Edgar Filing: CULLEN FROST BANKERS INC

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K


x		ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended: December 31, 2003

or

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission file number: 0-7275

CULLEN/ FROST BANKERS, INC.

(Exact name of registrant as specified in its charter)


	Texas		74-1751768

(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

100 W. Houston Street, San Antonio, Texas			78205

(Address of principal executive offices)			(Zip code)

Registrant’s telephone number, including area code:

(210) 220-4011

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


Common Stock, $.01 Par Value,
and attached Stock Purchase Rights		The New York Stock Exchange, Inc.

(Title of each class)		(Name of each exchange on which registered)

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

None

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 o

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 the 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. o

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

As of June 30, 2003, the last business day of the registrant’s most recently completed second fiscal quarter, the aggregate market value of the shares of common stock held by non-affiliates, based upon the closing price per share of the registrant’s common stock as reported on The New York Stock Exchange, Inc., was approximately $1,575,803,519.

As of February 5, 2004, there were 51,870,593 shares of the registrant’s common stock, $.01 par value, outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the 2004 Annual Meeting of Shareholders of Cullen/ Frost Bankers, Inc. to be held on May 19, 2004 are incorporated by reference in this Form 10-K in response to Part III, Items 10, 11, 12, 13 and 14.

TABLE OF CONTENTS


PART I
	ITEM 1. BUSINESS
	ITEM 2. PROPERTIES
	ITEM 3. LEGAL PROCEEDINGS
	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
PART II
	ITEM 5. MARKET FOR REGISTRANT’S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
	ITEM 6. SELECTED FINANCIAL DATA
	ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
	ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
	ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
	ITEM 9A. CONTROLS AND PROCEDURES
PART III
	ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
	ITEM 11. EXECUTIVE COMPENSATION
	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
	ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
PART IV
	ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
SIGNATURES
Subsidiaries
Consent of Independent Auditors
Power of Attorney
Rule 13a-14(a) Certification of CEO
Rule 13a-14(a) Certification of CFO
Section 1350 Certification of CEO
Section 1350 Certification of CFO

CULLEN/ FROST BANKERS, INC.

ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS


		Page

PART I

ITEM 1	BUSINESS		3
ITEM 2	PROPERTIES		14
ITEM 3	LEGAL PROCEEDINGS		14
ITEM 4	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS		14

PART II

ITEM 5	MARKET FOR REGISTRANT’S COMMON STOCK AND RELATED STOCKHOLDER MATTERS		15
ITEM 6	SELECTED FINANCIAL DATA		17
ITEM 7	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS		20
ITEM 7A	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK		54
ITEM 8	FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA		55
ITEM 9	CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE		98
ITEM 9A	CONTROLS AND PROCEDURES		98

PART III

ITEM 10	DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT		98
ITEM 11	EXECUTIVE COMPENSATION		98
ITEM 12	SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT		98
ITEM 13	CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS		98
ITEM 14	PRINCIPAL ACCOUNTING FEES AND SERVICES		98

PART IV

ITEM 15	EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K		99
SIGNATURES			101

PART I


ITEM 1.	BUSINESS

The disclosures set forth in this item are qualified by the section captioned “Forward-Looking Statements and Factors that Could Affect Future Results” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations of this report and other cautionary statements set forth elsewhere in this report.

The Corporation

Cullen/ Frost Bankers, Inc. (“Cullen/ Frost”), a Texas business corporation incorporated in 1977, is a financial holding company and a bank holding company headquartered in San Antonio, Texas that provides, through its subsidiaries (collectively referred to as “Corporation”), a broad array of products and services throughout 12 Texas markets. The Corporation offers commercial and consumer banking services, as well as trust and investment management, investment banking, insurance brokerage, leasing, asset-based lending, treasury management and item processing services. At December 31, 2003, Cullen/ Frost had consolidated total assets of $9.7 billion and was the largest independent bank holding company headquartered in the State of Texas.

The Corporation’s philosophy is to grow and prosper, building long-term relationships based on top quality service, high ethical standards, and safe, sound assets. The Corporation operates as a locally oriented, community-based financial services organization, augmented by experienced, centralized support in select critical areas. The Corporation’s local market orientation is reflected in its financial service centers and regional advisory boards, which are comprised of local business persons, professionals and other community representatives, that assist the Corporation’s financial centers in responding to local banking needs. Despite this local market, community-based focus, the Corporation offers many of the products available at much larger money-center financial institutions.

The Corporation serves a wide variety of industries including, among others, energy, services, retail, manufacturing, construction, telecommunications, healthcare, military, logistics and transportation. The Corporation’s customer base is similarly diverse. The Corporation is not dependent upon any single industry or customer.

The Corporation’s operating objectives include expansion, diversification within its markets, growth of its fee-based income, and growth internally and through acquisitions of financial institutions, branches and financial services businesses. From time to time, the Corporation engages in discussions and conducts due diligence activities related to possible acquisitions of other financial institutions and financial services companies. The Corporation seeks acquisition partners that are culturally similar and have experienced management and possess either significant market presence or have potential for improved profitability through financial management, economies of scale and expanded services. Acquisitions typically involve the payment of a premium over book and market values, and, therefore, some dilution of the Corporation’s tangible book value and net income per common share may occur in connection with any future transaction.

Although Cullen/ Frost is a corporate entity, legally separate and distinct from its affiliates, bank holding companies such as Cullen/ Frost, are generally required to act as a source of financial strength for their subsidiary banks. The principal source of Cullen/ Frost’s income is dividends from its subsidiaries. There are certain regulatory restrictions on the extent to which financial institution subsidiaries can pay dividends or otherwise supply funds to Cullen/ Frost. See the section captioned “Supervision and Regulation” for further discussion of these matters.

Cullen/ Frost’s executive offices are located at 100 W. Houston Street, San Antonio, Texas 78205, and its telephone number is (210) 220-4011.

Subsidiaries of Cullen/ Frost


	The New Galveston Company

Incorporated under the laws of Delaware, The New Galveston Company is a wholly owned second-tier financial holding company and bank holding company, which directly owns all of Cullen/ Frost’s banking and non-banking subsidiaries with the exception of Cullen/ Frost Capital Trust I.


	Cullen/ Frost Capital Trust I

Cullen/ Frost Capital Trust I (the “Trust”) is a Delaware statutory business trust formed in 1997 for the purpose of issuing $100 million in trust preferred securities and lending the proceeds to Cullen/ Frost. Cullen/ Frost guarantees, on a limited basis, payments of distributions on the trust preferred securities and payments on redemption of the trust preferred securities.

Prior to the implementation of a new accounting standard in the fourth quarter of 2003, the financial statements of the trust were included in the consolidated financial statements of the Corporation because Cullen/ Frost owns all of the outstanding common equity securities of the Trust. However, because Cullen/ Frost is not the primary beneficiary of the Trust, in accordance with the new accounting standard the financial statements of the Trust are no longer included in the consolidated financial statements of the Corporation. The Corporation’s prior financial statements have been restated to de-consolidate the Corporation’s investment in the Trust. See Note 23 — New Accounting Standards in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, which is located elsewhere in this report.

The trust preferred securities are currently included in the Tier 1 capital of Cullen/ Frost for regulatory capital purposes. However, because the financial statements of the Trust are no longer included in the Corporation’s consolidated financial statements, the Federal Reserve Board may in the future disallow inclusion of the trust preferred securities in Tier 1 capital for regulatory capital purposes. See Note 9 — Borrowed Funds and Note 12 — Regulatory Matters in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, which is located elsewhere in this report.

In February 2004, the Corporation formed Cullen/ Frost Capital Trust II for the purpose of issuing $120 million in trust preferred securities and lending the proceeds to Cullen/ Frost. Cullen/ Frost has guaranteed, on a limited basis, the payments of distributions on the trust preferred securities and the payments on redemption of the trust preferred securities. See Note 24 — Subsequent Events in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, which is located elsewhere in this report.


	The Frost National Bank

The Frost National Bank (“Frost Bank”) is primarily engaged in the business of commercial and consumer banking through 79 financial centers and 118 ATMs across Texas. Frost Bank serves the Texas metropolitan areas of Austin, Boerne, Corpus Christi, Dallas, Fort Worth, Galveston, Harlingen, Houston, McAllen, New Braunfels, San Antonio and San Marcos. Frost Bank was chartered as a national banking association in 1899, but its origin can be traced to a mercantile partnership organized in 1868. At December 31, 2003, Frost Bank had consolidated total assets of $9.7 billion and total deposits of $8.1 billion and was the largest commercial bank headquartered in the State of Texas.

Significant services offered by Frost Bank include:


	•	Commercial Banking. Frost Bank provides commercial banking services to corporations and other business clients. Loans are made for a wide variety of general corporate purposes, including financing for industrial and commercial properties and to a lesser extent, financing for interim construction related to industrial and commercial properties, financing for equipment, inventories and accounts receivable, and acquisition financing, as well as commercial leasing and treasury management services.

	•	Consumer Services. Frost Bank provides a full range of consumer banking services, including checking accounts, savings programs, automated teller machines, overdraft facilities, installment and


		real estate loans, home equity loans and lines of credit, drive-in and night deposit services, safe deposit facilities, and brokerage services.

	•	International Banking. Frost Bank provides international banking services to customers residing in or dealing with businesses located in Mexico. These services consist of accepting deposits (in U.S. dollars only), making loans (in U.S. dollars only), issuing letters of credit, handling foreign collections, transmitting funds, and to a limited extent, dealing in foreign exchange.

	•	Correspondent Banking. Frost Bank acts as correspondent for nearly 270 financial institutions, which are primarily banks in Texas. These banks maintain deposits with Frost Bank, which offers them a full range of services including check clearing, transfer of funds, fixed income security services, and securities custody and clearance services.

	•	Trust Services. Frost Bank provides a wide range of trust, investment, agency and custodial services for individual and corporate clients. These services include the administration of estates and personal trusts, as well as the management of investment accounts for individuals, employee benefit plans and charitable foundations. At December 31, 2003, the estimated fair value of trust assets was approximately $14.8 billion, including managed assets of $6.6 billion and custody assets of $8.2 billion.

	•	Capital Markets — Fixed-Income Services. Frost Bank’s Capital Markets Division was formed in 1999 to meet the transaction needs of fixed-income institutional investors. Services include sales and trading, new issue underwriting, money market trading, and securities safekeeping and clearance.


	Frost Insurance Agency, Inc.

Frost Insurance Agency, Inc. is a wholly owned subsidiary of Frost Bank that provides insurance brokerage services to individuals and businesses covering corporate and personal property and casualty insurance products, as well as group health and life insurance products.


	Frost Brokerage Services, Inc.

Frost Brokerage Services, Inc. (“FBS”) is a wholly owned subsidiary of Frost Bank that provides brokerage services and performs other transactions or operations related to the sale and purchase of securities of all types. FBS is registered as a fully disclosed introducing broker-dealer under the Securities Exchange Act of 1934 and, as such, does not hold any customer accounts.


	Frost Securities, Inc.

Frost Securities, Inc. (“FSI”) is a wholly owned subsidiary that provides advisory and private equity services to middle market companies in Texas.


	Main Plaza Corporation

Main Plaza Corporation is a wholly owned non-banking subsidiary that occasionally makes loans to qualified borrowers. Loans are funded with borrowings against Cullen/ Frost’s current cash or borrowings against internal credit lines.


	Daltex General Agency, Inc.

Daltex General Agency, Inc. is a wholly owned non-banking subsidiary that operates as a managing general insurance agency providing insurance on certain auto loans financed by Frost Bank.


	Other Subsidiaries

Cullen/ Frost has various other subsidiaries that are not significant to the consolidated entity.

Operating Segments

Cullen/ Frost’s operations are managed along two reportable operating segments consisting of Banking and the Financial Management Group. See the sections captioned “Results of Segment Operations” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 20 — Operating Segments in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, which are located elsewhere in this report.

Competition

There is significant competition among commercial banks in the Corporation’s market areas. As a result of the deregulation of the financial services industry (see the discussion of the Gramm-Leach-Bliley Financial Modernization Act of 1999 in the section of this item captioned “Supervision and Regulation”), the Corporation also competes with other providers of financial services, such as savings and loan associations, credit unions, consumer finance companies, securities firms, insurance companies, insurance agencies, commercial finance and leasing companies, full service brokerage firms and discount brokerage firms. Some of the Corporation’s competitors have greater resources and, as such, may have higher lending limits and may offer other services that are not provided by the Corporation. The Corporation generally competes on the basis of customer service and responsiveness to customer needs, available loan and deposit products, the rates of interest charged on loans, the rates of interest paid for funds, and the availability and pricing of trust, brokerage and insurance services.

Supervision and Regulation

Cullen/ Frost, Frost Bank and many of its non-banking subsidiaries are subject to extensive regulation under federal and state laws. The regulatory framework is intended primarily for the protection of depositors, federal deposit insurance funds and the banking system as a whole and not for the protection of security holders.

As discussed in more detail below, this regulatory environment may, among other things, restrict the Corporation’s ability to diversify into certain areas of financial services, acquire depository institutions and pay dividends on its capital stock. It also may require the Corporation to provide financial support to its banking subsidiary, maintain capital balances in excess of those desired by management and pay higher deposit insurance premiums.

Set forth below is a description of the significant elements of the laws and regulations applicable to Cullen/ Frost and its subsidiaries. The description is qualified in its entirety by reference to the full text of the statutes and regulations that are described.


	Regulatory Agencies

Cullen/ Frost is a legal entity separate and distinct from Frost Bank and its other subsidiaries. As a financial holding company and a bank holding company, Cullen/ Frost is regulated under the Bank Holding Company Act of 1956, as amended, and is subject to inspection, examination and supervision by the Board of Governors of the Federal Reserve System (“Federal Reserve Board”).

Frost Bank is organized as a national banking association under the National Bank Act. It is subject to regulation and examination by the Office of the Comptroller of the Currency (“OCC”) and the Federal Deposit Insurance Corporation (“FDIC”).

Many of the Corporation’s non-bank subsidiaries also are subject to regulation by the Federal Reserve Board and other federal and state agencies. Frost Securities, Inc. and Frost Brokerage Services, Inc. are regulated by the SEC, the National Association of Securities Dealers, Inc. (“NASD”) and state securities

regulators. The Corporation’s insurance subsidiaries are subject to regulation by applicable state insurance regulatory agencies. Other non-bank subsidiaries are subject to both federal and state laws and regulations.


	Bank Holding Company Activities

In general, the Bank Holding Company Act of 1956, as amended (“BHC Act”), limits the business of bank holding companies to banking, managing or controlling banks and performing certain servicing activities for subsidiaries. As a result of the Gramm-Leach-Bliley Financial Modernization Act of 1999 (“GLB Act”), however, bank holding companies that are financial holding companies may engage in any activity, or acquire and retain the shares of any company engaged in any activity, that is either (i) financial in nature or incidental to such financial activity (as determined by the Federal Reserve Board in consultation with the OCC) or (ii) complementary to a financial activity and that does not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally (as solely determined by the Federal Reserve Board). Activities that are financial in nature include securities underwriting and dealing, insurance underwriting and making merchant banking investments in commercial and financial companies. They also include activities that the Federal Reserve Board has determined, by order or regulation in effect prior to the enactment of the BHC Act, to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.

If a bank holding company seeks to engage in the broader range of activities that are permitted under the BHC Act for financial holding companies, (i) all of its depository institution subsidiaries must be “well capitalized” and “well managed” and (ii) it must file a declaration with the Federal Reserve Board that it elects to be a “financial holding company.” A depository institution subsidiary is considered to be “well capitalized” if it satisfies the requirements for this status discussed in the section captioned “Capital Adequacy and Prompt Corrective Action,” included elsewhere in this item. A depository institution subsidiary is considered “well managed” if it received a composite rating and management rating of at least “satisfactory” in its most recent examination. Cullen/ Frost’s declaration to become a financial holding company was declared effective by the Federal Reserve Board on March 11, 2000.

In order for a financial holding company to commence any new activity permitted by the BHC Act, or to acquire any company engaged in any new activity permitted by the BHC Act, each insured depository institution subsidiary of the financial holding company must have received a rating of at least “satisfactory” in its most recent examination under the Community Reinvestment Act. See the section captioned “Community Reinvestment Act” included elsewhere in this item.

The BHC Act generally limits acquisitions by bank holding companies that are not qualified as financial holding companies to commercial banks and companies engaged in activities that the Federal Reserve Board has determined to be so closely related to banking as to be a proper incident thereto. Financial holding companies like Cullen/ Frost are also permitted to acquire companies engaged in activities that are financial in nature and in activities that are incidental and complementary to financial activities without prior Federal Reserve Board approval.

The BHC Act, the Federal Bank Merger Act, the Texas Banking Code and other federal and state statutes regulate acquisitions of commercial banks. The BHC Act requires the prior approval of the Federal Reserve Board for the direct or indirect acquisition of more than 5.0% of the voting shares of a commercial bank or its parent holding company. Under the Federal Bank Merger Act, the prior approval of the OCC is required for a national bank to merge with another bank or purchase the assets or assume the deposits of another bank. In reviewing applications seeking approval of merger and acquisition transactions, the bank regulatory authorities will consider, among other things, the competitive effect and public benefits of the transactions, the capital position of the combined organization, the applicant’s performance record under the Community Reinvestment Act (see the section captioned “Community Reinvestment Act” included elsewhere in this item) and fair housing laws and the effectiveness of the subject organizations in combating money laundering activities.


	Dividends

The principal source of Cullen/ Frost’s cash revenues is dividends from Frost Bank. The prior approval of the OCC is required if the total of all dividends declared by a national bank in any calendar year would exceed the sum of the bank’s net profits for that year and its retained net profits for the preceding two calendar years, less any required transfers to surplus. Federal law also prohibits national banks from paying dividends that would be greater than the bank’s undivided profits after deducting statutory bad debt in excess of the bank’s allowance for loan losses. Under the foregoing dividend restrictions, and without adversely affecting its “well capitalized” status, Frost Bank could pay aggregate dividends of approximately $168.0 million to Cullen/ Frost, without obtaining affirmative governmental approvals, at December 31, 2003. This amount is not necessarily indicative of amounts that may be available to be paid in future periods.

In addition, Cullen/ Frost and Frost Bank are subject to other regulatory policies and requirements relating to the payment of dividends, including requirements to maintain adequate capital above regulatory minimums. The appropriate federal regulatory authority is authorized to determine under certain circumstances relating to the financial condition of a bank holding company or a bank that the payment of dividends would be an unsafe or unsound practice and to prohibit payment thereof. The appropriate federal regulatory authorities have indicated that paying dividends that deplete a bank’s capital base to an inadequate level would be an unsafe and unsound banking practice and that banking organizations should generally pay dividends only out of current operating earnings.


	Borrowings

There are various restrictions on the ability of Cullen/ Frost and its non-bank subsidiaries to borrow from, and engage in certain other transactions with, Frost Bank. In general, these restrictions require that any extensions of credit must be secured by designated amounts of specified collateral and are limited, as to any one of Cullen/ Frost or its non-bank subsidiaries, to 10% of Frost Bank’s capital stock and surplus, and, as to Cullen/ Frost and all such non-bank subsidiaries in the aggregate, to 20% of Frost Bank’s capital stock and surplus.

Federal law also provides that extensions of credit and other transactions between Frost Bank and Cullen/ Frost or one of its non-bank subsidiaries must be on terms and conditions, including credit standards, that are substantially the same or at least as favorable to Frost Bank as those prevailing at the time for comparable transactions involving other non-affiliated companies or, in the absence of comparable transactions, on terms and conditions, including credit standards, that in good faith would be offered to, or would apply to, non-affiliated companies.


	Source of Strength Doctrine

Federal Reserve Board policy requires bank holding companies to act as a source of financial and managerial strength to their subsidiary banks. Under this policy, Cullen/ Frost is expected to commit resources to support Frost Bank, including at times when Cullen/ Frost may not be in a financial position to provide it. Any capital loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to deposits and to certain other indebtedness of such subsidiary banks. The BHC Act provides that, in the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to priority of payment.

In addition, under the National Bank Act, if the capital stock of Frost Bank is impaired by losses or otherwise, the OCC is authorized to require payment of the deficiency by assessment upon Cullen/ Frost. If the assessment is not paid within three months, the OCC could order a sale of the Frost Bank stock held by Cullen/ Frost to make good the deficiency.


	Capital Adequacy and Prompt Corrective Action

Banks and bank holding companies are subject to various regulatory capital requirements administered by state and federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weighting and other factors.

The Federal Reserve Board, the OCC and the FDIC have substantially similar risk-based capital ratio and leverage ratio guidelines for banking organizations. The guidelines are intended to ensure that banking organizations have adequate capital given the risk levels of assets and off-balance sheet financial instruments. Under the guidelines, banking organizations are required to maintain minimum ratios for Tier 1 capital and total capital to risk-weighted assets (including certain off-balance sheet items, such as letters of credit). For purposes of calculating the ratios, a banking organization’s assets and some of its specified off-balance sheet commitments and obligations are assigned to various risk categories. A depository institution’s or holding company’s capital, in turn, is classified in one of three tiers, depending on type:


	•	Core Capital (Tier 1). Tier 1 capital includes common equity, retained earnings, qualifying non-cumulative perpetual preferred stock, a limited amount of qualifying cumulative perpetual stock at the holding company level, minority interests in equity accounts of consolidated subsidiaries, less goodwill, most intangible assets and certain other assets

	•	Supplementary Capital (Tier 2). Tier 2 capital includes, among other things, perpetual preferred stock not meeting the Tier 1 definition, qualifying mandatory convertible debt securities, qualifying subordinated debt, and allowances for possible loan and lease losses, subject to limitations.

	•	Market Risk Capital (Tier 3). Tier 3 capital includes qualifying unsecured subordinated debt.

Cullen/ Frost, like other bank holding companies, currently is required to maintain Tier 1 capital and “total capital” (the sum of Tier 1, Tier 2 and Tier 3 capital) equal to at least 4.0% and 8.0%, respectively, of its total risk-weighted assets (including various off-balance-sheet items, such as standby letters of credit). Frost Bank, like other depository institutions, is required to maintain similar capital levels under capital adequacy guidelines. For a depository institution to be considered “well capitalized” under the regulatory framework for prompt corrective action, its Tier 1 and total capital ratios must be at least 6.0% and 10.0% on a risk-adjusted basis, respectively.

Bank holding companies and banks are required to incorporate market and interest rate risk components into their risk-based capital standards. Under these market risk requirements, capital is allocated to support the amount of market risk related to a financial institution’s ongoing trading activities.

Bank holding companies and banks are also required to comply with minimum leverage ratio requirements. The leverage ratio is the ratio of a banking organization’s Tier 1 capital to its total adjusted quarterly average assets (as defined for regulatory purposes). The requirements necessitate a minimum leverage ratio of 3.0% for financial holding companies and national banks that either have the highest supervisory rating or have implemented the appropriate federal regulatory authority’s risk-adjusted measure for market risk. All other financial holding companies and national banks are required to maintain a minimum leverage ratio of 4.0%, unless a different minimum is specified by an appropriate regulatory authority. For a depository institution to be considered “well capitalized” under the regulatory framework for prompt corrective action, its leverage ratio must be at least 5.0%. The Federal Reserve Board has not advised Cullen/ Frost, and the OCC has not advised Frost Bank, of any specific minimum leverage ratio applicable to it.

The Federal Deposit Insurance Corporation Improvement Act of 1991, as amended (“FDICIA”), requires among other things, the federal banking agencies to take “prompt corrective action” in respect of depository institutions that do not meet minimum capital requirements. The FDICIA sets forth the following five capital tiers: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” A depository institution’s capital tier will depend upon how its capital

levels compare with various relevant capital measures and certain other factors, as established by regulation. The relevant capital measures are the total capital ratio, the Tier 1 capital ratio and the leverage ratio.

Under the regulations adopted by the federal regulatory authorities, a bank insured by the FDIC will be: (i) “well capitalized” if the institution has a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, and a leverage ratio of 5.0% or greater, and is not subject to any order or written directive by any such regulatory authority to meet and maintain a specific capital level for any capital measure; (ii) “adequately capitalized” if the institution has a total risk-based capital ratio of 8.0% or greater, a Tier 1 risk-based capital ratio of 4.0% or greater, and a leverage ratio of 4.0% or greater (3.0% in certain circumstances ) and is not “well capitalized”; (iii) “undercapitalized” if the institution has a total risk-based capital ratio that is less than 8.0%, a Tier 1 risk-based capital ratio of less than 4.0% or a leverage ratio of less than 4.0% (3.0% in certain circumstances); (iv) “significantly undercapitalized” if the institution has a total risk-based capital ratio of less than 6.0%, a Tier 1 risk-based capital ratio of less than 3.0% or a leverage ratio of less than 3.0%; and (v) “critically undercapitalized” if the institution’s tangible equity is equal to or less than 2.0% of average quarterly tangible assets. An institution may be downgraded to, or deemed to be in, a capital category that is lower than indicated by its capital ratios if it is determined to be in an unsafe or unsound condition or if it receives an unsatisfactory examination rating with respect to certain matters. Cullen/ Frost believes that, as of December 31, 2003, its bank subsidiary, Frost Bank, was “well capitalized,” based on the ratios and guidelines described above. A bank’s capital category is determined solely for the purpose of applying prompt corrective action regulations, and the capital category may not constitute an accurate representation of the bank’s overall financial condition or prospects for other purposes.

The FDICIA generally prohibits a depository institution from making any capital distributions (including payment of a dividend) or paying any management fee to its parent holding company if the depository institution would thereafter be undercapitalized. Undercapitalized institutions are subject to growth limitations and are required to submit a capital restoration plan. The agencies may not accept such a plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution’s capital. In addition, for a capital restoration plan to be acceptable, the depository institution’s parent holding company must guarantee that the institution will comply with such capital restoration plan. The aggregate liability of the parent holding company is limited to the lesser of (i) an amount equal to 5.0% of the depository institution’s total assets at the time it became undercapitalized and (ii) the amount which is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is treated as if it is “significantly undercapitalized.”

“Significantly undercapitalized” depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become “adequately capitalized,” requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. “Critically undercapitalized” institutions are subject to the appointment of a receiver or conservator.

For information regarding the capital ratios and leverage ratio of Cullen/ Frost and Frost Bank see the discussion under the section captioned “Capital and Liquidity” included in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 12 — Regulatory Matters in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, elsewhere in this report.

The federal regulatory authorities’ risk-based capital guidelines are based upon the 1988 capital accord of the Basel Committee on Banking Supervision (the “BIS”). The BIS is a committee of central banks and bank supervisors/regulators from the major industrialized countries that develops broad policy guidelines for use by each country’s supervisors in determining the supervisory policies they apply. In January 2001, the BIS released a proposal to replace the 1988 capital accord with a new capital accord that would set capital requirements for operational risk and refine the existing capital requirements for credit risk and market risk exposures. Operational risk is defined to mean the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems in connection with external events. The 1988 capital accord does

not include separate capital requirements for operational risk. The BIS has stated that its objective is to finalize a new capital accord by mid-year 2004 and for member countries to implement the accord by year-end 2006. The ultimate timing for a new accord, and the specifics of capital assessments for addressing operational risk, are uncertain. However, it is possible that a new capital accord addressing operational risk will eventually be adopted by the BIS and implemented by the United States federal bank regulatory authorities. The new capital requirements that may arise out of a new BIS capital accord could increase minimum capital requirements applicable to Cullen/ Frost and its subsidiaries.


	Deposit Insurance

Substantially all of the deposits of Frost Bank are insured up to applicable limits by the Bank Insurance Fund (“BIF”) of the FDIC and are subject to deposit insurance assessments to maintain the BIF. The FDIC utilizes a risk-based assessment system that imposes insurance premiums based upon a matrix that takes into account a bank’s capital level and supervisory rating. Frost Bank was not required to pay any deposit insurance premiums in 2003; however, it is possible that the FDIC could impose assessment rates in the future in connection with declines in the insurance funds or increases in the amount of insurance coverage. During 2003, Frost Bank paid Financing Corporation (“FICO”) assessments related to outstanding FICO bonds of $1.2 million to the FDIC as collection agent. The FICO is a mixed-ownership government corporation established by the Competitive Equality Banking Act of 1987 whose sole purpose was to function as a financing vehicle for the now defunct Federal Savings & Loan Insurance Corporation (“FSLIC”).


	Depositor Preference

The Federal Deposit Insurance Act provides that, in the event of the “liquidation or other resolution” of an insured depository institution, the claims of depositors of the institution, including the claims of the FDIC as subrogee of insured depositors, and certain claims for administrative expenses of the FDIC as a receiver, will have priority over other general unsecured claims against the institution. If an insured depository institution fails, insured and uninsured depositors, along with the FDIC, will have priority in payment ahead of unsecured, non-deposit creditors, including the parent bank holding company, with respect to any extensions of credit they have made to such insured depository institution.


	Liability of Commonly Controlled Institutions

FDIC-insured depository institutions can be held liable for any loss incurred, or reasonably expected to be incurred, by the FDIC due to the default of an FDIC-insured depository institution controlled by the same bank holding company, or for any assistance provided by the FDIC to an FDIC-insured depository institution controlled by the same bank holding company that is in danger of default. “Default” means generally the appointment of a conservator or receiver. “In danger of default” means generally the existence of certain conditions indicating that default is likely to occur in the absence of regulatory assistance.


	Community Reinvestment Act

The Community Reinvestment Act (“CRA”) requires depository institutions to assist in meeting the credit needs of their market areas consistent with safe and sound banking practice. Under the CRA, each depository institution is required to help meet the credit needs of its market areas by, among other things, providing credit to low- and moderate-income individuals and communities. Depository institutions are periodically examined for compliance with the CRA and are assigned ratings. In order for a financial holding company to commence any new activity permitted by the BHC Act, or to acquire any company engaged in any new activity permitted by the BHC Act, each insured depository institution subsidiary of the financial holding company must have received a rating of at least “satisfactory” in its most recent examination under the CRA. Furthermore, banking regulators take into account CRA ratings when considering approval of a proposed transaction.


	Financial Privacy

In accordance with the GLB Act, federal banking regulators adopted rules that limit the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties. These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to a nonaffiliated third party. The privacy provisions of the GLB Act affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors.


	USA PATRIOT Act of 2001

The USA PATRIOT Act of 2001 (the “USA Patriot Act”) was signed into law primarily as result of the terrorist attacks of September 11, 2001. The USA Patriot Act is comprehensive anti-terrorism legislation that substantially broadened the scope of anti-money laundering laws and regulations by imposing significant new compliance and due diligence obligations, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the United States.

The regulations adopted by the United States Treasury Department under the USA Patriot Act impose new obligations on financial institutions, such as Frost Bank and Cullen/ Frost’s broker-dealer subsidiary, to maintain appropriate policies, procedures and control to detect, prevent and report money laundering and terrorist financing. Additionally, the regulations require that the Corporation, upon request from the appropriate federal regulatory agency, provide records related to anti-money laundering, perform due diligence of private banking and correspondent accounts, establish standards for verifying customer identity and perform other related duties.

Failure of a financial institution to comply with the USA Patriot Act’s requirements could have serious legal and reputational consequences for the institution.


	Legislative Initiatives

From time to time, various legislative and regulatory initiatives are introduced in Congress and state legislatures, as well as by regulatory agencies. Such initiatives may include proposals to expand or contract the powers of bank holding companies and depository institutions or proposals to substantially change the financial institution regulatory system. Such legislation could change banking statutes and the operating environment of the Corporation in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. The Corporation cannot predict whether any such legislation will be enacted, and, if enacted, the effect that it, or any implementing regulations, would have on the financial condition or results of operations of the Corporation. A change in statutes, regulations or regulatory policies applicable to the Cullen/ Frost or any of its subsidiaries could have a material effect on the business of the Corporation.

Employees

At December 31, 2003, the Corporation employed 3,268 full-time equivalent employees. None of the Corporation’s employees are represented by collective bargaining agreements. The Corporation believes its employee relations to be good.

Executive Officers of the Registrant

The names, ages as of December 31, 2003, recent business experience and positions or offices held by each of the executive officers of Cullen/ Frost are as follows:


Name and Position Held	Age		Recent Business Experience

T.C. Frost Senior Chairman of the Board and Director		76	Officer and Director of Frost Bank since 1950. Chairman of the Board of Cullen/ Frost from 1973 to October 1995. Member of the Executive Committee of Cullen/Frost from 1973 to present. Chief Executive Officer of Cullen/ Frost from July 1977 to October 1997. Senior Chairman of Cullen/ Frost from October 1995 to present.
Richard W. Evans, Jr. Chairman of the Board, Chief Executive Officer and Director		57	Officer of Frost Bank since 1973. Executive Vice President of Frost Bank from 1978 to April 1985. President of Frost Bank from April 1985 to August 1993. Chairman of the Board and Chief Executive Officer of Frost Bank from August 1993 to present. Director and Member of the Executive Committee of Cullen/ Frost from August 1993 to present. Chairman of the Board and Chief Operating Officer of Cullen/ Frost from October 1995 to October 1997. Chairman of the Board and Chief Executive Officer of Cullen/ Frost from October 1997 to present.
Patrick B. Frost President of Frost Bank and Director		43	Officer of Frost Bank since 1985. President of Frost Bank from August 1993 to present. Director of Cullen/ Frost from May 1997 to present. Member of the Executive Committee of Cullen/ Frost from July 1997 to present.
Phillip D. Green Group Executive Vice President and Chief Financial Officer		49	Officer of Frost Bank since July 1980. Vice President and Controller of Frost Bank from January 1981 to January 1983. Senior Vice President and Controller of Frost Bank from January 1983 to July 1985. Senior Vice President and Treasurer of Cullen/Frost from July 1985 to April 1989. Executive Vice President and Treasurer of Cullen/Frost from May 1989 to October 1995. Executive Vice President and Chief Financial Officer of Cullen/Frost from October 1995 to July 1998. Senior Executive Vice President and Chief Financial Officer from July 1998 to May 2001. Group Executive Vice President and Chief Financial Officer from May 2001 to present.

There are no arrangements or understandings between any executive officer of Cullen/ Frost and any other person pursuant to which such executive officer was or is to be selected as an officer.

Available Information

Under the Securities Exchange Act of 1934, Cullen/ Frost is required to file annual, quarterly and current reports, proxy statements and other information with the Securities and Exchange Commission (“SEC”). You may read and copy any document Cullen/ Frost files with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information about the public reference room. The SEC maintains a website at http://www.sec.gov that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. Cullen/ Frost files electronically with the SEC.

Cullen/ Frost makes available, free of charge through its website, its reports on Forms 10-K, 10-Q and 8-K, and amendments to those reports, as soon as reasonably practicable after such reports are filed with the SEC. Additionally, the Corporation has adopted and posted on its website a code of ethics that applies to its principal executive officer, principal financial officer and principal accounting officer. The Corporation’s website also includes its corporate governance guidelines and the charters for its audit committee, its compensation and benefits committee, and its corporate governance and nominating committee. The address for the Corporation’s website is http://www.frostbank.com. The Corporation will provide a printed copy of any of the aforementioned documents to any shareholder that requests it.

ITEM 2. PROPERTIES

The Corporation’s primary offices are located in downtown San Antonio, Texas. These facilities, which are owned by the Corporation, house the Corporation’s executive and primary administrative offices as well as the principal banking headquarters of Frost Bank. The Corporation also owns or leases other facilities within its primary market areas of Austin, Boerne, Corpus Christi, Dallas, Fort Worth, Galveston, Harlingen, Houston, McAllen, New Braunfels, San Antonio and San Marcos. The Corporation considers its properties to be suitable and adequate for its present needs.

ITEM 3. LEGAL PROCEEDINGS

The Corporation is subject to various claims and legal actions that have arisen in the normal course of conducting business. Management does not expect the ultimate disposition of these matters to have a material adverse impact on the Corporation’s financial statements.

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

No matters were submitted to a vote of security holders during the fourth quarter of 2003.

PART II


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


	Common Stock Market Prices and Dividends

The Corporation’s common stock is traded on The New York Stock Exchange, Inc. (“NYSE”) under the symbol “CFR”. The tables below set forth for each quarter of 2003 and 2002 the high and low intra-day sales prices per share of Cullen/ Frost’s common stock as reported by the NYSE and the cash dividends declared per share.



	2003				2002

Sales Price Per Share	High		Low		High		Low


First quarter	$	33.90	$	29.05	$	36.51	$	29.65
Second quarter		34.60		30.05		40.75		33.59
Third quarter		39.00		32.00		38.26		28.30
Fourth quarter		41.06		37.31		35.90		29.30


Cash Dividends Per Share		2003		2002


First quarter		$	0.22	$	0.215
Second quarter			0.24		0.220
Third quarter			0.24		0.220
Fourth quarter			0.24		0.220

	Total	$	0.94	$	0.875

As of December 31, 2003, there were 51,776,093 shares of the Corporation’s common stock outstanding held by 1,948 holders of record. The closing price per share of common stock on December 31, 2003, was $40.57.

The Corporation’s management is currently committed to continuing to pay regular cash dividends; however, there is no assurance as to future dividends because they are dependent on future earnings, capital requirements and financial conditions. See the section captioned “Supervision and Regulation” included in Item 1. Business, the section captioned “Capital and Liquidity” included in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 12 — Regulatory Matters in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, all of which are included elsewhere in this report.

Stock-Based Compensation Plans

Information regarding stock-based compensation awards outstanding and available for future grants as of December 31, 2003, segregated between stock-based compensation plans approved by shareholders and stock-based compensation plans not approved by shareholders, is presented in the table below. Additional information regarding stock-based compensation plans is presented in Note 13 — Employee Benefit Plans in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data elsewhere in this report.


				Weighted-Average
		Number of Shares		Exercise
		to be Issued Upon		Price of		Number of Shares
		Exercise of		Outstanding		Available for
Plan Category		Outstanding Awards		Awards		Future Grants


Plans approved by shareholders			6,897,900	$	26.97		1,920,573
Plans not approved by shareholders			—		—		—

	Total		6,897,900	$	26.97		1,920,573

Stock Repurchase Plans

During the third quarter of 2001, the Corporation initiated a program to repurchase, from time to time, up to 2.6 million shares of its common stock over a two-year period at various prices in the open market or through private transactions. The Corporation did not repurchase any shares under this program during the first nine months of 2003. The repurchase program terminated in the third quarter of 2003 and a total of 1.2 million shares at a cost of $39.2 million were repurchased under this program. During the fourth quarter of 2003, the Corporation initiated a new program to repurchase, from time to time, up to 1.2 million shares of its common stock over a two-year period at various prices in the open market or through private transactions. As of December 31, 2003, 268 thousand shares at a cost of $10.7 million have been repurchased under this program.

ITEM 6. SELECTED FINANCIAL DATA

The following consolidated selected financial data is derived from the Corporation’s audited financial statements as of and for the five years ended December 31, 2003. The following consolidated financial data should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and related notes included elsewhere in this report. All of the Corporation’s acquisitions during the five years ended December 31, 2003 were accounted for using the purchase method. Accordingly, the operating results of the acquired companies are included with the Corporation’s results of operations since their respective dates of acquisition. Additionally, prior year amounts have been restated to de-consolidate the Corporation’s investment in Cullen/ Frost Capital Trust I in connection with the implementation of a new accounting standard related to variable interest entities during the fourth quarter of 2003 (see Note 23 — New Accounting Standards in the accompanying notes to consolidated financial statements included elsewhere in this report). Dollar amounts are in thousands, except per share data.



			Year Ended December 31,

			2003		2002			2001			2000			1999


Consolidated Statements of Income
Interest income:
	Loans, including fees		$	233,463	$	265,514		$	343,928		$	394,073		$	329,610
	Securities			125,778		120,221			106,933			109,248			113,561
	Interest-bearing deposits			104		172			200			331			122
	Federal funds sold and securities purchased under resale agreements			9,601		3,991			9,784			8,488			4,172

		Total interest income		368,946		389,898			460,845			512,140			447,465
Interest expense:
	Deposits			37,406		55,384			118,699			158,858			128,819
	Federal funds purchased and securities sold under repurchase agreements			4,059		5,359			12,054			17,889			12,500
	Junior subordinated deferrable interest debentures			8,735		8,735			8,735			8,735			8,735
	Subordinated notes payable and other borrowings			4,988		6,647			5,531			4,346			808

		Total interest expense		55,188		76,125			145,019			189,828			150,862

		Net interest income		313,758		313,773			315,826			322,312			296,603
Provision for possible loan losses				10,544		22,546			40,031			14,103			12,427

		Net interest income after provision for possible loan losses		303,214		291,227			275,795			308,209			284,176
Non-interest income:
	Trust fees			47,486		47,463			48,784			49,266			46,411
	Service charges on deposit accounts			87,805		78,417			70,534			60,627			58,787
	Insurance commissions and fees			28,660		25,912			18,598			10,698			3,912
	Other charges, commissions and fees			18,668		16,860			16,176			15,548			13,279
	Net gain (loss) on securities transactions			40		88			78			4			(86	)
	Other			32,702		32,229			29,547			29,472			28,426

		Total non-interest income		215,361		200,969			183,717			165,615			150,729
Non-interest expense:
	Salaries and wages			146,622		139,227			138,347			133,525			119,902
	Employee benefits			38,316		34,614			35,000			28,808			25,944
	Net occupancy			29,286		28,883			29,419			27,693			27,045
	Furniture and equipment			21,768		22,597			23,727			21,329			19,892
	Intangible amortization			5,886		7,083			15,127			15,625			15,000
	Restructuring charges			—		—			19,865			—			—
	Other			84,157		79,738			78,172			76,832			75,252

		Total non-interest expense		326,035		312,142			339,657			303,812			283,035
Income from continuing operations before income taxes and cumulative effect of accounting change				192,540		180,054			119,855			170,012			151,870
Income taxes				62,039		57,821			39,749			58,746			52,116

Income from continuing operations				130,501		122,233			80,106			111,266			99,754
Loss from discontinued operations, net of tax				—		(5,247	)		(2,200	)		(2,449	)		(2,112	)
Cumulative effect of change in accounting for derivatives, net of tax				—		—			3,010			—			—

		Net income	$	130,501	$	116,986		$	80,916		$	108,817		$	97,642

Selected Financial Data (continued)



		As of or for the Year Ended December 31,

		2003			2002			2001			2000			1999


Per Common Share Data
Basic:
	Income from continuing operations	$	2.54		$	2.40		$	1.55		$	2.13		$	1.87
	Net income		2.54			2.29			1.57			2.09			1.83
Diluted:
	Income from continuing operations		2.48			2.33			1.50			2.07			1.82
	Net income		2.48			2.23			1.52			2.03			1.78
Cash dividends declared and paid			0.94			0.875			0.84			0.76			0.675
Book value			14.87			13.72			11.58			11.14			9.64
Common Shares Outstanding
Period-end			51,776			51,295			51,355			51,430			52,823
Weighted-average shares — basic			51,442			51,001			51,530			52,123			53,368
Dilutive effect of stock compensation			1,216			1,422			1,818			1,534			1,378
Weighted-average shares — diluted			52,658			52,423			53,348			53,657			54,746
Performance Ratios
Return on average assets:
	Income from continuing operations		1.36	%		1.46	%		1.02	%		1.56	%		1.45	%
	Net income		1.36			1.40			1.03			1.52			1.42
Return on average equity:
	Income from continuing operations		17.78			18.77			13.05			20.87			19.08
	Net income		17.78			17.96			13.18			20.41			18.68
Net interest income to average earning assets			3.98			4.58			4.89			5.32			5.15
Dividend pay-out ratio			37.15			38.24			53.51			36.35			36.88
Balance Sheet Data
Period-end:
	Loans	$	4,590,746		$	4,518,913		$	4,518,608		$	4,534,645		$	4,166,728
	Earning assets		8,132,479			7,709,980			6,811,284			6,421,753			5,838,135
	Total assets		9,672,114			9,536,050			8,375,461			7,665,006			7,001,369
	Non-interest-bearing demand deposits		3,143,473			3,229,052			2,669,829			2,118,624			1,863,260
	Interest-bearing deposits		4,925,384			4,399,091			4,428,178			4,381,066			4,090,572
	Total deposits		8,068,857			7,628,143			7,098,007			6,499,690			5,953,832
	Long-term debt and other borrowings		255,845			271,257			284,152			139,307			120,256
	Shareholders’ equity		770,004			703,790			594,919			573,026			509,311
Average:
	Loans	$	4,497,489		$	4,536,999		$	4,546,596		$	4,352,868		$	3,934,406
	Earning assets		8,011,081			6,961,439			6,564,678			6,148,154			5,857,721
	Total assets		9,583,829			8,353,145			7,841,823			7,154,300			6,880,109
	Non-interest-bearing demand deposits		3,037,724			2,540,432			2,186,690			1,897,172			1,792,257
	Interest-bearing deposits		4,539,622			4,353,878			4,364,667			4,154,498			4,056,587
	Total deposits		7,577,346			6,894,310			6,551,357			6,051,670			5,848,844
	Long-term debt and other borrowings		264,428			275,136			200,166			170,105			117,072
	Shareholders’ equity		733,994			651,273			614,010			533,125			522,770
Asset Quality
Allowance for possible loan losses		$	83,501		$	82,584		$	72,881		$	63,265		$	58,345
Allowance for possible loan losses to period-end loans			1.82	%		1.83	%		1.61	%		1.40	%		1.40	%
Net loan charge-offs		$	9,627		$	12,843		$	30,415		$	9,183		$	8,764
Net loan charge-offs to average loans			0.21	%		0.28	%		0.67	%		0.21	%		0.22	%
Non-performing assets		$	52,794		$	42,908		$	37,430		$	18,933		$	18,837
Non-performing assets to:
	Total loans plus foreclosed assets		1.15	%		0.95	%		0.83	%		0.42	%		0.45	%
	Total assets		0.55			0.45			0.45			0.25			0.27
Consolidated Capital Ratios
	Tier 1 risk-based capital ratio		11.42	%		10.46	%		10.14	%		10.08	%		11.04	%
	Total risk-based capital ratio		15.01			14.16			13.98			11.24			12.28
	Leverage ratio		7.83			7.25			7.21			7.54			7.56
	Average shareholders’ equity to average total assets		7.66			7.80			7.83			7.45			7.60
Non-Financial Data
	Number of employees		3,268			3,183			3,387			3,394			3,336
	Shareholders of record		1,948			2,038			2,179			2,250			2,442

The following tables set forth unaudited consolidated selected quarterly statement of operations data for the years ended December 31, 2003 and 2002. Reported amounts have been restated to de-consolidate the Corporation’s investment in Cullen/ Frost Capital Trust I in connection with the implementation of a new accounting standard related to variable interest entities during the fourth quarter of 2003 (see Note 23 — New Accounting Standards in the accompanying notes to consolidated financial statements included elsewhere in this report). Dollar amounts are in thousands, except per share data.



		Year Ended December 31, 2003

		4th		3rd		2nd		1st
		Quarter		Quarter		Quarter		Quarter


Interest income		$	91,949	$	89,851	$	93,423	$	93,723
Interest expense			12,423		12,397		14,754		15,614

Net interest income			79,526		77,454		78,669		78,109
Provision for possible loan losses			1,500		1,998		3,446		3,600
Non-interest income			52,852		55,211		55,260		52,038
Non-interest expense			82,466		82,282		80,216		81,071

Income before income taxes			48,412		48,385		50,267		45,476
Income taxes			15,777		15,622		16,034		14,606

Net income		$	32,635	$	32,763	$	34,233	$	30,870

Net income per common share:
	Basic	$	0.63	$	0.64	$	0.67	$	0.60
	Diluted		0.61		0.62		0.65		0.59



		Year Ended December 31, 2003

		4th		3rd			2nd			1st
		Quarter		Quarter			Quarter			Quarter


Interest income		$	95,939	$	98,066		$	98,488		$	97,405
Interest expense			17,423		19,128			19,009			20,565

Net interest income			78,516		78,938			79,479			76,840
Provision for possible loan losses			4,500		5,850			5,396			6,800
Non-interest income			49,743		50,498			52,204			48,524
Non-interest expense			79,416		78,044			77,559			77,123

Income from continuing operations before income taxes			44,343		45,542			48,728			41,441
Income taxes			14,189		14,760			15,651			13,221

Income from continuing operations			30,154		30,782			33,077			28,220

Loss from discontinued operations, net of tax			—		(4,320	)		(424	)		(503	)
Net income		$	30,154	$	26,462		$	32,653		$	27,717

Basic per common share:
	Income from continuing operations	$	0.59	$	0.60		$	0.65		$	0.55
	Net income		0.58		0.59			0.62			0.53
Diluted per common share:
	Income from continuing operations	$	0.59	$	0.52		$	0.64		$	0.54
	Net income		0.58		0.51			0.61			0.52


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

Forward-Looking Statements and Factors that Could Affect Future Results

Certain statements contained in this Annual Report on Form 10-K that are not statements of historical fact constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (the “Act”), notwithstanding that such statements are not specifically identified. In addition, certain statements may be contained in the Corporation’s future filings with the SEC, in press releases, and in oral and written statements made by or with the approval of the Corporation that are not statements of historical fact and constitute forward-looking statements within the meaning of the Act. Examples of forward-looking statements include, but are not limited to: (i) projections of revenues, income or loss, earnings or loss per share, the payment or nonpayment of dividends, capital structure and other financial items; (ii) statements of plans and objectives of Cullen/ Frost or its management or Board of Directors, including those relating to products or services; (iii) statements of future economic performance; and (iv) statements of assumptions underlying such statements. Words such as “believes”, “anticipates”, “expects”, “intends”, “targeted” and similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements.

Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those in such statements. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to:


	•	Local, regional and international economic conditions and the impact they may have on the Corporation and its customers and the Corporation’s assessment of that impact.

	•	Changes in estimates of future reserve requirements based upon the periodic review thereof under relevant regulatory and accounting requirements.

	•	The effects of and changes in trade, monetary and fiscal policies and laws, including interest rate policies of the Federal Reserve Board.

	•	Inflation, interest rate, market and monetary fluctuations.

	•	Political instability.

	•	Acts of war or terrorism.

	•	The timely development and acceptance of new products and services and perceived overall value of these products and services by users.

	•	Changes in consumer spending, borrowings and savings habits.

	•	Technological changes.

	•	Acquisitions and integration of acquired businesses.

	•	The ability to increase market share and control expenses.

	•	Changes in the competitive environment among financial holding companies.

	•	The effect of changes in laws and regulations (including laws and regulations concerning taxes, banking, securities and insurance) with which the Corporation and its subsidiaries must comply.

	•	The effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Financial Accounting Standards Board and other accounting standard setters.

	•	Changes in the Corporation’s organization, compensation and benefit plans.

	•	The costs and effects of litigation and of unexpected or adverse outcomes in such litigation.

	•	Greater than expected costs or difficulties related to the integration of new lines of business.

	•	The Corporation’s success at managing the risks involved in the foregoing items.

Forward-looking statements speak only as of the date on which such statements are made. The Corporation undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made, or to reflect the occurrence of unanticipated events.

The Corporation

Cullen/ Frost Bankers, Inc. (Cullen/ Frost) is a financial holding company and a bank holding company headquartered in San Antonio, Texas that provides, through its wholly owned subsidiaries (collectively referred to as the “Corporation”), a broad array of products and services throughout 12 Texas markets. The Corporation offers commercial and consumer banking services, as well as trust and investment management, investment banking, insurance brokerage, leasing, asset-based lending, treasury management and item processing services.

Application of Critical Accounting Policies and Accounting Estimates

The accounting and reporting policies followed by the Corporation conform, in all material respects, to accounting principles generally accepted in the United States and to general practices within the financial services industry. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. While the Corporation bases estimates on historical experience, current information and other factors deemed to be relevant, actual results could differ from those estimates.

The Corporation considers accounting estimates to be critical to reported financial results if (i) the accounting estimate requires management to make assumptions about matters that are highly uncertain and (ii) different estimates that management reasonably could have used for the accounting estimate in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, could have a material impact on the Corporation’s financial statements. Accounting polices related to the allowance for possible loan losses are considered to be critical, as these policies involve considerable subjective judgment and estimation by management. The Corporation also considers accounting policies related to stock-based compensation to be critical due to the continuously evolving standards, changes to which could materially impact the way the Corporation accounts for stock options. Critical accounting policies, and the Corporation’s procedures related to these policies, are described in detail below. Also see Note 1 — Summary of Significant Accounting Policies in the accompanying notes to consolidated financial statements included elsewhere in this report.

Allowance for Possible Loan Losses. The allowance for possible loan losses is a reserve established through a provision for possible loan losses charged to expense, which represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The allowance for possible loan losses includes allowance allocations calculated in accordance with Statement of Financial Accounting Standards (SFAS) No. 114, “Accounting by Creditors for Impairment of a Loan,” as amended by SFAS 118, and allowance allocations determined in accordance with SFAS No. 5, “Accounting for Contingencies.” The level of the allowance reflects management’s continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality, present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. While management utilizes its best judgment and information available, the ultimate adequacy of the allowance is dependent upon a variety of factors beyond the Corporation’s control, including the performance of the Corporation’s loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications. See the section captioned “Allowance for Possible Loan Losses” elsewhere in this discussion for further details of the risk factors considered by management in estimating the necessary level of the allowance for possible loan losses.

Stock-based Compensation. The Corporation accounts for stock-based employee compensation plans based on the “intrinsic value method” provided in Accounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations. Because the exercise price of the Corporation’s employee stock options equals the market price of the underlying stock on the date of grant, no

compensation expense is recognized on options granted. Compensation expense for restricted stock awards is based on the market price of the stock on the date of grant and is recognized ratably over the vesting period of the award.

SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS 148, requires pro forma disclosures of net income and earnings per share for companies not adopting its fair value accounting method for stock-based employee compensation. The pro forma disclosures presented in Note 13 -Employee Benefit Plans in the accompanying notes to consolidated financial statements included elsewhere in this report use the fair value method of SFAS 123 to measure compensation expense for stock-based employee compensation plans. The fair value of stock options granted was estimated at the date of grant using the Black-Scholes option-pricing model. This model was developed for use in estimating the fair value of publicly traded options that have no vesting restrictions and are fully transferable. Additionally, the model requires the input of highly subjective assumptions. Because the Corporation’s employee stock options have characteristics significantly different from those of publicly traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the Black-Scholes option-pricing model does not necessarily provide a reliable single measure of the fair value of the Corporation’s employee stock options.

The Financial Accounting Standards Board (FASB) is currently working on a project to address issues related to equity-based compensation. The objective of the project is to cooperate with the International Accounting Standards Board (IASB) to achieve convergence to one single, global accounting standard for equity-based compensation. The goal of the project is to address that lack of comparability by resolving the following main issues: (1) whether compensation paid in the form of equity instruments should be recognized in the financial statements and (2) how compensation in the form of equity instruments should be measured in the financial statements.

The FASB has tentatively determined that all equity-based compensation should be recognized in the financial statements beginning in 2005. Companies transitioning to fair value based accounting for equity-based compensation will be required to use the “modified prospective” method or retroactively restate prior periods. Under the “modified prospective” method, companies must recognize equity compensation cost from the beginning of the year in which the recognition provisions are first applied as if the fair value method had been used to account for all awards granted, modified, or settled in fiscal years beginning after December 31, 1994. This results in the recognition of compensation expense for the unvested portion of equity compensation awards outstanding on the date of transition as well as for all subsequent awards. Deliberations as to how equity-based compensation should be measured are ongoing. The FASB is scheduled to issue an exposure draft in the first quarter of 2004 and has set a goal of completing its redeliberations and issuing a final accounting standard in the second half of 2004.

Overview

The following discussion and analysis presents the more significant factors affecting the Corporation’s financial condition as of December 31, 2003 and 2002, and results of operations for each of the three years in the period ended December 31, 2003. This discussion and analysis should be read in conjunction with the Corporation’s consolidated financial statements, notes thereto and other financial information appearing elsewhere in this report. All of the acquisitions during the reported periods were accounted for as purchase transactions, and as such, their related results of operations are included from the date of acquisition. None of the acquisitions had a material impact on the Corporation’s financial statements. See Note 2 — Acquisitions in the accompanying notes to consolidated financial statements included elsewhere in this report.

Prior year financial statements have been restated to de-consolidate the Corporation’s investment in Cullen/ Frost Capital Trust I in connection with the implementation of a new accounting standard related to variable interest entities during 2003 (see Note 23 — New Accounting Standards). Additionally, in 2002, the Corporation discontinued the operations of the capital markets division of its investment banking subsidiary, Frost Securities, Inc. (“FSI”). All operating results for this discontinued component of the Corporation’s operations have been reclassified to “discontinued operations” and are reported separately, net of tax, in the

income statement. All prior periods have been restated to reflect this change. See Note 21 — Discontinued Operations in the accompanying notes to consolidated financial statements included elsewhere in this report.

Taxable-equivalent adjustments are the result of increasing income from tax-free loans and investments by an amount equal to the taxes that would be paid if the income were fully taxable based on a 35% federal tax rate, thus making tax-exempt yields comparable to taxable asset yields.

Dollar amounts in tables are stated in thousands, except for per share amounts.

Results of Operations

Net income totaled $130.5 million, or $2.48 diluted per common share, in 2003 compared to $117.0 million, or $2.23 diluted per common share, in 2002 and $80.9 million, or $1.52 diluted per common share, in 2001. Income from continuing operations was equal to reported net income in 2003, while income from continuing operations totaled $122.2 million, or $2.33 diluted per common share, in 2002 and $80.1 million, or $1.50 diluted per common share in 2001. Income from continuing operations does not include the net after-tax effect of losses from the discontinued FSI operations, which totaled $5.2 million in 2002 and $2.2 million in 2001. Additionally, in 2001, income from continuing operations does not include the $3.0 million net after-tax increase to earnings representing the cumulative effect of a change in accounting for derivatives.

On January 1, 2002, in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” the Corporation ceased amortizing goodwill. If the non-amortization of goodwill provisions of SFAS 142 had been in effect in 2001, net income would have been $88.2 million, or $1.65 diluted per common share, and income from continuing operations would have been $87.4 million, or $1.64 diluted per common share. See Note 7 — Goodwill and Other Intangible Assets in the accompanying notes to consolidated financial statements included elsewhere in this report.

Selected income statement data, returns on average assets and average equity and dividends per share for the comparable periods were as follows:


			2003			2002			2001


Taxable-equivalent net interest income			$	318,945		$	318,772		$	320,695
Taxable-equivalent adjustment				5,187			4,999			4,869

Net interest income				313,758			313,773			315,826
Provision for possible loan losses				10,544			22,546			40,031
Non-interest income				215,361			200,969			183,717
Non-interest expense:
	Intangible amortization			5,886			7,083			15,127
	Restructuring charges			—			—			19,865
	Other			320,149			305,059			304,665

		Total non-interest expense		326,035			312,142			339,657

Income from continuing operations before income taxes and cumulative effect of accounting change				192,540			180,054			119,855
Income taxes				62,039			57,821			39,749

Income from continuing operations				130,501			122,233			80,106
Loss from discontinued operations, net of tax				—			(5,247	)		(2,200	)
Cumulative effect of change in accounting for derivatives, net of tax				—			—			3,010

Net income			$	130,501		$	116,986		$	80,916

Basic per common share:
	Income from continuing operations		$	2.54		$	2.40		$	1.55
	Net income			2.54			2.29			1.57
Diluted per common share:
	Income from continuing operations		$	2.48		$	2.33		$	1.50
	Net income			2.48			2.23			1.52
Return on average assets:
	Income from continuing operations			1.36	%		1.46	%		1.02	%
	Net income			1.36			1.40			1.03
Return on average equity:
	Income from continuing operations			17.78	%		18.77	%		13.05	%
	Net income			17.78			17.96			13.18

As stated above, the 2002 and 2001 net income amounts include the net after-tax effect of losses from the discontinued FSI operations. Additionally, in 2001, net income includes the $3.0 million net after-tax increase to earnings representing the cumulative effect of a change in accounting for derivatives. Because of these items, management believes an analysis of income from continuing operations provides a more relevant comparison. Income from continuing operations for 2003 increased $8.3 million, or 6.8%, compared to 2002. The increase was primarily the result of a $14.4 million increase in non-interest income and a $12.0 million decrease in the provision for possible loan losses. The impact of these items was partly offset by a $13.9 million increase in non-interest expense and a $4.2 million increase in income tax expense. Income from continuing operations for 2002 increased $42.1 million, or 52.6%, compared to 2001. The increase was primarily due to a $27.5 million decrease in non-interest expense, a $17.5 million decrease in the provision for possible loan losses and a $17.3 million increase in non-interest income. The impact of these items was partly offset by a $2.1 million decrease in net interest income and increased income taxes resulting from the higher level of earnings.

Details of the changes in the various components of net income are further discussed below.

Net Interest Income

Net interest income is the difference between interest income on earning assets, such as loans and securities, and interest expense on liabilities, such as deposits and borrowings, which are used to fund those assets. Net interest income is the Corporation’s largest source of revenue, representing 59.3% of total revenue during 2003. Net interest margin is the taxable-equivalent net interest income as a percentage of average earning assets for the period. The level of interest rates and the volume and mix of earning assets and interest-bearing liabilities impact net interest income and net interest margin.

The Federal Reserve Board influences the general market rates of interest, including the deposit and loan rates offered by many financial institutions. The Corporation’s loan portfolio is significantly affected by changes in the prime interest rate. The prime interest rate, which is the rate offered on loans to borrowers with strong credit, began 2001 at 9.50% and decreased 150 basis points in the first quarter, decreased 125 basis points in the second quarter, decreased 75 basis points in the third quarter and decreased 125 basis points in the fourth quarter to end the year at 4.75%. During 2002, the prime rate remained at 4.75% until the fourth quarter when the rate decreased 50 basis points to 4.25%. During 2003, the prime rate remained at 4.25% until the end of the second quarter, when the rate decreased 25 basis points to 4.00%. The federal funds rate, which is the cost of immediately available overnight funds, decreased in a similar manner. It began 2001 at 6.50% and decreased 475 basis points over the course of the year, and it began 2002 at 1.75% and decreased 50 basis points in the fourth quarter. During 2003, the federal funds rate remained at 1.25% until the end of the second quarter, when the rate decreased 25 basis points to 1.00%.

The Corporation’s balance sheet is asset sensitive, meaning that earning assets generally reprice more quickly than interest-bearing liabilities. Therefore, the Corporation’s net interest margin is likely to increase in sustained periods of rising interest rates and decrease in sustained periods of declining interest rates. The Corporation is primarily funded by core deposits, with demand deposits historically being a significant source of funds. This lower-cost funding base has historically had a positive impact on the Corporation’s net interest income and net interest margin. However, in a sustained declining interest rate environment, such as the interest rate environment experienced since early 2001, the Corporation experiences compression of its net interest margin. This compression results from resistance to further reductions in the interest rates paid on the Corporation’s already low cost deposit base, which, in turn, results in a disproportionately larger decrease in the yields on the Corporation’s earning assets. Further analysis of the components of the Corporation’s net interest margin is presented below.

The following table presents the changes in taxable-equivalent net interest income and identifies the changes due to differences in the average volume of earning assets and interest-bearing liabilities and the changes due to changes in the average interest rate on those assets and liabilities. The changes in net interest income due to changes in both average volume and average interest rate have been allocated to the average volume change or the average interest rate change in proportion to the absolute amounts of the change in each. The Corporation’s consolidated average balance sheets along with an analysis of taxable-equivalent net interest earnings are presented on pages 96 and 97 of this report.



			2003 vs. 2002									2002 vs. 2001


			Increase (decrease)									Increase (decrease)
			due to change in									due to change in

			Rate			Volume			Total			Rate			Volume			Total


Interest-bearing deposits			$	(29	)	$	(66	)	$	(95	)	$	(325	)	$	193		$	(132	)
Securities:
	U.S. Treasury			(222	)		(152	)		(374	)		(1,013	)		(593	)		(1,606	)
	U.S. government agencies and corporations			(20,003	)		25,747			5,744			(9,407	)		24,098			14,691
	States and political subdivisions
		Tax-exempt		(779	)		1,270			491			(174	)		1,018			844
		Taxable		1			(48	)		(47	)		3			(47	)		(44	)
	Other			(268	)		204			(64	)		(342	)		47			(295	)
Federal funds sold and resale agreements				(1,436	)		7,046			5,610			(5,481	)		(312	)		(5,793	)
Loans				(29,732	)		(2,297	)		(32,029	)		(77,757	)		(725	)		(78,482	)

		Total earning assets		(52,468	)		31,704			(20,764	)		(94,496	)		23,679			(70,817	)
Savings and Interest-on-Checking				(968	)		84			(884	)		(1,939	)		134			(1,805	)
Money market deposits accounts				(6,693	)		3,434			(3,259	)		(24,956	)		805			(24,151	)
Time accounts				(9,002	)		(2,972	)		(11,974	)		(27,733	)		(4,601	)		(32,334	)
Public funds				(1,782	)		(78	)		(1,860	)		(5,951	)		925			(5,026	)
Federal funds purchased and repurchase agreements				(4,878	)		3,578			(1,300	)		(8,191	)		1,496			(6,695	)
Junior subordinated deferrable interest debentures				—			—			—			—			—			—
Subordinated notes payable and other notes				(1,193	)		(64	)		(1,257	)		(1,491	)		3,657			2,166
Federal Home Loan Bank advances				(105	)		(298	)		(403	)		(512	)		(537	)		(1,049	)

Total interest-bearing liabilities				(24,621	)		3,684			(20,937	)		(70,773	)		1,879			(68,894	)

Changes in net interest income			$	(27,847	)	$	28,020		$	173		$	(23,723	)	$	21,800		$	(1,923	)

Taxable-equivalent net interest income for 2003 did not significantly change compared to 2002 while taxable-equivalent net interest income for 2002 decreased $1.9 million, or 0.6%, compared to 2001. The lack of significant fluctuation between the comparable periods resulted as the positive impact of growth in the average volume of earning assets was offset by the negative impact of declining average interest rates. The average volume of earning assets during 2003 increased almost $1.1 billion compared to 2002 while over the same time period the net interest margin decreased 60 basis points from 4.58% to 3.98%. Similarly, the average volume of earning assets during 2002 increased $396.8 million compared to 2001 while over the same time period the net interest margin decreased 31 basis points from 4.89% to 4.58%. Growth in average earning assets during 2003 was primarily in federal funds sold and securities purchased under resale agreements and U.S. government agency securities. Growth in average earning assets during 2002 was primarily in U.S. government agency securities. The decrease in the net interest margin over the comparable periods was primarily the result of the general decline in market interest rates and the compression resulting from disproportionately larger decreases in the yields on earning assets as explained above. During 2003, the net interest margin was also impacted by the use of dollar-roll repurchase agreements, as discussed in the next paragraph.

The average volume of federal funds sold and securities purchased under resale agreements increased $580.7 million in 2003 compared to 2002. Funding for this growth was primarily provided by increases in dollar-roll repurchase agreements. During the fourth quarter of 2002, the Corporation began to leverage earning assets by utilizing dollar-roll repurchase agreements. A dollar-roll repurchase agreement is similar to an ordinary repurchase agreement, except that the security transferred is a mortgage-backed security and the repurchase provisions of the transaction agreement explicitly allow for the return of a “similar” security rather

than the identical security initially sold. By utilizing dollar-roll repurchase agreements, the Corporation has been able to capitalize on the spread between the yield earned on federal funds sold and securities purchased under resale agreements and the cost of the dollar-roll repurchase agreements. During 2003, the dollar-roll repurchase agreements had a negative average cost of (0.07)% while the average yield earned on federal funds sold and securities purchased under resale agreements was 1.16%. This spread had a positive effect on the dollar amount of net interest income; however, because the funds were invested in lower yielding federal funds sold and securities purchased under resale agreements, the Corporation’s net interest margin was negatively impacted. The average yield on earning assets decreased from 5.67% in 2002 to 4.67% in 2003.

The average volume of U.S. government agency securities increased $498.7 million in 2003 compared to 2002 and increased $409.0 million in 2002 compared to 2001. Funding for this growth was primarily provided by deposit growth. The average volume of deposits increased $683.0 million in 2003 compared to 2002 and increased $343.0 million in 2002 compared to 2001. Non-interest-bearing deposits made up 72.8% of the growth in average deposits in 2003 and all of the growth in average deposits in 2002. Accordingly, the ratio of average non-interest-bearing deposits to total average deposits increased to 40.1% in 2003 from 36.8% in 2002 and 33.4% in 2001. This change in deposit mix, combined with a general decline in market rates, had the effect of (i) reducing the average cost of total deposits by 31 basis points in 2003 compared to 2002 and 101 basis points in 2002 compared to 2001; and, (ii) mitigating a portion of the impact of declining yields on earning assets on the Corporation’s net interest income.

The average volume of loans, the Corporation’s primary category of earning assets, did not significantly fluctuate over the comparable periods; however, the average yield on loans decreased 66 basis points in 2003 compared to 2002 and 172 basis points in 2002 compared to 2001.

The Corporation’s net interest spread, which represents the difference between the average rate earned on earning assets and the average rate paid on interest-bearing liabilities, was 3.69% in 2003 compared to 4.16% in 2002 and 4.14% in 2001. The net interest spread, as well as the net interest margin, will be impacted by future changes in short-term and long-term interest rate levels, as well as the impact from the competitive environment. A discussion of the effects of changing interest rates on net interest income is set forth in Item 7A. Quantitative and Qualitative Disclosures About Market Risk included elsewhere in this report.

The Corporation’s hedging policies permit the use of various derivative financial instruments, including interest rate swaps, caps and floors, to manage exposure to changes in interest rates. Details of the Corporation’s derivatives and hedging activities are set forth in Note 18 — Derivative Financial Instruments in the accompanying notes to consolidated financial statements included elsewhere in this report.

Provision for Possible Loan Losses

The provision for possible loan losses is determined by management as the amount to be added to the allowance for possible loan losses after net charge-offs have been deducted to bring the allowance to a level which, in management’s best estimate, is necessary to absorb probable losses within the existing loan portfolio. The provision for possible loan losses totaled $10.5 million in 2003 compared to $22.5 million in 2002 and $40.0 million in 2001. See the section captioned “Allowance for Possible Loan Losses” elsewhere in this discussion for further analysis of the provision for possible loan losses.

Non-Interest Income

The components of non-interest income were as follows:


		2003		2002		2001


Trust fees		$	47,486	$	47,463	$	48,784
Service charges on deposit accounts			87,805		78,417		70,534
Insurance commissions and fees			28,660		25,912		18,598
Other charges, commissions and fees			18,668		16,860		16,176
Net gain on securities transactions			40		88		78
Other			32,702		32,229		29,547

	Total	$	215,361	$	200,969	$	183,717

Total non-interest income for 2003 increased $14.4 million, or 7.2%, compared to 2002 while total non-interest income for 2002 increased $17.3 million, or 9.4%, compared to 2001. Growth in non-interest income over the comparable periods was primarily in deposit service charges and insurance commissions and fees. Changes in these items and the other components of non-interest income are discussed in more detail below.

Trust Fees. Trust fee income for 2003 did not significantly fluctuate compared to 2002. Investment fees are the most significant component of trust fees, making up approximately 71%, 72% and 75% of total trust fees in 2003, 2002 and 2001. Investment and other custodial account fees are generally based on the market value of assets within a trust account. Volatility in the equity markets impacts the market value of trust assets and the related investment fees.

Trust fee income for 2003 did not significantly fluctuate compared to 2002 as a $1.1 million increase in oil and gas trust management fees and a $167 thousand increase in real estate trust management fees were offset by a $1.0 million decline in investment fees and a $260 thousand decline in estate fees. The increase in oil and gas trust management fees resulted as accounts with oil and gas properties are charged based on energy prices, which saw improvement over 2002. The decline in investment fees was primarily due to weaker equity market conditions overall in 2003 compared to 2002, despite improvements in the latter part of 2003. Additionally, during the first quarter of 2003, the Corporation began outsourcing the administration of certain employee benefit plans, which resulted in lower investment fees.

Trust fee income for 2002 decreased $1.3 million, or 2.7%, compared to 2001 primarily due to declines in investment fees and oil and gas fees. Investment fees declined $1.5 million as declines and volatility in the equity markets negatively impacted the market value of trust assets and the related investment fees during the year. Oil and gas fees declined $1.2 million as a result of a weaker energy market in 2002 relative to 2001. The declines in investment fees and oil and gas fees were partially offset by new revenue from securities lending totaling $686 thousand and a $375 thousand increase in custody fees. The securities lending program, which the Corporation began offering in the fourth quarter of 2001, provides institutional investors the opportunity to add incremental returns on their investment and pension portfolios by lending custodial-held securities to broker/dealers.

At December 31, 2003, trust assets, including both managed assets and custody assets, were primarily composed of equity securities (45.9% of trust assets), fixed income securities (36.4% of trust assets) and cash equivalents (10.5% of trust assets). The estimated fair value of trust assets was approximately $14.8 billion (including managed assets of $6.6 billion and custody assets of $8.2 billion) at December 31, 2003, compared to approximately $12.6 billion (including managed assets of $5.9 billion and custody assets of $6.7 billion) at December 31, 2002 and approximately $13.3 billion (including managed assets of $6.0 billion and custody assets of $7.3 billion) at December 31, 2001.

Service Charges on Deposit Accounts. Service charges on deposit accounts for 2003 increased $9.4 million, or 12.0%, compared to 2002. The increase was primarily due to a $6.1 million increase in overdraft fees, which were mostly related to individual accounts, and a $4.2 million increase in service charges on commercial accounts. The increase in overdraft fees was primarily due to the implementation of an overdraft courtesy program in late 2002. The increase in service charges on commercial accounts was primarily related to

increased treasury management revenues. The increased treasury management revenues resulted primarily from higher levels of billable services as well as a lower earnings credit rate. The earnings credit rate is the value given to deposits maintained by treasury management customers. In a lower rate environment, deposit balances are not as valuable because of a lower earnings credit rate. This results in customers paying for more of their services through fees rather than through the use of deposit balances.

Service charges on deposits for 2002 increased $7.9 million, or 11.2%, compared to 2001 primarily from higher treasury management revenues on commercial accounts. These higher revenues resulted primarily from a lower earnings credit rate, as well as higher levels of billable services.

Effective October 4, 2003, the Corporation reduced certain maintenance and transaction fees applicable to all its consumer checking accounts. Accordingly, in the short-term, management expects this to have a slight negative impact on service charges on deposit accounts. The impact is expected to be less than $1.0 million and spread over several quarters.

Insurance Commissions and Fees. Insurance commissions and fees for 2003 increased $2.7 million, or 10.6%, compared to 2002 primarily due to the combined result of continued selling efforts and the effect of a tighter market for certain products resulting in higher insurance premiums and related commission revenues. Additionally, contingent commissions received from various insurance carriers related to the performance of insurance policies previously placed increased $1.1 million compared to 2002. The Corporation also acquired a small insurance agency during the first quarter of 2003. Growth in insurance commissions and fees depends on the Corporation’s continued selling efforts. Recently, however, the Corporation has begun to experience market pressure related to the pricing of insurance policies and commission levels.

Insurance commissions and fees for 2002 increased $7.3 million, or 39.3%, compared to 2001. The increase was the combined result of the impact of continued selling efforts and the effect of higher insurance premiums on commission revenues, as the insurance market tightened the availability of certain products. Additionally, the Corporation acquired AIS Insurance & Risk Management during the third quarter of 2001. The incremental benefit of this acquisition to insurance commission revenues in 2002 was approximately $2.6 million.

Other Charges, Commissions and Fees. Other charges, commissions and fees for 2003 increased $1.8 million, or 10.7%, compared to 2002. The increase was primarily due to increases in investment banking fees (up $1.5 million), accelerated realization of deferred loan fees due to loan prepayments (up $1.2 million) and increases in various other miscellaneous service charges. The increase in investment banking fees was primarily from corporate advisory services. The Corporation accelerated the realization of certain deferred loan fees because of loan prepayments resulting from the lower interest rate environment. Offsetting the aforementioned increases in other charges, commissions and fee items were decreases in money market fees (down $489 thousand), letter of credit fees (down $376 thousand), and ATM service fees (down $146 thousand) and income associated with the factoring of accounts receivable (down $143 thousand). The decrease in letter of credit fees was primarily due to the deferral of certain fees in accordance with a new accounting standard (see Note 23 — New Accounting Standards in the accompanying notes to consolidated financial statements included elsewhere in this report).

Other charges, commissions and fees for 2002 increased $684 thousand, or 4.2%, compared to 2001. The increase from 2001 was primarily related to higher corporate advisory fees, letter of credit fees, and money market income offset in part by lower income associated with the factoring of accounts receivable.

Other Non-Interest Income. Other non-interest income for 2003 increased $473 thousand, or 1.5%, compared to 2002. The lack of significant change resulted as increases in certain components of other non-interest income were offset by decreases in other components. Components of other non-interest income with significant increases included lease rental income (up $1.3 million), royalty income from mineral interests (up $952 thousand), check card income (up $659 thousand), and gains on sales of foreclosed assets and bank premises (up $1.2 million and $380 thousand, respectively). Components of other non-interest income with significant decreases included gains realized on the sale of student loans (down $1.4 million), annuity income (down $586 thousand) and automated services income generated from a data processing center sold in the

first quarter of 2002 (down $440 thousand). The Corporation also experienced decreases in certain other non-recurring other income items. During 2002, the Corporation sold $117.8 million in student loans with realized gains totaling $3.2 million compared to sales of $50.8 million in student with realized gains totaling $1.8 million during 2003.

Other non-interest income for 2002 increased $2.7 million, or 9.1%, compared to 2001. The increase was primarily due to a $1.8 million increase in gains recognized on the sale of student loans, a $1.5 million increase in earnings from the accretion of the cash surrender value of life insurance (the life insurance policies were purchased during the second quarter of 2001), a $1.6 million increase in annuity fee income and increased checkcard income (primarily from a higher number of cards and increased usage). Partially offsetting the increase was the impact of the sale of a data processing center during the first quarter of 2002, which resulted in approximately $2.0 million less revenues compared to 2001. Additionally, during 2001, the Corporation realized a $1.1 million gain from the sale of an interest rate floor.

Non-Interest Expense

The components of non-interest expense were as follows:


		2003		2002		2001


Salaries and wages		$	146,622	$	139,227	$	138,347
Employee benefits			38,316		34,614		35,000
Net occupancy			29,286		28,883		29,419
Furniture and equipment			21,768		22,597		23,727
Intangible amortization			5,886		7,083		15,127
Restructuring charges			—		—		19,865
Other			84,157		79,738		78,172

	Total	$	326,035	$	312,142	$	339,657

Total non-interest expense for 2003 increased $13.9 million, or 4.5%, compared to 2002 while total non-interest expense for 2002 decreased $27.5 million, or 8.1%, compared to 2001. Growth in non-interest expense in 2003 was primarily in salaries and wages, employee benefits and other non-interest expenses. Excluding the impact of restructuring charges totaling $19.9 million in 2001 and the elimination of goodwill amortization in accordance with a new accounting standard in 2002 (goodwill amortization totaled $8.0 million in 2001), total non-interest expense did not significantly fluctuate between 2001 and 2002. These items and the changes in the various components of non-interest expense are discussed in more detail below.

Salaries and Wages. Salaries and wages expense for 2003 increased $7.4 million, or 5.3%, compared to 2002. The increase is primarily related to increases in headcount, merit increases and increases in commissions paid in connection with increased revenues associated with Frost Insurance Agency. Salaries and wages expense for 2002 increased $880 thousand, or 0.6%, compared to 2001. The lack of any significant increase from 2001 was the result of restructuring actions taken in late 2001, as further discussed below. This impact was offset by the Corporation’s reinstatement of an accrual for performance-related management bonuses eliminated in 2001, a full year of salaries associated with an insurance agency acquired during the second half of 2001 and increased commissions paid in connection with increased revenues associated with Frost Insurance Agency.

Employee Benefits. Employee benefits expense for 2003 increased $3.7 million, or 10.7%, compared to 2002. The increase is primarily related to increases in retirement plan expense, profit sharing plan expense and payroll taxes. Employee benefits expense for 2002 decreased by $386 thousand, or 1.1%, compared to 2001 primarily as a result of restructuring actions taken in late 2001, as further discussed below. These actions resulted in decreases in most employee benefit costs, including retirement plan expense, 401(k) matching expense, payroll taxes and medical insurance costs, primarily due to lower staffing levels. The impact of these items was partly offset by costs related to a newly implemented deferred profit sharing plan and higher workers compensation costs.

The Corporation froze its defined benefit and restoration plans effective as of December 31, 2001. These plans were replaced by a deferred profit sharing plan. Management believes these actions reduce the volatility in retirement plan expense. However, the Corporation still has funding obligations related to the defined benefit and restoration plans and could recognize retirement expense related to these plans in future years, which would be dependent on the return earned on plan assets, the level of interest rates and employee turnover. Employee benefits expense related to the defined benefit and restoration plans totaled $3.1 million in 2003, $1.0 million in 2002 and $8.0 million in 2001. Future expense related to these plans is dependent upon a variety of factors, including the actual return on plan assets. For additional information related to these plans, see Note 13 -Employee Benefit Plans in the accompanying notes to consolidated financial statements included elsewhere in this report

Net Occupancy. Net occupancy expense for 2003 increased $403 thousand, or 1.4%, compared to 2002. The Corporation experienced decreased lease expense resulting from its purchase of the twenty-one story Frost Bank office tower and the adjacent parking garage facility in downtown San Antonio in the second quarter of 2002. The Corporation also experienced an increase in parking garage income as a result of the purchase. The impact of these items was offset by increased building maintenance, insurance and utilities costs, higher depreciation expense on leasehold improvements, higher lease expense related to various other facilities and higher depreciation expense related to the purchased office tower and garage. Net occupancy expense for 2002 decreased $536 thousand, or 1.8%, compared to 2001 primarily due to the reduction in lease expense resulting from the purchases of the aforementioned office tower and parking garage during the second quarter of 2002. This decrease was partially offset by higher lease expense related to various other facilities, higher depreciation expense related to the purchased office tower and garage and costs associated with closing a branch location during 2002.

Furniture and Equipment. Furniture and equipment expense for 2003 decreased $829 thousand, or 3.7%, compared to 2002. The decrease from 2002 is primarily related to a $599 thousand decrease in furniture and equipment depreciation, a $603 thousand decrease in software amortization and a $272 thousand decrease in equipment rental expense partly offset by a $587 thousand increase in software maintenance expense. Furniture and equipment expense for 2002 decreased $1.1 million, or 4.8%, compared to 2001 primarily due to a $711 thousand decrease in furniture and equipment depreciation and a $436 thousand decrease in software maintenance expense.

Intangible Amortization. Intangible amortization is primarily related to core deposit intangibles, and to a lesser extent, intangibles related to non-compete agreements and customer relationships. Intangible amortization for 2003 decreased $1.2 million, or 16.9%, compared to 2002. The decrease is primarily related to the completion of the amortization of certain intangible assets, partly offset by additional amortization related to intangible assets recorded during the first quarter of 2003 in connection with the acquisition of an insurance agency. Intangible amortization for 2002 decreased $8.0 million, or 53.2%, compared to 2001 due to the elimination of goodwill amortization in accordance with the adoption of a new accounting standard on January 1, 2002 (see Note 7 — Goodwill and Other Intangible Assets in the accompanying notes to consolidated financial statements included elsewhere in this report). Intangible amortization for 2001 included $8.0 million of goodwill amortization and $7.1 million of other intangible amortization.

Restructuring Charges. During the fourth quarter of 2001, the Corporation recorded restructuring charges totaling $19.9 million. The restructuring charges included separation and benefit charges of $11.5 million related to a voluntary early retirement program. Voluntary early retirement was accepted by about four percent of the staff. The $11.5 million charge included $6.0 million related to additional pension benefits, $1.4 million for future medical benefits and $4.1 million for cash severance payments based on length of service. The restructuring charges also included a $6.7 million charge related to the freezing of the Corporation’s defined benefit and restoration plans. These plans were replaced by a deferred profit sharing plan. The remaining $1.7 million in restructuring charges related to severance and outplacement services for a two percent reduction in workforce.

Other Non-Interest Expense. Other non-interest expense for 2003 increased $4.4 million, or 5.5%, compared to 2002. Significant components of the increase included professional services expense (up

$1.2 million), expenses related to leased properties (up $1.1 million), advertising/promotional expenses (up $842 thousand), check card expenses (up $651 thousand), and higher federal reserve service charges (up $552 thousand). Due to the lower interest rate environment, the Corporation paid more fees for services rather than through the use of credits related to balances held at the Federal Reserve. The Corporation also experienced less significant increases in various other components of other non-interest expense. The impact of these items was partly offset by decreases in various components of other non-interest expense. Components with significant decreases included losses on foreclosed assets (down $1.1 million), other miscellaneous losses (down $1.2 million), and telephone expense (down $559 thousand).

Other non-interest expense for 2002 increased $1.6 million, or 2.0%, compared to 2001. The increase is primarily related to increases in Federal Reserve service charges (up $1.5 million) due to the lower interest rate environment, losses on foreclosed assets (up $1.1 million) and state sales and use taxes (up $490 thousand). The impact of these items was partly offset by decreases in professional services expense, and decreases in various other miscellaneous operating expenses.

Results of Segment Operations

The Corporation’s operations are managed along two operating segments: Banking and the Financial Management Group (“FMG”). A description of each business and the methodologies used to measure financial performance is described in Note 20 — Operating Segments in the accompanying notes to consolidated financial statements included elsewhere in this report. Net income (loss) by operating segment is presented below:


		2003			2002			2001


Banking		$	132,008		$	120,550		$	90,189
Financial Management Group			7,801			11,158			11,353
Non-Banks			(9,308	)		(9,475	)		(5,514	)
Discontinued operations			—			(5,247	)		(2,200	)
Restructuring charges			—			—			(12,912	)

	Consolidated net income	$	130,501		$	116,986		$	80,916

Banking

Net income for 2003 increased $11.5 million, or 9.5%, compared to 2002. The increase primarily resulted from a $12.0 million decrease in the provision for possible loan losses and a $14.6 million increase in non-interest income. The impact of these items was partly offset by a $11.2 million increase in non-interest expense. Net income for 2002 increased $30.4 million, or 33.7%, compared to 2001. The increase primarily resulted from a $17.5 million decrease in the provision for possible loan losses, a $16.2 million increase in non-interest income and a $11.4 million decrease in non-interest expense.

Net interest income for 2003 increased $1.2 million compared to 2002 while net interest income for 2002 increased $262 thousand compared to 2001. The lack of significant fluctuation between the comparable periods resulted as the positive impact of growth in the average volume of earning assets was offset by the negative impact of declining average interest rates. In 2003, the impact of the increase in the average volume of earning assets was somewhat constrained as the majority of the growth in earning assets was in lower-yielding federal funds sold and securities purchased under resale agreements, which also led to a decrease in net interest margins over the comparable periods. See the analysis of net interest income included in the section captioned “Net Interest Income” included elsewhere in this discussion.

The provision for possible loan losses for 2003 totaled $10.5 million compared to $22.5 million in 2002 and $40.0 million in 2001. See the analysis of the provision for possible loan losses included in the section captioned “Allowance for Possible Loan Losses” included elsewhere in this discussion.

Non-interest income for 2003 increased $14.6 million, or 10.4%, compared to 2002 primarily due to an increase in service charges on deposit accounts and other charges and increased insurance commissions and

fees. Non-interest income for 2002 increased $17.3 million, or 16.1%, compared to 2001 primarily due to increases in service charges on deposits and other charges and increased insurance commissions and fees. See the analysis of service charges on deposit accounts and other charges and insurance commissions and fees included in the section captioned “Non-Interest Income” included elsewhere in this discussion.

Non-interest expense for 2003 increased $11.2 million, or 4.4%, compared to 2002. The increase was primarily related to increases in salaries and wages and employee benefits. Combined, these categories of non-interest expense increased $9.8 million over the comparable period. The increase was primarily the result of increases in headcount, merit increases, increases in commissions paid in connection with increased revenues associated with Frost Insurance Agency, increases in payroll taxes and increases in employee benefit plan expenses. Non-interest expense for 2002 decreased $11.4 million, or 4.3%, compared to 2001. The decrease primarily resulted from the elimination of goodwill amortization in accordance with a new accounting standard adopted on January 1, 2002. Non-interest expense for 2001 included $8.0 million of goodwill amortization. Also contributing to the decrease was a $5.5 million, or 3.7%, decrease in salaries and benefits, as a result of the restructuring actions taken during the fourth quarter of 2001. See the analysis of salaries and wages, employee benefits, intangibles amortization and restructuring charges included in the section captioned “Non-Interest Expense” included elsewhere in this discussion.

Frost Insurance Agency, which is included in the Banking operating segment, had gross revenues of $29.1 million in 2003 compared to $26.1 million in 2002 and $18.8 million in 2001. Insurance commissions and fees, which make up almost all of these revenues, increased $3.0 million, or 11.7%, in 2003 compared to 2002 and $7.3 million, or 38.8%, in 2002 compared to 2001. The increases over the comparable periods were primarily the result of continued selling efforts and the effect of a tighter market resulting in higher insurance premiums and related commission revenues. Revenue growth was also partly due to the acquisition of insurance agencies during in the first quarter of 2003 and the third quarter of 2001. Additionally, the Corporation had increases in rebate income received from various insurance carriers related to the performance of insurance policies previously placed.

Financial Management Group (FMG)

Net income for 2003 decreased $3.4 million, or 30.1%, compared to 2002. The decrease was primarily due to decreases in net interest income, service charges and other non-interest income combined with increases in salaries and wages, employee benefits and other non-interest expense. Net income for 2002 decreased $195 thousand, or 1.7%, compared to 2001 primarily due to a decrease in net interest income mostly offset by decreases in non-interest expense and income taxes.

Net interest income for 2003 decreased $1.2 million, or 25.0%, compared to 2002 and decreased $2.3 million, or 32.8%, in 2002 compared to 2001 primarily because the lower interest rate environment over the comparable periods has reduced the funds transfer price paid on FMG’s securities sold under repurchase agreements.

Non-interest income for 2003 decreased $1.1 million, or 1.9%, compared to 2002. The decline from 2002 was due to decreases in money market income, annuity income and brokerage commissions. Total non-interest income for 2002 increased $141 thousand compared to 2001, as increased revenues from securities lending and custody fees offset declines in investment fees and oil and gas fees.

Trust fee income is the most significant income component for FMG. Investment fees are the most significant component of trust fees, making up approximately 71%, 72% and 75% of total trust fees during 2003, 2002 and 2001. Investment and other custodial account fees are generally based on the market value of assets within a trust account. Volatility in the equity markets impacts the market value of trust assets and the related investment fees. Total trust fee income for 2003 did not significantly fluctuate compared to 2002 as declines in investment fees and estate fees were offset by an increase in oil and gas and real estate trust management fees. The decrease in trust fee income during 2002 compared to 2001 was primarily the result of declines in investment fees and oil and gas fees partially offset by new revenue from securities lending and custody fees. See the analysis of trust fees included in the section captioned “Non-Interest Income” included elsewhere in this discussion.

Non-interest expense for 2003 increased $2.0 million, or 4.2%, compared to 2002 primarily due to increases in salaries and wages, employee benefits and other non-interest expense. The increases in salaries and wages and employee benefits were primarily the result of merit increases, increases in payroll taxes and increases in employee benefit plan expenses. The increases in other non-interest expense were primarily due to general increases in the various components of other non-interest expense, including cost allocations. Non-interest expense for 2002 decreased $975 thousand, or 2.0%, compared to 2001 primarily due to a decrease in professional service fees.

Non-Banks

The $167 thousand decrease in the net loss for the Non-Banks operating segment for 2003 compared to 2002 was primarily due to an increase in royalty income from mineral interests and other miscellaneous income items partly offset by an increase in salaries, professional services expense and other miscellaneous expense items. The $4.0 million increase in the net loss for Non-Banks for 2002 was due to the reinstatement of certain performance-related bonus accruals.

Discontinued Operations

In the third quarter of 2002, the Corporation discontinued the operations of the capital markets division of its investment banking subsidiary, Frost Securities, Inc. All operating results for this discontinued component of the Corporation’s operations have been reclassified to “discontinued operations” and are reported separately, net of tax, in the income statement. The continuing advisory and private equity services operations of Frost Securities are included in the Banking segment.

Restructuring Charges

During fourth quarter of 2001, the Corporation recorded restructuring charges totaling $19.9 million. The restructuring charges included separation and benefit charges of $11.5 million related to a voluntary early retirement program. Voluntary early retirement was accepted by about four percent of the staff. The $11.5 million charge included $6.0 million related to additional pension benefits, $1.4 million for future medical benefits and $4.1 million for cash severance payments based on length of service. The restructuring charges also included a $6.7 million charge related to the freezing of the Corporation’s defined benefit and restoration plans. These plans were replaced by a deferred profit sharing plan. The remaining $1.7 million in restructuring charges related to severance and outplacement services for a two percent reduction in workforce.

Income Taxes

The Corporation recognized income tax expense on continuing operations of $62.0 million, for an effective rate of 32.2% in 2003 compared to $57.8 million, for an effective rate of 32.1%, in 2002 and $39.7 million, for an effective rate of 33.2%, in 2001. The effective income tax rates differed from the U.S. statutory rate of 35% during the comparable periods primarily due to the effect of tax-exempt income from loans, securities and life insurance policies. Prior to 2002, the effective tax rate was also impacted by non-deductible goodwill amortization.

Sources and Uses of Funds

The following table illustrates, during the years presented, the mix of the Corporation’s funding sources and the assets in which those funds are invested as a percentage of the Corporation’s average total assets for the period indicated. Average assets totaled $9.6 billion in 2003 compared to $8.4 billion in 2002 and $7.8 billion in 2001.


			2003			2002			2001


Sources of Funds:
	Deposits:
		Non-interest-bearing		31.7	%		30.4	%		27.9	%
		Interest-bearing		47.3			52.1			55.7
	Federal funds purchased and securities sold under repurchase agreements			8.9			4.8			4.5
	Long-term debt and other borrowings			2.8			3.3			2.5
	Other non-interest-bearing liabilities			1.7			1.6			1.6
	Equity capital			7.6			7.8			7.8

		Total		100.0	%		100.0	%		100.0	%

Uses of Funds:
	Loans			46.9	%		54.3	%		58.0	%
	Securities			27.9			25.9			22.4
	Federal funds sold, securities purchased under resale agreements and other interest-earning assets			8.7			3.1			3.3
	Other non-interest-earning assets			16.5			16.7			16.3

		Total		100.0	%		100.0	%		100.0	%

Deposits continue to be the Corporation’s primary source of funding. Over the comparable periods, the relative mix of deposits has shifted towards non-interest-bearing deposits, which has been a key factor in maintaining the Corporation’s relatively low cost of funds. Non-interest-bearing deposits totaled 40.1% of total average deposits in 2003 compared to 36.8% in 2002 and 33.4% in 2001. Federal funds purchased and securities sold under repurchase agreements increased in relative proportion in 2003 due to the use of dollar-roll repurchase agreements to leverage earning assets, primarily federal funds sold and securities purchased under resale agreements (see the section captioned “Net Interest Income” included elsewhere in this discussion).

The Corporation primarily invests funds in loans and securities. Loans continue to be the largest component of the Corporation’s mix of invested assets; however, weaker economic conditions, among other things, has limited the Corporation’s ability to significantly grow its loan portfolio. Additionally, the Corporation stopped originating mortgage and indirect consumer loans during 2000, and as such, these portfolios have continued to decrease, particularly because of high levels of mortgage refinances due to the low interest rate environment. See additional discussion regarding the Corporation’s loan portfolio in the section captioned “Loans” included elsewhere in this discussion. The majority of funds provided by deposit growth have been invested in U.S. government agency securities.

Loans

Year-end loans were as follows:


						Percentage
			2003			of Total			2002			2001			2000			1999


Commercial and industrial			$	2,196,223			47.8	%	$	2,155,550		$	1,985,447		$	1,873,809		$	1,635,097
Real estate:
	Construction:
		Commercial		349,152			7.6			315,340			373,431			342,944			325,156
		Consumer		23,399			0.5			45,152			44,623			44,078			53,951
	Land:
		Commercial		178,022			3.9			158,271			128,782			148,777			118,290
		Consumer		5,169			0.1			8,231			7,040			9,282			10,009
	Commercial mortgages			1,102,138			24.0			1,050,957			994,485			1,011,105			849,906
	1-4 family residential mortgages			113,756			2.5			179,077			244,897			310,946			340,213
	Other consumer			292,255			6.4			276,429			278,849			267,790			240,229

		Total real estate		2,063,891			45.0			2,033,457			2,072,107			2,134,922			1,937,754
Consumer:
	Indirect			8,358			0.2			25,262			65,217			136,921			211,246
	Other			304,453			6.6			289,190			345,899			341,546			352,155
Other, including foreign				28,962			0.6			23,295			54,943			54,796			36,693
Unearned discount				(11,141	)		(0.2	)		(7,841	)		(5,005	)		(7,349	)		(6,217	)

	Total		$	4,590,746			100.0	%	$	4,518,913		$	4,518,608		$	4,534,645		$	4,166,728

Overview. Loans totaled $4.6 billion at December 31, 2003 and remained relatively stable compared to December 31, 2002. Excluding shared national credits purchased (“SNCs”), 1-4 family residential mortgages, the indirect lending portfolio and student loans, loans increased 5.0% from December 31, 2002. SNCs, which are discussed further below, are participations purchased from upstream financial organizations and tend to be larger in size than the Corporation’s originated portfolio. The Corporation stopped originating mortgage and indirect consumer loans during 2000, and as such, these portfolios are excluded when analyzing the growth of the loan portfolio. Student loans are similarly excluded because the Corporation primarily originates these loans for resale and thus are considered to be “held for sale.” Student loans are included in total loans in the consolidated balance sheet. Student loans are generally sold after the deferment period has ended; however, from time to time, the Corporation has sold such loans prior to the end of the deferment period.

The majority of the Corporation’s loan portfolio is comprised of the commercial and industrial loans and real estate loans. Commercial and industrial loans made up 47.8% and 47.7% of total loans while real estate loans made up 45.0% and 45.0% of total loans at December 31, 2003 and 2002, respectively. Real estate loans include both commercial and consumer balances.

Loan Origination/ Risk Management. Cullen/ Frost has certain lending policies and procedures in place that are designed to maximize loan income within an acceptable level of risk. Management reviews and approves these policies and procedures on a regular basis. A reporting system supplements the review process by providing management with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies and non-performing and potential problem loans. Diversification in the loan portfolio is a means of managing risk associated with fluctuations in economic conditions.

Commercial and industrial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and prudently expand its business. Once it is determined that the borrower’s management possesses sound ethics and solid business acumen, the Corporation’s management examines current and projected cash flows to determine the ability of the borrower to repay their obligations as agreed. Underwriting standards are designed to promote relationship banking rather than transactional banking. Most

commercial and industrial loans are secured by the assets being financed or other business assets; however, some short-term loans may be made on an unsecured basis.

Commercial real estate loans are subject to underwriting standards and processes similar to commercial and industrial loans, in addition to those of real estate loans. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. As detailed in the discussion of real estate loans below, the properties securing the Corporation’s commercial real estate portfolio are diverse in terms of type and geographic location. This diversity helps reduce the Corporation’s exposure to adverse economic events that affect any single market or industry. Management monitors and evaluates commercial real estate loans based on collateral, geography and risk grade criteria. As a general rule, the Corporation avoids financing single-purpose projects unless other underwriting factors are present to help mitigate risk. The Corporation also utilizes third-party experts to provide insight and guidance about economic conditions and trends affecting market areas it serves. In addition, management tracks the level of owner-occupied commercial real estate loans versus non-owner occupied loans. At December 31, 2003, approximately half of the Corporation’s commercial real estate loans were secured by owner-occupied properties.

From time to time, the Corporation may originate loans to developers and builders that are secured by non-owner occupied properties. In such cases, the Corporation generally requires the borrower to have had an existing relationship with the Corporation and have a proven record of success. Commercial real estate loans are underwritten utilizing feasibility studies, independent appraisal reviews, sensitivity analysis of absorption and lease rates and financial analysis of the developers and property owners. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim mini-perm loan commitment from the Corporation until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, general economic conditions and the availability of long-term financing.

The Corporation originates consumer loans utilizing a computer-based credit scoring analysis to supplement the underwriting process. To monitor and manage consumer loan risk, policies and procedures are developed and modified, as needed, jointly by line and staff personnel. This activity, coupled with relatively small loan amounts that are spread across many individual borrowers, minimizes risk. Additionally, trend and outlook reports are reviewed by management on a regular basis. Underwriting standards for home equity loans are heavily influenced by statutory requirements, which include, but are not limited to, a maximum loan-to-value percentage of 80%, collection remedies, the number of such loans a borrower can have at one time and documentation requirements.

The Corporation maintains an independent loan review department that reviews and validates the credit risk program on a periodic basis. Results of these reviews are presented to management. The loan review process complements and reinforces the risk identification and assessment decisions made by lenders and credit personnel, as well as the Corporation’s policies and procedures.

Commercial and Industrial Loans. Excluding purchased SNCs, commercial and industrial loans at December 31, 2003 increased 5.4% from December 31, 2002 to $2.0 billion. The Corporation’s commercial and industrial loans are a diverse group of loans to small, medium and large businesses. The purpose of these loans varies from supporting seasonal working capital needs to term financing of equipment. While some short-term loans may be made on an unsecured basis, most are secured by the assets being financed with collateral margins that are consistent with the Corporation’s loan policy guidelines. The commercial and industrial loan portfolio also includes the commercial lease and asset-based lending portfolios. At December 31, 2003, commercial leases totaled $77.9 million and asset-based loans totaled $36.7 million compared to $57.6 million and $49.8 million at December 31, 2002.

Industry Concentrations. As of December 31, 2003 and 2002, there were no concentrations of loans within any single industry in excess of 10% of total loans, as segregated by Standard Industrial Classification code (“SIC code”). The SIC code is a federally designed standard industrial numbering system used by the Corporation to categorize loans by the borrower’s type of business. The following table summarizes the industry concentrations of the Corporation’s commercial and industrial loan portfolio, as segregated by SIC

code. Industry concentrations are stated as a percentage of year-end total commercial and industrial loans as of December 31, 2003 and 2002:


			2003			2002


Commercial and Industrial Loan Concentrations:
	Energy			9.0	%		8.0	%
	Manufacturing, other			6.0			5.5
	Services			5.0			5.6
	Building construction			5.0			4.1
	General and specific trade contractors			4.2			3.8
	Medical services			4.1			3.6
	Wholesale equipment			3.4			3.2
	Retail			3.3			4.4
	Legal			3.3			3.9
	All other (33 categories in both 2003 and 2002)			56.7			57.9

		Total loans		100.0	%		100.0	%

The Corporation’s largest concentration in any single industry is in energy. Year-end energy loans were as follows:


			2003		2002


Energy Loans:
	Production		$	210,161	$	207,070
	Service			69,527		74,835
	Traders			28,125		36,350
	Manufacturing			21,672		17,122
	Refining			18,640		27,084

		Total loans — Energy SIC portfolio	$	348,125	$	362,461

Large Credit Relationships and Shared National Credits. Frost Bank is currently the largest independent commercial bank based in Texas. The market areas served by the Corporation include three of the top ten most populous cities in the United States. The market areas served by the Corporation are also home to a significant number of Fortune 500 companies. As a result, the Corporation originates and maintains large credit relationships with numerous commercial customers in the ordinary course of business. The Corporation considers large credit relationships to be those with commitments equal to or in excess of $10.0 million, excluding treasury management lines exposure, prior to any portion being sold. Large relationships also include loan participations purchased if the credit relationship with the agent is equal to or in excess of $10.0 million. In addition to the Corporation’s normal policies and procedures related to the origination of large credits, the Corporation’s Central Credit Committee (CCC) must approve all new and renewed credit facilities which are part of large credit relationships. The CCC meets regularly and reviews large credit relationship activity and discusses the current pipeline, among other things. The following table provides additional information on the Corporation’s large credit relationships outstanding at year-end.



		2003						2002


				Period End Balances						Period End Balances
		Number of						Number of
		Relationships		Committed		Outstanding		Relationships		Committed		Outstanding


Large Credit Relationships:
	$20.0 million and greater		28	$	760,275	$	386,516		33	$	885,892	$	466,896
	$10.0 million to $19.9 million		90		1,230,510		751,559		76		1,036,586		651,820

The Corporation’s purchased SNC portfolio totaled $176.0 million at December 31, 2003, decreasing from $239.4 million at December 31, 2002. The decrease during 2003 was due to the repayment of several large credits. At December 31, 2003, 69.7% of outstanding purchased SNCs were related to the energy industry. The remaining purchased SNCs were diversified throughout various other industries, with no other

single industry exceeding more than 10% of the total purchased SNC portfolio. Additionally, almost all of the outstanding balance of purchased SNCs was included in the commercial and industrial portfolio, with the remainder included in the real estate categories. SNC participations are originated in the normal course of business to meet the needs of the Corporation’s customers. As a matter of policy, the Corporation generally only participates in SNCs for companies headquartered in or which have significant operations within the Corporation’s market areas. In addition, the Corporation must have direct access to the company’s management, an existing banking relationship or the expectation of broadening the relationship with other banking products and services. The following table provides additional information about certain credits within the Corporation’s purchased SNCs portfolio as of year-end.



		2003						2002


				Period End Balances						Period End Balances
		Number of						Number of
		Relationships		Committed		Outstanding		Relationships		Committed		Outstanding


Purchased Shared National Credits:
	$20.0 million and greater		5	$	114,546	$	21,673		6	$	135,000	$	39,776
	$10.0 million to $19.9 million		20		262,328		132,115		21		298,291		171,146

Real Estate Loans. Real estate loans totaled $2.1 billion at December 31, 2003 and remained relatively stable compared to December 31, 2002. Excluding 1-4 family residential mortgage loans, which are discussed below, total real estate loans increased $95.8 million, or 5.2%, from December 31, 2002. Commercial real estate totaled $1.6 billion and $1.5 billion at December 31, 2003 and 2002 and represented 78.9% and 75.0% of total real estate loans, respectively. The majority of this portfolio consists of commercial real estate mortgages, which includes both permanent and intermediate term loans. The Corporation’s primary focus for the commercial real estate portfolio has been growth in loans secured by owner-occupied properties. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Consequently, these loans must undergo the analysis and underwriting process of a commercial and industrial loan, as well as that of a real estate loan. At December 31, 2003, approximately half of the Corporation’s commercial real estate loans were secured by owner-occupied properties.

The following tables summarize the Corporation’s commercial real estate loan portfolio, as segregated by (i) the type of property securing the credit and (ii) the geographic region in which the property is located. Property type concentrations are stated as a percentage of year-end total commercial real estate loans as of December 31, 2003 and 2002:


			2003			2002


Property Type:
	Office building			19.6	%		19.7	%
	Office/warehouse			14.5			12.3
	1-4 family			8.9			9.3
	Non-farm/nonresidential			5.6			6.5
	Retail			5.6			5.5
	Medical offices and services			4.9			5.1
	All other			40.9			41.6

		Total commercial real estate loans		100.0	%		100.0	%

Geographic Region:
	Houston			25.9	%		27.9	%
	Fort Worth			22.4			23.4
	San Antonio			20.3			21.1
	Austin			10.8			10.6
	Dallas			8.3			6.2
	Corpus Christi			7.1			6.5
	Rio Grande Valley			5.2			4.3

		Total commercial real estate loans		100.0	%		100.0	%

Consumer Loans. The consumer loan portfolio, including all consumer real estate, totaled $747.4 million at December 31, 2003, decreasing $76.0 million, or 9.2%, from December 31, 2002. However, excluding 1-4 family residential mortgages, indirect loans and student loans, total consumer loans decreased $8.6 million, or 1.5%, from December 31, 2002.

As the following table illustrates as of year-end, the consumer loan portfolio has four distinct segments, including consumer real estate, consumer non-real estate, indirect consumer loans and 1-4 family residential mortgages.


		2003		2002


Construction		$	23,399	$	45,152
Land			5,169		8,231
Other consumer real estate			292,255		276,429

	Total consumer real estate		320,823		329,812
Consumer non-real estate			304,453		289,190
Indirect			8,358		25,262
1-4 family residential mortgages			113,756		179,077

	Total consumer loans	$	747,390	$	823,341

Consumer real estate loans, excluding 1-4 family mortgages, decreased $9.0 million, or 2.7%, from December 31, 2002. Home equity loans, which were first permitted in the State of Texas beginning January 1, 1998, made up 66.4% and 59.4% of the consumer real estate loans total at December 31, 2003 and 2002. The Corporation offers home equity loans up to 80% of the estimated value of the personal residence of the borrower, less the value of existing mortgages and home improvement loans. During September 2003, Texas voters approved an amendment to the Texas constitution related to home equity lending. The amendment permits financial institutions to offer home equity lines of credit. As a result, the Corporation has added home equity lines of credit to its loan offerings and began originating such lines in the fourth quarter. At December 31, 2003, balances outstanding on home equity lines of credit totaled $8.5 million.

The consumer non-real estate loan portfolio primarily consists of automobile loans, unsecured revolving credit products, personal loans secured by cash and cash equivalents, student loans and other similar types of credit facilities. Consumer non-real estate loans increased 5.3% from December 31, 2002 primarily due to growth in student loans, despite the fact that the Corporation sold approximately $50.8 million of student loans during 2003. Excluding student loans, consumer non-real estate loans increased $413 thousand, or 0.2% from December 31, 2002.

The indirect consumer loan segment has continued to decrease since the Corporation’s decision to discontinue originating these types of loans during 2000. As of December 31, 2003, the majority of the portfolio was comprised of purchased home improvement and home equity loans as well as new and used automobile loans. The portfolio is not expected to completely pay off before December 31, 2004 due to the longer life of the non-auto loans in this portfolio. However, the portfolio is expected to decrease by that time.

The Corporation also discontinued originating 1-4 family residential mortgage loans in 2000. Although this portfolio will continue to decline due to the decision to withdraw from the mortgage origination business, high levels of mortgage refinances due to the low interest rate environment have accelerated the decrease.

Foreign Loans. The Corporation has made U.S. dollar denominated loans and commitments to borrowers in Mexico. The outstanding balance of these loans and the unfunded amounts available under these commitments were not significant at December 31, 2003 or 2002.

Maturities and Sensitivities of Loans to Changes in Interest Rates. The following table presents the maturity distribution of the Corporation’s loans, excluding 1-4 family residential real estate loans, student loans and unearned discounts, at December 31, 2003. The table also presents the portion of loans that have

fixed interest rates or variable interest rates that fluctuate over the life of the loans in accordance with changes in an interest rate index such as the prime rate or LIBOR.


		Due in		After One,		After
		One Year		but Within		Five
		or Less		Five Years		Years		Total


Commercial and industrial		$	1,087,283	$	973,049	$	135,891	$	2,196,223
Real estate construction			175,936		108,980		87,635		372,551
Commercial real estate and land			185,632		551,180		543,348		1,280,160
Consumer and other			133,867		174,694		272,356		580,917

	Total	$	1,582,718	$	1,807,903	$	1,039,230	$	4,429,851

Loans with fixed interest rates		$	399,494	$	557,249	$	639,531	$	1,596,274
Loans with floating interest rates			1,183,224		1,250,654		399,699		2,833,577

	Total	$	1,582,718	$	1,807,903	$	1,039,230	$	4,429,851

The Corporation may renew loans at maturity when requested by a customer whose financial strength appears to support such renewal or when such renewal appears to be in the Corporation’s best interest. In such instances, the Corporation generally requires payment of accrued interest and may adjust the rate of interest, require a principal reduction or modify other terms of the loan at the time of renewal.

Non-Performing Assets and Potential Problem Loans

Non-Performing Assets. Year-end non-performing assets and accruing past due loans were as follows:


			2003			2002			2001			2000			1999


Non-accrual loans:
	Commercial and industrial		$	35,914		$	19,878		$	23,552		$	13,072		$	9,661
	Real estate			10,766			7,167			7,231			3,458			4,967
	Consumer and other			771			7,816			2,413			132			226

		Total non-accrual loans		47,451			34,861			33,196			16,662			14,854
Restructured loans				—			—			—			—			—
Foreclosed assets:
	Real estate			5,054			8,005			4,094			1,843			2,755
	Other			289			42			140			428			1,228

		Total foreclosed assets		5,343			8,047			4,234			2,271			3,983

	Total non-performing assets		$	52,794		$	42,908		$	37,430		$	18,933		$	18,837

Non-performing assets as a percentage of:
	Total loans and foreclosed assets			1.15	%		0.95	%		0.83	%		0.42	%		0.45	%
	Total assets			0.55			0.45			0.45			0.25			0.27
Accruing past due loans:
	30 to 89 days past due		$	24,419		$	30,766		$	35,549		$	43,671		$	26,692
	90 or more days past due			14,462			9,081			13,601			7,972			6,910

		Total accruing past due loans	$	38,881		$	39,847		$	49,150		$	51,643		$	33,602

Non-performing assets include non-accrual loans, restructured loans and foreclosed assets. Non-performing assets at December 31, 2003 increased 23.0% from December 31, 2002. The increase during 2003 was primarily related to an increase in non-accrual real estate loans and commercial and industrial loans. The majority of the increase occurred during the fourth quarter of 2003 when the Corporation placed two large commercial loans on non-accrual status. Prior to the fourth quarter, management had reported these loans as potential problem loans.

Generally, loans are placed on non-accrual status if principal or interest payments become 90 days past due and/or management deems the collectibility of the principal and/or interest to be in question, as well as

when required by regulatory requirements. Loans to a customer whose financial condition has deteriorated are considered for non-accrual status whether or not the loan is 90 days or more past due. For consumer loans, collectibility and loss are generally determined before the loan reaches 90 days past due. Accordingly, losses on consumer loans are recorded at the time they are determined. Consumer loans that are 90 days or more past due are generally either in liquidation/payment status or bankruptcy awaiting confirmation of a plan. Once interest accruals are discontinued, accrued but uncollected interest is charged to current year operations. Subsequent receipts on non-accrual loans are recorded as a reduction of principal, and interest income is recorded only after principal recovery is reasonably assured. Classification of a loan as non-accrual does not preclude the ultimate collection of loan principal or interest.

Restructured loans are loans on which, due to deterioration in the borrower’s financial condition, the original terms have been modified in favor of the borrower or either principal or interest has been forgiven.

Foreclosed assets represent property acquired as the result of borrower defaults on loans. Foreclosed assets are recorded at estimated fair value, less estimated selling costs, at the time of foreclosure. Write-downs occurring at foreclosure are charged against the allowance for possible loan losses. On an ongoing basis, properties are appraised as required by market indications and applicable regulations. Write-downs are provided for subsequent declines in value and are included in other non-interest expense along with other expenses related to maintaining the properties.

The after-tax impact (based on a 35% marginal tax rate) of lost interest from non-performing assets was approximately $1.5 million in 2003 compared to $2.2 million in 2002 and $2.6 million in 2001.

Potential Problem Loans. Potential problem loans consist of loans that are performing in accordance with contractual terms but for which management has concerns about the ability of an obligor to continue to comply with repayment terms because of the obligor’s potential operating or financial difficulties. Management monitors these loans closely and reviews their performance on a regular basis. As of December 31, 2003, the Corporation had six loans of this type totaling $6.9 million, which are not included in either of the non-accrual or 90 days past due loan categories.

Allowance for Possible Loan Losses

The allowance for possible loan losses is a reserve established through a provision for possible loan losses charged to expense, which represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The allowance for possible loan losses includes allowance allocations calculated in accordance with SFAS No. 114, “Accounting by Creditors for Impairment of a Loan,” as amended by SFAS 118, and allowance allocations determined in accordance with SFAS No. 5, “Accounting for Contingencies.” The level of the allowance reflects management’s continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality, present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. While management utilizes its best judgment and information available, the ultimate adequacy of the allowance is dependent upon a variety of factors beyond the Corporation’s control, including the performance of the Corporation’s loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications.

The Corporation’s allowance for possible loan losses consists of three elements: (i) specific valuation allowances established for probable losses on specific loans; (ii) historical valuation allowances calculated based on historical loan loss experience for similar loans with similar characteristics and trends; and (iii) unallocated general valuation allowances determined based on general economic conditions and other qualitative risk factors both internal and external to the Corporation.

The allowances established for probable losses on specific loans are based on a regular analysis and evaluation of classified loans. Loans are classified based on an internal credit risk grading process that evaluates, among other things: (i) the obligor’s ability to repay; (ii) the underlying collateral, if any; and

(iii) the economic environment and industry in which the borrower operates. This analysis is performed at the relationship manager level for all commercial loans. Loans with a calculated grade that is below a predetermined grade are adversely classified. Once a loan is classified, a special assets officer analyzes the loan to determine whether the loan is impaired and, if impaired, the need to specifically allocate a portion of the allowance for possible loan losses to the loan. Specific valuation allowances are determined by analyzing the borrower’s wherewithal to repay amounts owed, collateral deficiencies, the relative risk grade of the loan and economic conditions affecting the borrower’s industry, among other things. If after review, a specific valuation allowance is not assigned to the loan, and the loan is not considered to be impaired, the loan is included with a pool of similar loans that is assigned a historical valuation allowance calculated based on historical loss experience.

Historical valuation allowances are calculated based on the historical loss experience of specific types of loans and the internal risk grade of such loans at the time they were charged-off. The Corporation calculates historical loss ratios for pools of similar loans with similar characteristics based on the proportion of actual charge-offs experienced to the total population of loans in the pool. The historical loss ratios are periodically updated based on actual charge-off experience. A historical valuation allowance is established for each pool of similar loans based upon the product of the historical loss ratio and the total dollar amount of the loans in the pool. The Corporation’s pools of similar loans include similarly risk-graded groups of commercial and industrial loans, commercial real estate loans, consumer loans and 1-4 family residential mortgages.

Unallocated general valuation allowances are based on general economic conditions and other qualitative risk factors both internal and external to the Corporation. In general, such valuation allowances are determined by evaluating, among other things: (i) the experience, ability and effectiveness of the bank’s lending management and staff; (ii) the effectiveness of the Corporation’s loan policies, procedures and internal controls; (iii) changes in asset quality; (iv) changes in loan portfolio volume; (v) the composition and concentrations of credit; (vi) the impact of competition on loan structuring and pricing; (vii) the effectiveness of the internal loan review function; (viii) the impact of environmental risks on portfolio risks; and (ix) the impact of rising interest rates on portfolio risk. Management evaluates the degree of risk that each one of these components has on the quality of the loan portfolio on a quarterly basis. Each component is determined to have either a high, moderate or low degree of risk. The results are then input into a “general allocation matrix” to determine an appropriate general valuation allowance.

Included in both the specific and general valuation allowances are allocations for groups of similar loans with risk characteristics that exceed certain concentration limits established by management. Concentration risk limits have been established, among other things, for certain industry concentrations, large balance and highly leveraged credit relationships that exceed specified risk grades, and loans originated with policy exceptions that exceed specified risk grades.

Loans identified as losses by management, internal loan review and/or bank examiners are charged-off. Furthermore, consumer loan accounts are charged-off automatically based on regulatory requirements.

The table below provides an allocation of the year-end allowance for possible loan losses by loan type; however, allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories:



		2003					2002					2001					2000					1999

		Allowance		Percentage			Allowance		Percentage			Allowance		Percentage			Allowance		Percentage			Allowance		Percentage
		for		of Loans			for		of Loans			for		of Loans			for		of Loans			for		of Loans
		Possible		in each			Possible		in each			Possible		in each			Possible		in each			Possible		in each
		Loan		Category to			Loan		Category to			Loan		Category to			Loan		Category to			Loan		Category to
		Losses		Total Loans			Losses		Total Loans			Losses		Total Loans			Losses		Total Loans			Losses		Total Loans


Commercial and industrial		$	37,338		47.6	%	$	38,925		47.6	%	$	30,831		43.9	%	$	25,149		41.3	%	$	22,502		39.2	%
Real estate			16,269		45.0			10,805		44.9			10,427		45.8			11,389		47.0			9,485		46.4
Consumer			2,926		6.8			3,481		7.0			9,909		9.1			10,846		10.5			12,621		13.5
Other, including foreign			909		0.6			1,345		0.5			423		1.2			279		1.2			216		0.9
Unallocated			26,059		—			28,028		—			21,291		—			15,602		—			13,521		—

	Total	$	83,501		100.0	%	$	82,584		100.0	%	$	72,881		100.0	%	$	63,265		100.0	%	$	58,345		100.0	%

The reserve allocations related to real estate loans increased in 2003 primarily due to increases in allocations for specifically identified loans. The reserve allocations for commercial loans were increased in 2002 in response to the softening economy during 2001. Also, during 2002 the Corporation assessed the impact on consumer loan losses of the decision in 2000 to exit indirect consumer lending. Since exiting indirect lending, consumer loan losses have declined significantly. In response to this decline in loan losses, the consumer reserve allocation was reduced in line with the lower risk in the consumer portfolio.

The unallocated reserve increased in 2001 and 2002 in response to deterioration in the economy, which was exacerbated by the terrorist attacks of September 11, 2001. The deteriorating economic conditions helped create a higher risk environment for loan portfolios. The Corporation responded to this higher risk environment by increasing unallocated reserves based on risk factors thought to increase with the slowing economy.

Activity in the allowance for loan losses is presented in the following table. There were no charge-offs or recoveries related to foreign loans during any of the periods presented.


			2003			2002			2001			2000			1999


Balance of allowance for possible
	loan losses at beginning of year		$	82,584		$	72,881		$	63,265		$	58,345		$	53,616
Provision for possible loan losses				10,544			22,546			40,031			14,103			12,427
Loan loss reserve of acquired institutions				—			—			—			—			1,066
Charge-offs:
	Commercial and industrial			(11,627	)		(13,112	)		(32,074	)		(6,999	)		(5,349	)
	Real estate			(1,607	)		(2,249	)		(336	)		(465	)		(357	)
	Consumer			(3,760	)		(3,328	)		(4,340	)		(5,625	)		(7,420	)
	Other, including foreign			(1	)		(35	)		(30	)		(73	)		(7	)

		Total charge-offs		(16,995	)		(18,724	)		(36,780	)		(13,162	)		(13,133	)

Recoveries:
	Commercial and industrial			5,581			3,940			3,658			1,549			1,799
	Real estate			272			452			917			388			582
	Consumer			1,514			1,484			1,779			2,030			1,919
	Other, including foreign			1			5			11			12			69

		Total recoveries		7,368			5,881			6,365			3,979			4,369

Net charge-offs				(9,627	)		(12,843	)		(30,415	)		(9,183	)		(8,764	)

Balance at end of year			$	83,501		$	82,584		$	72,881		$	63,265		$	58,345

Net charge-offs as a percentage of average loans				0.21	%		0.28	%		0.67	%		0.21	%		0.22	%
Allowance for possible loan losses as a percentage of year-end loans				1.82			1.83			1.61			1.40			1.40
Allowance for possible loan losses as a percentage of year-end non-accrual loans				176.0			236.9			219.5			379.7			361.0
Average loans outstanding during the year			$	4,497,489		$	4,536,999		$	4,546,596		$	4,352,868		$	3,934,406
Loans outstanding at year-end				4,590,746			4,518,913			4,518,608			4,534,645			4,166,728
Non-accrual loans outstanding at year-end				47,451			34,861			33,196			16,662			14,854

The allowance for possible loan losses is maintained at a level considered appropriate by management, based on estimated probable losses within the existing loan portfolio. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The provision for possible loan losses reflects loan quality trends, including the level of net charge-offs or recoveries, among other factors. The provision for possible loan losses decreased $12.0 million from $22.5 million in 2002 to $10.5 million in 2003. Higher provisions were considered necessary during 2002 due to the overall uncertainty in the economy. During 2002, the provision for possible loan losses decreased $17.5 million from the $40.0 million recorded in 2001. The provision for possible loan losses was higher in 2001 primarily due to the deterioration of two large credits and the prevailing weak economic conditions, which were exacerbated by the terrorist acts of September 11, 2001.

Net charge-offs in 2003 decreased $3.2 million compared to 2002 while net charge-offs in 2002 decreased $17.6 million compared to 2001. The general decline in net charge-offs during the comparable periods is reflective of the more stringent credit standards implemented as a result of credit quality issues experienced in 2001. Commercial and industrial loan charge-offs in 2001 were significantly impacted by the deterioration of two large credits. Combined, the Corporation charged-off $22.0 million related to these credits in 2001; however, $1.3 million of this amount was recovered in 2002 when the Corporation sold its remaining interest in one of the loans. Despite increasing in 2003 compared to 2002, the Corporation has experienced an overall

downward trend in consumer loan charge-offs since 1999 primarily due to the discontinuation of its indirect lending program in 2000.

Management believes the level of the allowance for possible loan losses was adequate as of December 31, 2003. Should any of the factors considered by management in evaluating the adequacy of the allowance for possible loan losses change, the Corporation’s estimate of probable loan losses could also change, which could affect the level of future provisions for possible loan losses.

Securities

Year-end securities were as follows:



			2003					2002					2001

					Percentage					Percentage					Percentage
			Amount		of Total			Amount		of Total			Amount		of Total


Held to maturity:
	U.S. government agencies and corporations		$	21,850		0.7	%	$	33,556		1.4	%	$	48,491		2.3	%
	States and political subdivisions			2,113		0.1			2,454		0.1			2,615		0.1
	Other			1,125		—			125		—			125		—

		Total		25,088		0.8			36,135		1.5			51,231		2.4
Available for sale:
	U.S. Treasury			—					17,003		0.7			14,362		0.7
	U.S. government agencies and corporations			2,701,847		90.9			2,166,669		88.1			1,887,709		87.5
	States and political subdivisions			204,685		6.9			199,039		8.1			174,475		8.1
	Other			34,206		1.2			34,415		1.4			28,701		1.3

		Total		2,940,738		99.0			2,417,126		98.3			2,105,247		97.6
Trading:
	U.S. Treasury			3,091		0.1			—		—			—		—
	U.S. government agencies and corporations			2,498		0.1			4,995		0.2			—		—
	Other			—		—			—		—			118		—

		Total		5,589		0.2			4,995		0.2			118		—

		Total securities	$	2,971,415		100.0	%	$	2,458,256		100.0	%	$	2,156,596		100.0	%

The following table summarizes the maturity distribution schedule with corresponding weighted-average yields of securities held to maturity and securities available for sale as of December 31, 2003. Weighted-average yields have been computed on a fully taxable-equivalent basis using a tax rate of 35%. Mortgage-backed securities and collateralized mortgage obligations are included in maturity categories based on their stated maturity date. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations. Other securities classified as available for sale include stock in the Federal Reserve Bank and the Federal Home Loan Bank, which have no maturity date. These securities have been included in the total column only.



			Within 1 Year					1-5 Years					5-10 Years					After 10 Years					Total

					Weighted					Weighted					Weighted					Weighted					Weighted
					Average					Average					Average					Average					Average
			Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield


Held to maturity:
	U.S. government agencies and corporations		$	—		—	%	$	2,534		8.25	%	$	392		11.38	%	$	18,924		4.87	%	$	21,850		5.38	%
	States and political subdivisions			380		4.90			852		5.00			881		5.00			—		—			2,113		4.98
	Other			—		—			1,125		4.39			—		—			—		—			1,125		4.39

		Total	$	380		4.90		$	4,511		6.67		$	1,273		6.97		$	18,924		4.87		$	25,088		5.30

Available for Sale:
	U.S. government agencies and corporations		$	164,893		1.18	%	$	25,804		5.73	%	$	3,769		6.13	%	$	2,507,381		5.01	%	$	2,701,847		4.78	%
	States and political subdivisions			4,275		5.90			30,373		4.87			129,950		4.38			40,087		4.57			204,685		4.52
	Other			—		—			—		—			—		—			—		—			34,206		3.39

		Total	$	169,168		1.30		$	56,177		5.27		$	133,719		4.43		$	2,547,468		5.00		$	2,940,738		4.75

Obligations of U.S. government agencies and corporations classified as available for sale in the tables above included securities loaned in connection with dollar-roll repurchase agreements with a fair value $395.7 million at December 31, 2002. There were no securities loaned in connection with dollar-roll repurchase agreements at December 31, 2003 or 2001.

Securities are classified as held to maturity and carried at amortized cost when management has the positive intent and ability to hold them to maturity. Securities are classified as available for sale when they might be sold before maturity. Securities available for sale are carried at fair value, with unrealized holding gains and losses reported in other comprehensive income. The remaining securities are classified as trading. Trading securities are held primarily for sale in the near term and are carried at their fair values, with unrealized gains and losses included immediately in other income. Management determines the appropriate classification of securities at the time of purchase. Securities with limited marketability, such as stock in the Federal Reserve Bank and the Federal Home Loan Bank, are carried at cost.

At December 31, 2003, there were no holdings of any on issuer, other than the U.S. government and its agencies, in an amount greater than 10% of the Corporation’s shareholders’ equity.

The average yield of the securities portfolio was 4.87% in 2003 compared to 5.76% in 2002 and 6.33% in 2001. The decline in the average yield over the comparable periods primarily resulted from the investment of new funds received from deposit growth at lower current yields and the reinvestment of proceeds from the early repayment of mortgage-backed securities in similar investments, also at lower current yields. The early repayment of mortgage-backed securities primarily resulted from borrower refinancing due to lower market interest rates. The overall growth in the securities portfolio over the comparable periods was primarily funded by deposit growth.

Deposits

The table below presents the daily average balances of deposits by type and weighted-average rates paid thereon during the years presented:



			2003					2002					2001

			Average		Average			Average		Average			Average		Average
			Balance		Rate Paid			Balance		Rate Paid			Balance		Rate Paid


Non-interest-bearing:
	Commercial and individual		$	2,133,906				$	1,942,228				$	1,883,931
	Correspondent banks			848,737					553,318					262,840
	Public funds			55,081					44,886					39,919

		Total		3,037,724					2,540,432					2,186,690
Interest-bearing:
	Private accounts:
		Savings and Interest-on-Checking		1,052,637		0.09	%		1,003,713		0.18	%		966,429		0.37	%
		Money market deposit accounts		2,153,489		0.96			1,857,130		1.28			1,825,991		2.63
		Time accounts of $100,000 or more		557,248		1.31			649,920		2.03			718,456		4.57
		Time accounts under $100,000		444,333		1.24			505,826		2.28			547,543		4.43
	Public funds			331,915		0.93			337,289		1.47			306,248		3.26

		Total		4,539,622		0.82			4,353,878		1.27			4,364,667		2.72

		Total deposits	$	7,577,346		0.49	%	$	6,894,310		0.80	%	$	6,551,357		1.81	%

Average deposits increased $683.0 million in 2003 compared to 2002 and $343.0 million in 2002 compared to 2001. The increase in 2003 included $497.3 million, or 72.8%, related to non-interest-bearing deposits while the increase in 2002 included $353.7 million, or 103.1% related to non-interest-bearing deposits. Accordingly, the ratio of average non-interest-bearing deposits to total average deposits increased to 40.1% in 2003 from 36.8% in 2002 and 33.4% in 2001. This change in proportions, combined with a general decline in market rates, had the effect of (i) reducing the average cost of total deposits by 31 basis points in 2003 compared to 2002 and 101 basis points in 2002 compared to 2001; and, (ii) mitigating a portion of the impact of declining yields on earning assets on the Corporation’s net interest income.

The following table presents the proportion of each component of average non-interest-bearing deposits to the total of such deposits during the years presented:


	2003			2002			2001


Commercial and individual		70.3	%		76.4	%		86.2	%
Correspondent banks		27.9			21.8			12.0
Public funds		1.8			1.8			1.8

Total		100.0	%		100.0	%		100.0	%

During 2003, average non-interest-bearing deposits increased $497.3 million, or 19.6%, compared to 2002. The growth was primarily in correspondent bank accounts. Average correspondent bank balances increased $295.4 million in 2003 compared to 2002. The increase was largely due to increased volume related to a single customer who accounted for $184.9 million of the increase. During 2002, average non-interest-bearing deposits increased $353.7 million, or 16.2%, compared to 2001. During the first quarter of 2002, a large mortgage originator and servicing customer for which the Corporation was the depository and clearing bank was acquired by another bank (the same customer which accounted for a large portion of the increase in average correspondent bank balances in 2003, as discussed above). Prior to its acquisition, the customer’s account balances were included in commercial and individual accounts; however, upon its acquisition, the customer’s account balances were reclassified to correspondent bank deposits.

Also contributing to the increase in average non-interest-bearing deposits during 2003 was a $191.7 million increase in average commercial and individual deposit balances. In 2002, after adjusting for the reclassification of the aforementioned mortgage originator and servicing customer, average commercial and individual deposit balances increased $253.1 million, or 15.0%. The increases in 2003 and 2002 were primarily attributable to the maintenance of higher cash balances by customers.

The following table presents the proportion of each component of average interest-bearing deposits to the total of such deposits during the years presented:


		2003			2002			2001


Private accounts:
	Savings and Interest-on-Checking		23.2	%		23.1	%		22.1	%
	Money market deposit accounts		47.4			42.7			41.8
	Time accounts of $100,000 or more		12.3			14.9			16.5
	Time accounts under $100,000		9.8			11.6			12.6
Public funds			7.3			7.7			7.0

	Total		100.0	%		100.0	%		100.0	%

Total average interest-bearing deposits increased $185.7 million, or 4.3%, in 2003 compared to 2002 and decreased $10.8 million, or 0.2%, in 2002 compared to 2001. The growth in average deposits in 2003 compared to 2002 was primarily in money market deposit accounts and savings and Interest-on-Checking accounts partly offset by declines in time accounts and public funds. The Corporation has experienced a shift in the relative mix of the portfolio during the comparable periods as the proportion of money market deposits has increased while the proportion of time accounts has decreased. The shift in relative proportions appears to be related to the uncertain low interest rate environment. Due to this uncertainty, it appears that many customers are less inclined to invest their funds for extended periods and are choosing to maintain such funds in the more readily accessible money market deposit accounts.

Geographic Concentrations. The following table summarizes the Corporation’s average total deposit portfolio, as segregated by the geographic region from which the deposit accounts were originated. Certain accounts, such as correspondent bank deposits, are recorded at the statewide level. Geographic concentrations are stated as a percentage of average total deposits during the years presented.


		2003			2002			2001


San Antonio			35.7	%		37.7	%		41.6	%
Houston			17.0			18.1			18.1
Fort Worth			12.5			12.7			13.2
Austin			11.8			11.9			11.9
Corpus Christi			7.3			7.6			7.4
Dallas			3.4			2.7			2.5
Rio Grande Valley			1.4			1.4			1.3
Statewide			10.9			7.9			4.0

	Total		100.0	%		100.0	%		100.0	%

The Corporation experienced deposit growth in all regions during 2003. The most significant growth occurred in the Statewide region, increasing $282.4 million, or 51.7%, primarily due to an increase in correspondent bank deposits. As discussed above, a single correspondent bank customer accounted for $184.9 million of the increase in average volume. Despite decreasing in proportion to total deposits, the San Antonio region had the second largest increase in average deposits in 2003, increasing $102.3 million, or 3.9%. Excluding the Statewide region, the most significant percentage growth occurred in the Dallas region, which increased $71.2 million, or 38.4%. This growth is the result of the Corporation’s continued efforts to expand in this region. During 2002, the Corporation experienced a decline in the relative proportion of deposits within the San Antonio region. This shift was due in part to the aforementioned reclassification to correspondent

bank deposits of deposits received from the large mortgage originator and servicing customer, for whom the Corporation is the depository and clearing bank.

Foreign Deposits. Mexico has historically been considered a part of the natural trade territory of the Corporation’s banking offices. Accordingly, U.S. dollar-denominated foreign deposits from sources within Mexico have traditionally been a significant source of funding. Average deposits from foreign sources, primarily Mexico, totaled $678.7 million in 2003, $703.9 million in 2002 and $737.7 million in 2001.

Short-Term Borrowings

The Corporation’s primary source of short-term borrowings is federal funds purchased from correspondent banks and securities sold under repurchase agreements in the natural trade territory of the Corporation, as well as from upstream banks. Federal funds purchased and securities sold under repurchase agreements totaled $421.8 million, $811.2 million and $305.4 million at December 31, 2003, 2002 and 2001. The maximum amount of these borrowings outstanding at any month-end was $1.1 billion in 2003, $811.2 million in 2002 and $400.4 million in 2001. The weighted-average interest rate on federal funds purchased was 0.83%, 1.18% and 1.49% at December 31, 2003, 2002 and 2001. Generally, the interest rates on securities sold under repurchase agreements are a percentage of the federal funds rate.

The following table presents the Corporation’s average net funding position during the years indicated:



		2003						2002						2001

		Average			Average			Average			Average			Average			Average
		Balance			Rate Paid			Balance			Rate Paid			Balance			Rate Paid


Federal funds sold and securities purchased under resale agreements		$	825,452			1.16	%	$	244,790			1.63	%	$	253,112			3.87	%
Federal funds purchased and securities sold under repurchase agreements			(854,517	)		0.48			(400,511	)		1.34			(351,319	)		3.43

	Net funds position	$	(29,065	)				$	(155,721	)				$	(98,207	)

The increase in the average funds purchased position during the comparable periods was primarily related to the use of dollar-roll repurchase agreements. A dollar-roll repurchase agreement is similar to an ordinary repurchase agreement, except that the security transferred is a mortgage-backed security and the repurchase provisions of the transaction agreement explicitly allow for the return of a “similar” security rather than the identical security initially sold. During the fourth quarter of 2002, the Corporation began to leverage earning assets by utilizing dollar-roll repurchase agreements to capitalize on the spread between the yield earned on federal funds sold and securities purchased under resale agreements and the cost of the dollar-roll repurchase agreements. This spread has a positive effect on the dollar amount of net interest income; however, because the funds are invested in lower yielding federal funds sold and securities purchased under resale agreements, the Corporation’s net interest margin is negatively impacted. See the section captioned “Net Interest Income” included elsewhere in this discussion.

Off-Balance-Sheet Arrangements, Commitments, Guarantees, and Contractual Obligations

The following table summarizes the Corporation’s contractual obligations and other commitments to make future payments as of December 31, 2003. Payments for borrowings do not include interest. Payments related to leases are based on actual payments specified in the underlying contracts. Loan commitments and standby letters of credit are presented at contractual amounts; however, since many of these commitments are expected to expire unused or only partially used, the total amounts of these commitments do not necessarily reflect future cash requirements.



		Payments Due by Period

				More than 1		3 years or
				year but less		more but less		5 years or
		1 year or less		than 3 years		than 5 years		more		Total


Contractual obligations:
	Subordinated notes payable	$	—	$	—	$	—	$	150,000	$	150,000
	Junior subordinated deferrable interest debentures		—		—		—		103,093		103,093
	Federal Home Loan Bank advances		1,856		512		305		79		2,752
	Operating leases		11,323		19,839		15,609		26,168		72,939
	Deposits with stated maturity dates		971,417		78,797		227		100		1,050,541

			984,596		99,148		16,141		279,440		1,379,325
Other commitments:
	Loan commitments		29,542		1,797,535		373,769		165,983		2,366,829
	Standby letters of credit		2,506		173,380		12,312		32		188,230

			32,048		1,970,915		386,081		166,015		2,555,059

	Total contractual obligations and other commitments	$	1,016,644	$	2,070,063	$	402,222	$	445,455	$	3,934,384

In the normal course of business, the Corporation enters into various transactions, which, in accordance with accounting principles generally accepted in the United States, are not included in its consolidated balance sheets. The Corporation enters into these transactions to meet the financing needs of its customers. These transactions include commitments to extend credit and standby letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in the consolidated balance sheets. The Corporation also holds certain assets which are not included in its consolidated balance sheets including assets held in fiduciary or custodial capacity on behalf of its trust customers and certain collateral funds resulting from acting as an agent in its securities lending program.

Loan Commitments. The Corporation enters into contractual commitments to extend credit, normally with fixed expiration dates or termination clauses, at specified rates and for specific purposes. Substantially all of the Corporation’s commitments to extend credit are contingent upon customers maintaining specific credit standards at the time of loan funding. The Corporation minimizes its exposure to loss under these commitments by subjecting them to credit approval and monitoring procedures. Management assesses the credit risk associated with certain commitments to extend credit in determining the level of the allowance for possible loan losses. Loan commitments outstanding at December 31, 2003 are included in the table above.

Standby Letters of Credit. Standby letters of credit are written conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party. In the event the customer does not perform in accordance with the terms of the agreement with the third party, the Corporation would be required to fund the commitment. The maximum potential amount of future payments the Corporation could be required to make is represented by the contractual amount of the commitment. If the commitment is funded, the Corporation would be entitled to seek recovery from the customer. The Corporation’s policies generally require that standby letter of credit arrangements contain security and debt covenants similar to those contained in loan agreements. Standby letters of credit outstanding at December 31, 2003 are included in the table above.

Trust Accounts. The Corporation also holds certain assets in fiduciary or custodial capacity on behalf of its trust customers. The estimated fair value of trust assets was approximately $14.8 billion (including managed assets of $6.6 billion and custody assets of $8.2 billion) at December 31, 2003. These assets were primarily composed of equity securities (45.9% of trust assets), fixed income securities (36.4% of trust assets) and cash equivalents (10.5% of trust assets).

Securities Lending. The Corporation lends certain customer securities to creditworthy brokers on behalf of those customers. If the borrower fails to return these securities, the Corporation indemnifies its customers

based on the fair value of the securities. The Corporation holds collateral received in securities lending transactions as an agent. Accordingly, such collateral assets are not assets of the Corporation. The Corporation requires borrowers to provide collateral equal to or in excess of 100% of the fair value of the securities borrowed. The collateral is valued daily and additional collateral is requested as necessary. The maximum future payments guaranteed by the Corporation under these contractual agreements (representing the fair value of securities lent to brokers) totaled $1.8 billion at December 31, 2003. At December 31, 2003, the Corporation held liquid assets with a fair value of $1.9 billion as collateral for these agreements.

Capital and Liquidity

At December 31, 2003, shareholders’ equity totaled $770.0 million compared $703.8 million at December 31, 2002. In addition to net income of $130.5 million, other significant changes in shareholders’ equity during 2003 included $48.5 million of dividends paid and $15.3 million in proceeds from stock option exercises and the related tax benefits of $3.6 million. The accumulated other comprehensive income component of shareholders’ equity totaled $8.1 million at December 31, 2003 compared to $32.5 million at December 31, 2002. This fluctuation was mostly related to the after-tax effect of changes in the fair value of securities available for sale. Under regulatory requirements, the unrealized gain or loss on securities available for sale does not increase or reduce regulatory capital and is not included in the calculation of risk-based capital and leverage ratios. Regulatory agencies for banks and bank holding companies utilize capital guidelines designed to measure Tier 1 and total capital and take into consideration the risk inherent in both on-balance sheet and off-balance sheet items. See Note 12 — Regulatory Matters in the accompanying notes to consolidated financial statements included elsewhere in this report.

The Corporation paid quarterly dividends of $0.22, $0.24, $0.24 and $0.24 per common share during the first, second, third and fourth quarters of 2003, respectively, and quarterly dividends of $0.215, $0.22, $0.22 and $0.22 per common share during the first, second, third and fourth quarters of 2002, respectively. This equates to a dividend payout ratio of 37.2% in 2003 and 38.2% in 2002. In addition, the Corporation initiated a program during the third quarter of 2001 to repurchase up to 2.6 million shares of its common stock over a two-year period, from time to time, at various prices in the open market or through private transactions. The Corporation did not repurchase any shares under this program during the first nine months of 2003. The repurchase program terminated in the third quarter of 2003 and a total of 1.2 million shares at a cost of $39.2 million were repurchased under this program. During the fourth quarter of 2003, the Corporation initiated a new program to repurchase up to 1.2 million shares of its common stock over a two-year period, from time to time, at various prices in the open market or through private transactions. As of December 31, 2003, 268 thousand shares at a cost of $10.7 million have been repurchased under this program.

Liquidity measures the ability to meet current and future cash flow needs as they become due. The liquidity of a financial institution reflects its ability to meet loan requests, to accommodate possible outflows in deposits and to take advantage of interest rate market opportunities. The ability of a financial institution to meet its current financial obligations is a function of balance sheet structure, the ability to liquidate assets, and the availability of alternative sources of funds. The Corporation seeks to ensure its funding needs are met by maintaining a level of liquid funds through asset/liability management.

Asset liquidity is provided by liquid assets which are readily marketable or pledgeable or which will mature in the near future. Liquid assets include cash, interest-bearing deposits in banks, securities available for sale, maturities and cash flow from securities held to maturity, and federal funds sold and securities purchased under resale agreements.

Liability liquidity is provided by access to funding sources which include core deposits and correspondent banks in the Corporation’s natural trade area that maintain accounts with and sell federal funds to Frost Bank, as well as federal funds purchased and securities sold under repurchase agreements from upstream banks.

Since Cullen/ Frost is a holding company and does not conduct operations, its primary sources of liquidity are dividends upstreamed from Frost Bank and borrowings from outside sources. See Note 12 — Regulatory Maters in the accompanying notes to consolidated financial statements included elsewhere in this report

regarding such dividends. Outside funding sources available at the holding company level include a $25.0 million short-term line of credit with another financial institution. The line of credit matures annually and bears interest at a fixed LIBOR-based rate or floats with the prime rate. There were no borrowings outstanding on this line of credit at December 31, 2003.

The liquidity position of the Corporation is continuously monitored and adjustments are made to the balance between sources and uses of funds as deemed appropriate. Management is not aware of any events that are reasonably likely to have a material adverse effect on the Corporation’s liquidity, capital resources or operations. In addition, management is not aware of any regulatory recommendations regarding liquidity, which if implemented, would have a material adverse effect on the Corporation.

Impact of Inflation and Changing Prices

The Corporation’s financial statements included herein have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). GAAP presently requires the Corporation to measure financial position and operating results primarily in terms of historic dollars. Changes in the relative value of money due to inflation or recession are generally not considered. The primary effect of inflation on the operations of the Corporation is reflected in increased operating costs. In management’s opinion, changes in interest rates affect the financial condition of a financial institution to a far greater degree than changes in the inflation rate. While interest rates are greatly influenced by changes in the inflation rate, they do not necessarily change at the same rate or in the same magnitude as the inflation rate. Interest rates are highly sensitive to many factors that are beyond the control of the Corporation, including changes in the expected rate of inflation, the influence of general and local economic conditions and the monetary and fiscal policies of the United States government, its agencies and various other governmental regulatory authorities, among other things, as further discussed in the next section.

Regulatory and Economic Policies

The Corporation’s business and earnings are affected by general and local economic conditions and by the monetary and fiscal policies of the United States government, its agencies and various other governmental regulatory authorities, among other things. The Federal Reserve Board regulates the supply of money in order to influence general economic conditions. Among the instruments of monetary policy available to the Federal Reserve Board are (i) conducting open market operations in United States government obligations, (ii) changing the discount rate on financial institution borrowings, (iii) imposing or changing reserve requirements against financial institution deposits, and (iv) restricting certain borrowings and imposing or changing reserve requirements against certain borrowing by financial institutions and their affiliates. These methods are used in varying degrees and combinations to affect directly the availability of bank loans and deposits, as well as the interest rates charged on loans and paid on deposits. For that reason alone, the policies of the Federal Reserve Board have a material effect on the earnings of the Corporation.

Governmental policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future; however, the Corporation cannot accurately predict the nature, timing or extent of any effect such policies may have on its future business and earnings.

Recently Issued Accounting Pronouncements

See Note 23 — New Accounting Standards in the accompanying notes to consolidated financial statements included elsewhere in this report for details of recently issued accounting pronouncements and their expected impact on the Corporation’s financial statements.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The disclosures set forth in this item are qualified by the section captioned “Forward-Looking Statements and Factors that Could Affect Future Results” included in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, of this report, and other cautionary statements set forth elsewhere in this report.

Market risk refers to the risk of loss arising from adverse changes in interest rates, foreign currency exchange rates, commodity prices, and other relevant market rates and prices, such as equity prices. The risk of loss can be assessed from the perspective of adverse changes in fair values, cash flows, and future earnings. Due to the nature of its operations, the Corporation is primarily exposed to interest rate risk and, to a lesser extent, liquidity risk.

Interest rate risk on the Corporation’s balance sheets consists of reprice, option, and basis risks. Reprice risk results from differences in the maturity, or repricing, of asset and liability portfolios. Option risk arises from “embedded options” present in many financial instruments such as loan prepayment options, deposit early withdrawal options and interest rate options. These options allow customers opportunities to benefit when market interest rates change, which typically results in higher costs or lower revenue for the Corporation. Basis risk refers to the potential for changes in the underlying relationship between market rates and indices, which subsequently result in a narrowing of profit spread on an earning asset or liability. Basis risk is also present in administered rate liabilities, such as savings accounts, negotiable order of withdrawal accounts, and money market accounts where historical pricing relationships to market rates may change due to the level or directional change in market interest rates.

The Corporation seeks to avoid fluctuations in its net interest margin and to maximize net interest income within acceptable levels of risk through periods of changing interest rates. Accordingly, the Corporation’s interest rate sensitivity and liquidity are monitored on an ongoing basis by its Asset and Liability Committee (“ALCO”), which oversees market risk management and establishes risk measures, limits and policy guidelines for managing the amount of interest rate risk and its effect on net interest income and capital. A variety of measures are used to provide for a comprehensive view of the magnitude of interest rate risk, the distribution of risk, the level of risk over time and the exposure to changes in certain interest rate relationships.

The Corporation utilizes an earnings simulation model as the primary quantitative tool in measuring the amount of interest rate risk associated with changing market rates. The model quantifies the effects of various interest rate scenarios on projected net interest income and net income over the next 12 months. The model was used to measure the impact on net interest income relative to a base case scenario of rates increasing 200 basis points or decreasing 50 basis points (due to the already low level of short-term rates) over the next 12 months. These simulations incorporate assumptions regarding balance sheet growth and mix, pricing and the repricing and maturity characteristics of the existing and projected balance sheet. The impact of interest rate derivatives, such as interest rate swaps, caps and floors, is also included in the model. Other interest rate-related risks such as prepayment, basis and option risk are also considered. The resulting model simulations project that a 200 basis point increase in rates will result in a positive variance in net interest income of 2.2% relative to the base case over the next 12 months, while a decrease of 50 basis points will result in a negative variance in net interest income of 1.6% relative to the base case over the next 12 months. This compares to last year’s estimate when a 200 basis points increase in rates resulted in a positive variance in net interest income of 3.4% relative to the base case over the next 12 months, while a decrease of 50 basis points resulted in a negative variance in net interest income of 1.4%. The Corporation’s trading portfolio is not significant, and, as such, separate quantitative disclosure is not presented.

The Committee continuously monitors and manages the balance between interest rate-sensitive assets and liabilities. The objective is to manage the impact of fluctuating market rates on net interest income within acceptable levels. In order to meet this objective, management may lengthen or shorten the duration of assets or liabilities or enter into derivative contracts to mitigate potential market risk.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Management’s Report Regarding Responsibility for Financial Reporting

To the Shareholders of

Cullen/ Frost Bankers, Inc.

The management of Cullen/ Frost Bankers, Inc. is responsible for the preparation of the financial statements, related financial data and other information in this annual report. The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States and include amounts based on management’s estimates and judgment where appropriate. Financial information appearing throughout this annual report is consistent with the financial statements.

In meeting its responsibility both for the integrity and fairness of these financial statements and information, management depends on the accounting systems and related internal accounting controls that are designed to provide reasonable assurances that transactions are authorized and recorded in accordance with established procedures, that assets are safeguarded and that proper and reliable records are maintained.

The concept of reasonable assurance is based on the recognition that the cost of a system of internal controls should not exceed the related benefits. As an integral part of the system of internal controls, Cullen/ Frost maintains an internal audit staff, which monitors compliance with and evaluates the effectiveness of the system of internal controls and coordinates audit coverage with the independent auditors.

The Audit Committee of Cullen/ Frost’s Board of Directors, which is composed entirely of directors independent of management, meets regularly with management, regulatory examiners, internal auditors, the asset review staff and independent auditors to discuss financial reporting matters, internal controls, regulatory reports, internal auditing and the nature, scope and results of the audit efforts. Internal Audit and Asset Review report directly to the Audit Committee. The banking regulators, internal auditors and independent auditors have direct access to the Audit Committee.

The consolidated financial statements have been audited by Ernst & Young LLP, independent auditors, who render an independent opinion on management’s financial statements. Their appointment was approved by the Audit Committee, and this approval was ratified by the shareholders. The audit by the independent auditors provides an additional assessment of the degree to which Cullen/ Frost’s management meets its responsibility for financial reporting. Their opinion on the financial statements is based on auditing procedures, which include their consideration of internal controls and performance of selected tests of transactions and records, as they deem appropriate. These auditing procedures are designed to provide an additional reasonable level of assurance that the financial statements are fairly presented in conformity with accounting principles generally accepted in the United States, in all material respects.


Richard W. Evans, Jr. Chairman and Chief Executive Officer		Phillip D. Green Group Executive Vice President and Chief Financial Officer

Report of Ernst & Young LLP

Independent Auditors

To the Board of Directors and Shareholders

of Cullen/ Frost Bankers, Inc.

We have audited the accompanying consolidated balance sheets of Cullen/ Frost Bankers, Inc. (the Corporation) as of December 31, 2003 and 2002, and the related consolidated statements of income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2003. These financial statements are the responsibility of the Corporation’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the 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 audits provide 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 Cullen/ Frost Bankers, Inc. at December 31, 2003 and 2002, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States.

As discussed in Note 1 to the consolidated financial statements, effective January 1, 2002, the Corporation adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets.”

San Antonio, Texas

January 27, 2004,

except for Note 24, as to which

the date is February 13, 2004

Cullen/ Frost Bankers, Inc.

Consolidated Statements of Income

(Dollars in thousands, except per share amounts)



				Year Ended December 31,

				2003		2002			2001


Interest income:
	Loans, including fees			$	233,463	$	265,514		$	343,928
	Securities:
		Taxable			117,342		112,079			99,323
		Tax-exempt			8,436		8,142			7,610
	Interest-bearing deposits				104		172			200
	Federal funds sold and securities purchased under resale agreements				9,601		3,991			9,784

			Total interest income		368,946		389,898			460,845
Interest expense:
	Deposits				37,406		55,384			118,699
	Federal funds purchased and securities sold under repurchase agreements				4,059		5,359			12,054
	Junior subordinated deferrable interest debentures				8,735		8,735			8,735
	Subordinated notes payable and other borrowings				4,988		6,647			5,531

			Total interest expense		55,188		76,125			145,019

			Net interest income		313,758		313,773			315,826
Provision for possible loan losses					10,544		22,546			40,031

			Net interest income after provision for possible loan losses		303,214		291,227			275,795
Non-interest income:
	Trust fees				47,486		47,463			48,784
	Service charges on deposit accounts				87,805		78,417			70,534
	Insurance commissions and fees				28,660		25,912			18,598
	Other charges, commissions and fees				18,668		16,860			16,176
	Net gain on securities transactions				40		88			78
	Other				32,702		32,229			29,547

			Total non-interest income		215,361		200,969			183,717
Non-interest expense:
	Salaries and wages				146,622		139,227			138,347
	Employee benefits				38,316		34,614			35,000
	Net occupancy				29,286		28,883			29,419
	Furniture and equipment				21,768		22,597			23,727
	Intangible amortization				5,886		7,083			15,127
	Restructuring charges				—		—			19,865
	Other				84,157		79,738			78,172

			Total non-interest expense		326,035		312,142			339,657

Income from continuing operations before income taxes and cumulative effect of accounting change					192,540		180,054			119,855
Income taxes					62,039		57,821			39,749

Income from continuing operations					130,501		122,233			80,106
Loss from discontinued operations, net of tax					—		(5,247	)		(2,200	)
Cumulative effect of change in accounting for derivatives, net of tax					—		—			3,010

			Net income	$	130,501	$	116,986		$	80,916

Basic per common share:
	Income from continuing operations			$	2.54	$	2.40		$	1.55
	Net income				2.54		2.29			1.57
Diluted per common share:
	Income from continuing operations			$	2.48	$	2.33		$	1.50
	Net income				2.48		2.23			1.52

See accompanying Notes to Consolidated Financial Statements.

Cullen/ Frost Bankers, Inc.

Consolidated Balance Sheets

(Dollars in thousands, except per share amounts)



				December 31,

				2003			2002


Assets:
Cash and due from banks				$	1,067,888		$	1,331,136
Interest-bearing deposits					2,793			8,661
Federal funds sold and securities purchased under resale agreements					567,525			724,150

	Total cash and cash equivalents				1,638,206			2,063,947
Securities held to maturity, at amortized cost					25,088			36,135
Securities available for sale, at estimated fair value					2,940,738			2,417,126
Trading account securities					5,589			4,995
Loans, net of unearned discounts					4,590,746			4,518,913
	Less: Allowance for possible loan losses				(83,501	)		(82,584	)

		Net loans			4,507,245			4,436,329
Premises and equipment, net					168,611			171,261
Goodwill					98,873			97,838
Other intangible assets, net					16,001			21,330
Cash surrender value of life insurance policies					105,978			104,650
Accrued interest receivable and other assets					165,785			182,439

			Total assets	$	9,672,114		$	9,536,050

Liabilities:
Deposits:
	Non-interest-bearing demand deposits			$	3,143,473		$	3,229,052
	Interest-bearing deposits				4,925,384			4,399,091

			Total deposits		8,068,857			7,628,143
Federal funds purchased and securities sold under repurchase agreements					421,801			811,218
Subordinated notes payable and other borrowings					152,752			168,164
Junior subordinated deferrable interest debentures					103,093			103,093
Accrued interest payable and other liabilities					155,607			121,642

			Total liabilities		8,902,110			8,832,260
Shareholders’ Equity:
Junior participating preferred stock, par value $.01 per share; 250,000 shares authorized; none issued					—			—
Common stock, par value $.01 per share; 90,000,000 shares authorized; 53,561,616 shares issued					536			536
Surplus					200,844			196,830
Retained earnings					625,405			549,422
Deferred compensation					(3,771	)		(1,957	)
Accumulated other comprehensive income, net of tax					8,063			32,548
Treasury stock, 1,785,523 shares in 2003 and 2,266,141 shares in 2002, at cost					(61,073	)		(73,589	)

			Total shareholders’ equity		770,004			703,790

			Total liabilities and shareholders’ equity	$	9,672,114		$	9,536,050

See accompanying Notes to Consolidated Financial Statements.

Cullen/ Frost Bankers, Inc.

Consolidated Statements of Cash Flows

(Dollars in thousands)



			Year Ended December 31,

			2003			2002			2001


Operating Activities:
Net income			$	130,501		$	116,986		$	80,916
Adjustments to reconcile net income to net cash from operating activities:
	Provision for possible loan losses			10,544			22,546			40,031
	Deferred tax benefit			(3,778	)		(7,817	)		(7,505	)
	Accretion of loan discounts			(4,127	)		(4,512	)		(2,355	)
	Securities premium amortization (discount accretion), net			1,167			1,203			(2,204	)
	Net gain on sale of assets			(3,465	)		(2,102	)		(2,018	)
	Net gain on securities transactions			(40	)		(88	)		(78	)
	Depreciation and amortization			25,751			27,072			35,530
	Tax benefit from stock option exercises			3,638			4,361			3,475
	Amortization of deferred compensation			833			4,838			1,330
	Charge for discontinued operations			—			3,035			—
	Earnings on life insurance policies			(4,624	)		(4,968	)		(3,428	)
	Net change in:
		Trading account securities		(594	)		(4,877	)		2,353
		Loans held for sale		(13,015	)		59,458			13,456
		Accrued interest receivable and other assets		25,334			96,789			(71,131	)
		Accrued interest payable and other liabilities		34,237			(29,459	)		12,000

	Net cash from operating activities			202,362			282,465			100,372
Investing Activities:
	Securities held to maturity:
	Purchases			(1,000	)		—			—
	Maturities, calls and principal repayments			12,023			15,049			19,824
	Securities available for sale:
		Purchases		(8,603,817	)		(7,933,246	)		(6,674,787	)
		Sales		6,768,029			6,992,946			5,478,619
		Maturities, calls and principal repayments		1,272,290			721,200			680,894
	Net change in loans			(65,555	)		(67,523	)		(23,063	)
	Net cash paid (received) in acquisitions			(750	)		19,163			(4,954	)
	Proceeds from sales of premises and equipment			1,070			2,202			591
	Purchases of premises and equipment			(12,512	)		(43,147	)		(18,070	)
	Purchase of life insurance policies			—			—			(100,000	)
	Return of capital on life insurance policies			3,296			3,747			—
	Proceeds from sales of repossessed properties			7,211			2,926			1,959

	Net cash from investing activities			(619,715	)		(286,683	)		(638,987	)
Financing Activities:
	Net change in deposits			440,714			508,391			598,317
	Net change in short-term borrowings			(389,417	)		505,834			(57,727	)
	Net proceeds from issuance of subordinated notes			—			—			148,646
	Principal payments on notes payable and other borrowings			(15,412	)		(12,895	)		(5,156	)
	Proceeds from stock option exercises			15,294			10,754			43
	Purchase of treasury stock			(11,082	)		(28,733	)		(10,424	)
	Repurchase of restricted stock			—			(1,151	)		(169	)
	Cash dividends paid			(48,485	)		(44,737	)		(43,296	)

	Net cash from financing activities			(8,388	)		937,463			630,234

Net change in cash and cash equivalents				(425,741	)		933,245			91,619
Cash and cash equivalents at beginning of year				2,063,947			1,130,702			1,039,083

Cash and cash equivalents at end of year			$	1,638,206		$	2,063,947		$	1,130,702

See accompanying Notes to Consolidated Financial Statements

Cullen/ Frost Bankers, Inc.

Consolidated Statement of Changes in Shareholders’ Equity

(Dollars in thousands)


													Accumulated
													Other
													Comprehensive
													Income
			Common				Retained			Deferred			(Loss),			Treasury
			Stock		Surplus		Earnings			Compensation			Net of Tax			Stock			Total


Balance at January 1, 2001			$	536	$	187,673	$	450,872		$	(2,866	)	$	(4,023	)	$	(59,166	)	$	573,026
Comprehensive income:
	Net income			—		—		80,916			—			—			—			80,916
	Other comprehensive income			—		—		—			—			(9,982	)		—			(9,982	)

		Total comprehensive income																		70,934

Stock option exercises				—		—		(6,333	)		—			—			6,376			43
Tax benefit from stock compensation				—		3,475		—			—			—			—			3,475
Purchase of treasury stock				—		—		—			—			—			(10,424	)		(10,424	)
Restricted stock awards				—		708		—			(3,205	)		—			2,497			—
Repurchase of restricted stock				—		—		99			915			—			(1,183	)		(169	)
Amortization of deferred compensation				—		—		—			1,330			—			—			1,330
Cash dividends				—		—		(43,296	)		—			—			—			(43,296	)

Balance at December 31, 2001				536		191,856		482,258			(3,826	)		(14,005	)		(61,900	)		594,919
Comprehensive income:
	Net income			—		—		116,986			—			—			—			116,986
	Other comprehensive income			—		—		—			—			46,553			—			46,553

		Total comprehensive income																		163,539

Stock option exercises				—		—		(5,088	)		—			—			15,842			10,754
Tax benefit from stock compensation				—		4,361		—			—			—			—			4,361
Purchase of treasury stock				—		—		—			—			—			(28,733	)		(28,733	)
Restricted stock awards				—		613					(3,126	)		—			2,513			—
Repurchase of restricted stock				—		—		3			157			—			(1,311	)		(1,151	)
Amortization of deferred compensation				—		—		—			4,838			—			—			4,838
Cash dividends				—		—		(44,737	)		—			—			—			(44,737	)

Balance at December 31, 2002				536		196,830		549,422			(1,957	)		32,548			(73,589	)		703,790
Comprehensive income:
	Net income			—		—		130,501			—			—			—			130,501
	Other comprehensive income			—		—		—			—			(24,485	)		—			(24,485	)

		Total comprehensive income																		106,016

Stock option exercises				—		—		(6,033	)		—			—			21,327			15,294
Tax benefit from stock compensation				—		3,638		—			—			—						3,638
Purchase of treasury stock				—		—		—			—			—			(11,082	)		(11,082	)
Restricted stock awards				—		376		—			(2,647	)		—			2,271			—
Amortization of deferred compensation				—		—		—			833			—			—			833
Cash dividends				—		—		(48,485	)		—			—			—			(48,485	)

Balance at December 31, 2003			$	536	$	200,844	$	625,405		$	(3,771	)	$	8,063		$	(61,073	)	$	770,004

See accompanying Notes to Consolidated Financial Statements

Cullen/ Frost Bankers, Inc.

Notes To Consolidated Financial Statements

(table amounts in thousands, except per share amounts)

Note 1 — Summary of Significant Accounting Policies

Nature of Operations. Cullen/ Frost Bankers, Inc. (Cullen/ Frost) is a financial holding company and a bank holding company headquartered in San Antonio, Texas that provides, through its subsidiaries (collectively referred to as the “Corporation”), a broad array of products and services throughout 12 Texas markets. In addition to general commercial and consumer banking, other products and services offered include trust and investment management, investment banking, insurance brokerage, leasing, asset-based lending, treasury management and item processing.

Basis of Presentation. The consolidated financial statements include the accounts of Cullen/ Frost and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. The accounting and reporting policies followed by the Corporation are in accordance with accounting principles generally accepted in the United States and conform to general practices within the banking industry.

Certain items in prior financial statements have been reclassified to conform to the current presentation. Additionally, the prior year financial statements have been restated to de-consolidate the Corporation’s investment in Cullen/ Frost Capital Trust I in connection with the implementation of a new accounting standard related to variable interest entities during the fourth quarter of 2003 (see Note 23 — New Accounting Standards). All acquisitions during 2003, 2002 and 2001 were accounted for using the purchase method. Accordingly, the operating results of the acquired companies are included with the Corporation’s results of operations since their respective dates of acquisition (see Note 2 — Acquisitions).

Use of Estimates. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabil