on June 21, 2005 or any remedial actions taken by Pacific Capital Bancorp with respect thereto and (ii) the proposal process used by the Audit Committee to select another independent registered public accounting firm.

Very truly yours,

PricewaterhouseCoopers LLP

EX-21

Exhibit 21

SUBSIDIARIES OF REGISTRANT

Pacific Capital Bank, N.A.

PCB Service Corporation

Formerly Pacific Capital Commercial Mortgage Corporation

Pacific Capital Service Corporation – Inactive

SBB&T RAL Funding Corporation

SBB&T Automobile Loan Securitization Corporation

All of the above subsidiaries are incorporated in the State of California.

EX-23.1

Exhibit 23.1

Consent of Independent Registered Public Accounting Firm

We consent to the incorporation by reference in the Registration Statements on Form S-8 (File Nos. 33-48724, 333-05117, 333-05119, 333-74831, 333-40220, 333-44752, 333-88634 and 333-127982) and Form S-3 (File No. 333-125938) of Pacific Capital Bancorp of our reports dated March 13, 2006, with respect to the consolidated financial statements of Pacific Capital Bancorp, management’s assessment of the effectiveness of internal control over financial reporting, and the effectiveness of internal control over financial reporting of Pacific Capital Bancorp, included in this Annual Report on Form 10-K for the year ended December 31, 2005.

/s/ Ernst & Young LLP

Los Angeles, California

March 15, 2006

EX-23.2

Exhibit 23.2

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

We hereby consent to the incorporation by reference in the Registration Statements on Form S-3 (No. 333-125938) and Form S-8 (No. 333-127982, 333-88634, 333-44752, 333-40220, 333-74831, 333-05119, 333-05117) of Pacific Capital Bancorp of our report dated March 22, 2005, except as to the effects of the reclassification of 2004 and 2003 amounts for reportable segments as discussed in Note 25, as to which the date is March 14, 2006, relating to the 2004 and 2003 financial statements, which appears in this Annual Report on Form 10-K.

PricewaterhouseCoopers LLP

San Francisco, California

March 15, 2006

EX-31.1

Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Exhibit 31.1

I, William S. Thomas, Jr., Chief Executive Officer, certify that:

1. I have reviewed this annual report on Form 10-K of Pacific Capital Bancorp;

2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;

3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this annual report;

4. The Registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the Registrant and have:

a. designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;

b. (paragraph omitted pursuant to SEC Release Nos. 33-8238 and 34-47986);

c. evaluated the effectiveness of the Registrant’s disclosure controls and procedures and presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this annual report based on such evaluation; and

d. disclosed in this annual report any change in the Registrant’s internal control over financial reporting that occurred during the Registrant’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Registrant’s internal control over financial reporting; and

5. The Registrant’s other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the Registrant’s auditors and the audit committee of the Registrant’s board of directors (or persons performing the equivalent functions):

a. all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the Registrant’s ability to record, process, summarize and report financial information; and

b. any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant’s internal control over financial reporting.

Date:	March 15, 2006	/s/ William S. Thomas, Jr.
		William S. Thomas, Jr. President and Chief Executive Officer (Principal Executive Officer)

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EX-31.2

Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Exhibit 31.2

I, Donald Lafler, Chief Financial Officer, certify that:

1. I have reviewed this annual report on Form 10-K of Pacific Capital Bancorp;

2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this annual report;

4. The Registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the Registrant and have:

a. designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;

b. (paragraph omitted pursuant to SEC Release Nos. 33-8238 and 34-47986);

c. evaluated the effectiveness of the Registrant’s disclosure controls and procedures and presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this annual report based on such evaluation; and

d. disclosed in this annual report any change in the Registrant’s internal control over financial reporting that occurred during the Registrant’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Registrant’s internal control over financial reporting; and

5. The Registrant’s other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the Registrant’s auditors and the audit committee of the Registrant’s board of directors (or persons performing the equivalent functions):

a. all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the Registrant’s ability to record, process, summarize and report financial information; and

b. any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant’s internal control over financial reporting.

Date:	March 15, 2006	/s/ Donald Lafler
		Donald Lafler Executive Vice President and Chief Financial Officer

141

EX-32

Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 Exhibit 32

In connection with the filing of the Annual Report on Form 10-K for the Year Ended December 31, 2005 (the “Report”) by Pacific Capital Bancorp (“Registrant”), each of the undersigned hereby certifies that:

1. The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, and

2. The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of Registrant.

/s/ William S. Thomas, Jr.

William S. Thomas, Jr.

President &

Chief Executive Officer

Date: March 15, 2006 /s/ Donald Lafler. Donald Lafler Executive Vice President & Chief Financial Officer

142