FINANCIAL STATEMENT PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES

6 Months Ended

Jun. 30, 2011

FINANCIAL STATEMENT PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES

FINANCIAL STATEMENT PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES

1.  FINANCIAL STATEMENT PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES

The unaudited interim condensed consolidated financial statements include the accounts of State Bancorp, Inc. (the “Company”) and its wholly owned subsidiary, State Bank of Long Island and its subsidiaries (the “Bank”). State Bancorp, Inc. and subsidiaries are collectively referred to hereafter as the “Company.”  All intercompany accounts and transactions have been eliminated.

The Company has two unconsolidated subsidiaries, State Bancorp Capital Trust I and State Bancorp Capital Trust II (collectively the “Trusts”), entities formed in 2002 and 2003, respectively, to issue trust preferred securities. The Company has fully and unconditionally guaranteed all obligations of State Bancorp Capital Trust I and State Bancorp Capital Trust II under the trust agreements relating to the respective trust preferred securities.  (See Note 8 of the Notes to Consolidated Financial Statements included in Item 8, “Financial Statements and Supplementary Data” of the Company’s 2010 Annual Report on Form 10-K.)

In the opinion of the Company’s management, the preceding unaudited interim condensed consolidated financial statements contain all adjustments, consisting of normal accruals, necessary for a fair presentation of its condensed consolidated balance sheets as of June 30, 2011 and December 31, 2010, its condensed consolidated statements of operations for the three and six months ended June 30, 2011 and 2010, its condensed consolidated statements of cash flows for the six months ended June 30, 2011 and 2010 and its condensed consolidated statements of stockholders’ equity and comprehensive income (loss) for the six months ended June 30, 2011 and 2010. The preceding unaudited interim condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X, as well as in accordance with predominant practices within the banking industry. They do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. The results of operations for the three and six months ended June 30, 2011 are not necessarily indicative of the results of operations to be expected for the remainder of the year. For further information, please refer to the audited consolidated financial statements and footnotes thereto included in the Company’s 2010 Annual Report on Form 10-K.

Accounting for Derivative Financial Instruments

From time to time, the Bank may execute customer interest rate swap transactions together with offsetting interest rate swap transactions with institutional dealers.  Each swap is mutually exclusive, and the swaps are marked to market with changes in fair value recognized as other income, with the fair value for each individual swap generally offsetting the corresponding other. In the event of default, future changes in the fair value of these swap agreements are no longer offset and are recognized as income or loss as appropriate. The customer swap program provides a customer financing option that can result in longer maturity terms without incurring the associated interest rate risk. The Company does not currently hold any derivative financial instruments for trading purposes.

For the three and six months ended June 30, 2011, net credit valuation adjustments (“CVA”) of $18 and $10 thousand, respectively, were recorded as reductions to other income. For the three and six months ended June 30, 2010, $64 and $80 thousand, respectively, were recorded as reductions to other income. The CVA represents the consideration of credit risk of the counterparties to a transaction and the effect of any credit enhancements related to the transaction. As all customer interest rate swap transactions are currently offset by swap transactions with institutional dealers, we expect that their future impact on the Company’s financial statements will be immaterial. At June 30, 2011 and December 31, 2010, the total gross notional amount of swap transactions outstanding was $34 million and $35 million, respectively.

Information on the Company’s derivative financial instruments at June 30, 2011 and December 31, 2010 follows (in thousands).

	Fair Values of Derivative Instruments
		June 30, 2011		December 31, 2010
	Balance Sheet Location	Fair Value		Fair Value
Derivatives not designated as hedging instruments:
Interest rate contracts	Other assets	$	1,997	$	2,111
Interest rate contracts	Other liabilities	$	2,093	$	2,198

Accounting for Bank Owned Life Insurance

The Bank is the beneficiary of a policy that insures the lives of certain current and former senior officers of the Bank and its subsidiaries.  The Company has recognized the cash surrender value, or the amount that can be realized under the insurance policy, as an asset in the consolidated balance sheets. Changes in the cash surrender value and insurance benefit payments are recorded in other income.

Allowance for Loan Losses

The allowance for loan losses is established through a provision for loan losses charged to expense. Loans are charged against the allowance when management believes that the collectibility of the principal is unlikely, while recoveries of previously charged-off loans are credited to the allowance. The balance in the allowance for loan losses is maintained at a level that, in the opinion of management, is sufficient to absorb probable inherent losses. To determine that level, management evaluates problem loans based on the financial condition of the borrower, the value of collateral and/or guarantor support. Based upon the resultant risk categories assigned to each loan and the procedures regarding impairment described below, an appropriate allowance level is determined. Management also evaluates the quality of, and changes in, the portfolio, while taking into consideration the Bank’s historical loss experience, the existing economic climate of the service area in which the Bank operates, examinations by regulatory authorities, internal reviews and other evaluations in determining the appropriate allowance balance. Management utilizes all available information to estimate the adequacy of the allowance for loan losses. However, the ultimate collectibility of a substantial portion of the loan portfolio and the need for future additions to the allowance will be based upon changes in credit and economic conditions and other relevant factors.

The allowance consists of specific and general components. The specific component relates to loans that are impaired. Commercial and industrial loans and commercial real estate loans of all loan classes are considered impaired when, based on current information and events, it is probable that the Company will not be able to collect all of the principal and interest due under the contractual terms of the loan. Problem loans, for which certain terms have been modified, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings (“TDRs”). Generally, management individually evaluates all non-accrual loans and TDRs in excess of $250 thousand for impairment. Those non-accrual loans and TDRs of all classes with balances less than $250 thousand as well as other groups of smaller-balance homogeneous loans, such as consumer and residential real estate loans, are collectively evaluated for impairment. The allowance for loan losses related to loans that are impaired includes reserves which are generally based on underlying collateral, discounted cash flow or the observable market price if the intent is to sell the loan.

The general component covers loans not individually evaluated for impairment and is based upon historical experience adjusted for current factors. For all loans regardless of portfolio segment, the Bank prepares a combined migration analysis which analyzes the historical loss experience. The migration analysis is prepared annually during the first quarter of the year for the purpose of determining the assigned allocation factors which are essential components of the allowance for loan losses calculation. Actual loss experience is supplemented by other risk components updated on a quarterly basis including large relationship risk, commercial/residential contractor risk, rising interest rate risk, energy and oil dependent risk, real estate risk and economic condition uncertainty.

The following portfolio segments have been identified: commercial and industrial loans (“C&I”), commercial real estate (“CRE”), residential real estate, loans to individuals and tax exempt and other loans. The Bank provides loans to small, moderate size and middle market borrowers and business entities diversified across industries. Loan types primarily include business installment loans, commercial lines of credit and commercial real estate loans. Loans are generally categorized as C&I, CRE and small business loans. C&I loans consist of a broad range of  loans to a wide variety of business clients for acquisition of equipment, machinery or leasehold improvements, short term or seasonal working capital needs, and business expansion. C&I loans also include owner-occupied mortgages where the source of repayment is not from the property. CRE loans consist of loans on multifamily, mixed use, retail, office and industrial property or construction loans. Small business loans are a subset of C&I loans where the origination amount is less than $1 million.

Risk characteristics of the C&I portfolio segment vary and depend upon the specific borrower’s business and industry sector. Risk characteristics of the real estate portfolio segments tend to be cyclical and, in the Bank’s case, generally specific to the Long Island and New York City geographical area; at present the real estate market generally continues to be lackluster. Risk characteristics of the loans to individuals segment vary depending on the type of loan, the timing of repayment, the sources of repayment, and value and stability of any collateral.

Management’s goal is to have a balanced portfolio of loans. The allowable risk for the portfolio is determined by senior management through credit policies and annual business plans which are approved by the Board of Directors. The Bank monitors concentrations of risk as appropriate. A concentration of credit is the total of funded and unfunded loans, real estate loans, lines of credit, etc., issued to borrowers sharing similar characteristics such as industry, collateral/security type, size, pricing, location and other items that might have a bearing on risk management. It is also the Bank’s goal to diversify credit risk among a broad range of industries and/or industry sectors, and to monitor concentration on an ongoing basis.

Generally, the Bank processes a charge-off for any portion of a loan that is determined to be uncollectable regardless of portfolio segment or loan class. In addition, commercial loans under $25 thousand are generally fully charged off in the quarter in which they reach 180 days past due unless the loan is secured by real estate or liquid collateral; commercial loans $25 thousand and over are charged off if classified as a loss; non-revolving consumer loans are generally charged off in the quarter they reach 120 days past due; residential real estate loans are partially charged off for the amount that the loan exceeds the current value of the collateral property, no later than 180 days past due.

Other-Than-Temporary Impairment (“OTTI”) of Investment Securities

Accounting guidance requires an entity to assess whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of these criteria is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings.  For securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) OTTI related to other factors, which is recognized in other comprehensive income and 2) OTTI related to credit loss, which must be recognized in the statement of operations.  The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis.

Management evaluates securities for OTTI on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. In estimating OTTI, management considers: 1) the length of time and extent that fair value has been less than cost, 2) the financial condition and near term prospects of the issuer, 3) whether the market decline was affected by macroeconomic conditions and 4) whether the Company has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. In analyzing an issuer’s financial condition, the Company’s management considers whether the securities are issued by the U.S. Government or its agencies, whether downgrades by bond rating agencies have occurred, industry analysts’ reports and the issuer’s financial statements and related disclosures.

Recent Accounting Guidance

In July 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2010-20, “Receivables: Disclosure about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.” The objective of this ASU is for an entity to provide disclosures that facilitate financial statement users’ evaluation of the nature of credit risk inherent in the entity’s portfolio of financing receivables, how that risk is analyzed and assessed in arriving at the allowance for credit losses, and the changes and reasons for those changes in the allowance for credit losses.  An entity should provide disclosures on a disaggregated basis on two defined levels: 1) portfolio segment and 2) class of financing receivable. The ASU makes changes to existing disclosure requirements and includes additional disclosure requirements about financing receivables, including credit quality indicators of financing receivables at the end of the reporting period by class of financing receivables, the aging of past due financing receivables at the end of the reporting period by class of financing receivables, and the nature and extent of TDRs that occurred during the period by class of financing receivables and their effect on the allowance for credit losses. The Company’s adoption on March 31, 2011 of the disclosures regarding activity in the allowance for loan losses and its adoption on December 31, 2010 of the other disclosures in this ASU except for those parts pertaining to TDRs, being disclosure-related only, had no impact on its results of operations. At its January 4, 2011, meeting, the FASB affirmed its decision to temporarily defer the effective date for TDRs.

In April 2011, the FASB issued ASU No. 2011-02, “Receivables (Topic 310): A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring.” This ASU amends Topic 310 and provides additional guidance to creditors for evaluating whether a modification or restructuring of a receivable is a troubled debt restructuring. The amendments in this update are effective for the first interim or annual period beginning on or after June 15, 2011 and should be applied retrospectively to the beginning of the annual period of adoption.  The new guidance will require creditors to evaluate modifications and restructurings of receivables using a more principles-based approach, which may result in more modifications and restructurings being considered troubled debt restructurings. For purposes of measuring impairment of these receivables, an entity should apply the amendments prospectively for the first interim or annual period beginning on or after June 15, 2011. Early adoption is permitted. We do not expect that this accounting standards update will have a material impact on our financial condition, results of operations or financial statement disclosures.

In June 2011, the FASB issued ASU No. 2011-05, “Comprehensive Income (Topic 22): Presentation of Comprehensive Income.”  The guidance contained in this ASU is the result of a joint project by the FASB and the International Accounting Standards Board (“IASB”) to improve the presentation of comprehensive income and to increase the consistency between U.S. GAAP and International Financial Reporting Standards (“IFRS”). The ASU provides only two options for presenting other comprehensive income (“OCI”). The first option is to present the total of comprehensive income in the statement of income in one continuous statement.  The second option is to present two separate but consecutive statements.  The amendments in this ASU should be applied retrospectively.  For public entities, the amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011.  Early adoption is permitted.  The amendments do not require any transition disclosures. We do not expect that this ASU will have a material impact on our financial condition, results of operations or financial statement disclosures.

Merger-Related Expenses

In connection with the Company’s previously announced transaction with Valley National Bancorp (“Valley”), the Company has incurred expenses of $1.4 million for the six months ended June 30, 2011. These consist primarily of legal expenses and investment bankers’ costs.