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, 2004

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)

(210) 220-4011

(Registrant’s telephone number, including area code)

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, 2004, 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 $2.2 billion.

As of January 31, 2005, there were 51,902,952 shares of the registrant’s common stock, $.01 par value, outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the 2005 Annual Meeting of Shareholders of Cullen/ Frost Bankers, Inc. to be held on May 18, 2005 are incorporated by reference in this Form 10-K in response to Part III, Items 10, 11, 12, 13 and 14.

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 EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES		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		55
ITEM 8.	FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA		57
ITEM 9.	CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE		100
ITEM 9A.	CONTROLS AND PROCEDURES		100
ITEM 9B.	OTHER INFORMATION		102

PART III

ITEM 10.	DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT		103
ITEM 11.	EXECUTIVE COMPENSATION		103
ITEM 12.	SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT		103
ITEM 13.	CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS		103
ITEM 14.	PRINCIPAL ACCOUNTING FEES AND SERVICES		103

PART IV

ITEM 15.	EXHIBITS, FINANCIAL STATEMENT SCHEDULES		104
SIGNATURES			106
Restoration Profit Sharing Plan
Subsidiaries of Cullen/Frost Bankers, Inc.
Consent of Independent Registered Public Accounting Firm
Power of Attorney
Certification of the CEO
Certification of the CFO
Certification of the CEO
Certification of the CFO

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 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. At December 31, 2004, Cullen/ Frost had consolidated total assets of $10.0 billion and was one of the largest independent bank holding companies 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, manufacturing, services, construction retail, telecommunications, healthcare, military 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. The Corporation seeks merger or 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. The Corporation regularly evaluates merger and acquisition opportunities and conducts due diligence activities related to possible transactions with other financial institutions and financial services companies. As result, merger or acquisition discussions and, in some cases, negotiations may take place and future mergers or acquisitions involving cash, debt or equity securities may occur. 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 these 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 and Cullen/ Frost Capital Trust II.


	Cullen/ Frost Capital Trust I and Cullen/ Frost Capital Trust II

Cullen/ Frost Capital Trust I (“Trust I”) and Cullen/ Frost Capital Trust II (“Trust II”) are Delaware statutory business trusts formed in 1997 and 2004, respectively, for the purpose of issuing $100 million and $120 million, respectively, 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.

Trust I and Trust II are variable interest entities (VIEs) for which the Corporation is not the primary beneficiary, as defined in Financial Accounting Standards Board Interpretation (“FIN”) No. 46 “Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51 (Revised December 2003).” In accordance with FIN 46R, which was implemented in the fourth quarter of 2003, the accounts of Trust I and Trust II are not included in the Corporation’s consolidated financial statements. Prior to the fourth quarter of 2003, the financial statements of Trust I were included in the consolidated financial statements of the Corporation because Cullen/ Frost owns all of the outstanding common equity securities of the Trust. See the Corporation’s accounting policy related to consolidation in Note 1 — Summary of Significant Accounting Policies in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, which is located elsewhere in this report.

Despite the fact that the accounts of Trust I and Trust II are not included in the Corporation’s consolidated financial statements, the $220 million in trust preferred securities issued by these subsidiary trusts are included in the Tier 1 capital of Cullen/ Frost for regulatory capital purposes as allowed by the Federal Reserve Board. In May 2004, the Federal Reserve Board proposed a rule that would continue to allow the inclusion of trust preferred securities issued by unconsolidated subsidiary trusts in Tier 1 capital, but with stricter quantitative limits and clearer qualitative standards. Under the proposal, after a three-year transition period, the aggregate amount of trust preferred securities and certain other capital elements would be limited to 25% of Tier 1 capital elements, net of goodwill. The amount of trust preferred securities and certain other elements in excess of the limit could be included in Tier 2 capital, subject to restrictions. Bank holding companies with significant international operations would generally be expected to limit trust preferred securities and certain other capital elements to 15% of Tier 1 capital elements, net of goodwill. Based on the proposed rule, the Corporation expects to include all of its $220 million in trust preferred securities in Tier 1 capital. However, the provisions of the final rule could significantly differ from those proposed and there can be no assurance that the Federal Reserve Board will not further limit the amount of trust preferred securities permitted to be included in Tier 1 capital for regulatory capital purposes. The trust preferred securities could be redeemed without penalty if they were no longer permitted to be included in Tier 1 capital. 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.


	The Frost National Bank

The Frost National Bank (“Frost Bank”) is primarily engaged in the business of commercial and consumer banking through 78 financial centers and 121 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, 2004, Frost Bank had consolidated total assets of $9.9 billion and total deposits of $8.2 billion and was one of the largest commercial banks 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 (generally only in U.S. dollars), 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 approximately 281 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, 2004, the estimated fair value of trust assets was $17.1 billion, including managed assets of $7.8 billion and custody assets of $9.3 billion.

	•	Capital Markets — Fixed-Income Services. Frost Bank’s Capital Markets Division was formed 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 Premium Finance Corporation

Incorporated during the fourth quarter of 2004, Frost Premium Finance Corporation is a wholly owned subsidiary of Frost Bank that, beginning in 2005, will make loans to qualified borrowers for the purpose of financing their purchase of property and casualty insurance.


	Frost Securities, Inc.

Frost Securities, Inc. 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 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 19 — 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.

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 (“BHC Act”), 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 BHC Act limits the business of bank holding companies to banking, managing or controlling banks and other activities that the Federal Reserve Board has determined to be so closely related to banking as to be a proper incident thereto. As a result of the Gramm-Leach-Bliley Financial Modernization Act of 1999 (“GLB Act”), which amended the BHC Act, bank holding companies that are financial holding companies may engage in any activity, or acquire and retain the shares of a 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.

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 a 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 $207.2 million to Cullen/ Frost, without obtaining affirmative governmental approvals, at December 31, 2004. This amount is not necessarily indicative of amounts that may be paid or 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 the 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 Act, as amended (“FDIA”), 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 FDIA 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 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, 2004, 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 FDIA 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 June 2004, the BIS published a new capital accord to replace its 1988 capital accord. The new capital accord would, among other things, set capital requirements for operational risk and refine the existing capital requirements for credit risk and market risk. 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 United States federal regulatory authorities are currently expected to release proposed rules to implement the BIS’s new capital accord in mid-year 2005. It is currently anticipated that these authorities would release final rules in mid-year 2006, and that the final rules would become effective in January 2008. The Corporation cannot predict the timing or final form of the United States rules implementing the new capital accord and their impact on the Corporation. The new capital requirements that may arise from the final rules could increase the 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 2004; 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 2004, Frost Bank paid $1.2 million in Financing Corporation (“FICO”) assessments related to outstanding FICO bonds 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.


	Depositor Preference

The FDIA 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 of 1977 (“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.


	Anti-Money Laundering Initiatives and the USA Patriot Act

A major focus of governmental policy on financial institutions in recent years has been aimed at combating money laundering and terrorist financing. The USA PATRIOT Act of 2001 (the “USA Patriot Act”) substantially broadened the scope of United States 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 United States Treasury Department has issued a number of implementing regulations which apply to various requirements of the USA Patriot Act to financial institutions such as the Cullen/ Frost’s bank and broker-dealer subsidiaries. These regulations impose obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing and to verify the identity of their customers. Failure of a financial institution to maintain and implement adequate programs to combat money laundering and terrorist financing, or to comply with all of the relevant laws or regulations, 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 Cullen/ Frost or any of its subsidiaries could have a material effect on the business of the Corporation.

Employees

At December 31, 2004, the Corporation employed 3,234 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, 2004, 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		77	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		58	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		44	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		50	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 or furnished to 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 requesting shareholder.


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 2004.

PART II


ITEM 5.	MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES


	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 2004 and 2003 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.



	2004				2003

Sales Price Per Share	High		Low		High		Low


First quarter	$	43.47	$	38.84	$	33.90	$	29.05
Second quarter		45.10		41.05		34.60		30.05
Third quarter		46.50		41.85		39.00		32.00
Fourth quarter		49.20		45.90		41.06		37.31


Cash Dividends Per Share		2004		2003


First quarter		$	0.240	$	0.22
Second quarter			0.265		0.24
Third quarter			0.265		0.24
Fourth quarter			0.265		0.24

	Total	$	1.035	$	0.94

As of December 31, 2004, there were 51,923,852 shares of the Corporation’s common stock outstanding held by 1,868 holders of record. The closing price per share of common stock on December 31, 2004, was $48.60.

The Corporation’s management is currently committed to continuing to pay regular cash dividends; however, there can be no assurance as to future dividends because they are dependent on the Corporation’s future earnings, capital requirements and financial condition. 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, 2004, 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.


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


Plans approved by shareholders			6,043,950	$	30.29		1,159,773
Plans not approved by shareholders			—		—		—

	Total		6,043,950	$	30.29		1,159,773


	Stock Repurchase Plans

During 2004, the Corporation maintained two stock repurchase plans authorized by the Corporation’s board of directors. Stock repurchase plans allow the Corporation to proactively manage its capital position and return excess capital to shareholders. Shares purchased under such plans also provide the Corporation with shares of common stock necessary to satisfy obligations related to stock compensation awards. The Corporation’s board of directors approved the first of the two stock repurchase plans on October 23, 2003. This plan, which was completed in 2004, authorized the Corporation to repurchase from time to time up to 1.2 million shares of its common stock over a two-year period ending October 23, 2005 in the open market or through private transactions. Under the plan, during 2003, the Corporation repurchased 267.9 thousand shares at a cost of $10.7 million. During 2004, the Corporation repurchased the remaining 932.1 thousand shares authorized under the plan at a cost of $39.7 million. The Corporation’s board of directors approved the second stock repurchase plan on April 29, 2004. Under this plan, the Corporation is authorized to repurchase up to 2.1 million shares of its common stock from time to time over a two-year period ending April 29, 2006 in the open market or through private transactions. As of December 31, 2004, the Corporation has repurchased a total of 533.2 thousand shares under this plan at a cost of $25.5 million.

The Corporation previously maintained a stock repurchase plan implemented in September 2001. The repurchase plan was terminated during September 2003. No shares were repurchased under this plan in 2003. During 2002, the Corporation repurchased 800.0 thousand shares at a cost of $28.8 million.

The following table provides information with respect to purchases made by or on behalf of the Corporation or any “affiliated purchaser” (as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934), of the Corporation’s common stock during the fourth quarter of 2004.


								Maximum
								Number of
								Shares That May
						Total Number of		Yet Be Purchased
						Shares Purchased as		Under the Plans
	Total Number of			Average Price		Part of Publicly		at the End
Period	Shares Purchased			Paid Per Share		Announced Plans⁽¹⁾		of the Period


October 1, 2004 to October 31, 2004		—		$	—		—		2,180,300
November 1, 2004 to November 30, 2004		485	⁽²⁾		48.15		—		2,180,300
December 1, 2004 to December 31, 2004		613,500			47.64		613,500		1,566,800

Total		613,985		$	47.64		613,500


(1)	Shares purchased under two stock repurchase plans authorized by the Corporation’s board of directors on October 23, 2003 and April 29, 2004, respectively. Additional details related to these plans are set forth elsewhere in this section.

(2)	Includes repurchases made in connection with the exercise of certain employee stock options and the vesting of certain share awards.


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, 2004. 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, 2004 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. Dollar amounts are in thousands, except per share data.



			Year Ended December 31,

			2004			2003		2002			2001			2000


Consolidated Statements of Income
Interest income:
	Loans, including fees		$	249,612		$	233,463	$	265,514		$	343,928		$	394,073
	Securities			135,035			125,778		120,221			106,933			109,248
	Interest-bearing deposits			63			104		172			200			331
	Federal funds sold and resell agreements			8,834			9,601		3,991			9,784			8,488

		Total interest income		393,544			368,946		389,898			460,845			512,140
Interest expense:
	Deposits			39,150			37,406		55,384			118,699			158,858
	Federal funds purchased and repurchase agreements			5,775			4,059		5,359			12,054			17,889
	Junior subordinated deferrable interest debentures			12,143			8,735		8,735			8,735			8,735
	Subordinated notes payable and other borrowings			5,038			4,988		6,647			5,531			4,346

		Total interest expense		62,106			55,188		76,125			145,019			189,828

		Net interest income		331,438			313,758		313,773			315,826			322,312
Provision for possible loan losses				2,500			10,544		22,546			40,031			14,103

		Net interest income after provision for possible loan losses		328,938			303,214		291,227			275,795			308,209
Non-interest income:
	Trust fees			53,910			47,486		47,463			48,784			49,266
	Service charges on deposit accounts			87,415			87,805		78,417			70,534			60,627
	Insurance commissions and fees			30,981			28,660		25,912			18,598			10,698
	Other charges, commissions and fees			19,353			18,668		16,860			16,176			15,548
	Net gain (loss) on securities transactions			(3,377	)		40		88			78			4
	Other			36,828			32,702		32,229			29,547			29,472

		Total non-interest income		225,110			215,361		200,969			183,717			165,615
Non-interest expense:
	Salaries and wages			158,039			146,622		139,227			138,347			133,525
	Employee benefits			40,176			38,316		34,614			35,000			28,808
	Net occupancy			29,375			29,286		28,883			29,419			27,693
	Furniture and equipment			22,771			21,768		22,597			23,727			21,329
	Intangible amortization			5,346			5,886		7,083			15,127			15,625
	Restructuring charges			—			—		—			19,865			—
	Other			89,323			84,157		79,738			78,172			76,832

		Total non-interest expense		345,030			326,035		312,142			339,657			303,812
Income from continuing operations before income taxes and cumulative effect of accounting change				209,018			192,540		180,054			119,855			170,012
Income taxes				67,693			62,039		57,821			39,749			58,746

Income from continuing operations				141,325			130,501		122,233			80,106			111,266
Loss from discontinued operations, net of tax				—			—		(5,247	)		(2,200	)		(2,449	)
Cumulative effect of change in accounting for derivatives, net of tax				—			—		—			3,010			—

		Net income	$	141,325		$	130,501	$	116,986		$	80,916		$	108,817

Selected Financial Data (continued)



		As of or for the Year Ended December 31,

		2004			2003			2002			2001			2000


Per Common Share Data
Basic:
	Income from continuing operations	$	2.74		$	2.54		$	2.40		$	1.55		$	2.13
	Net income		2.74			2.54			2.29			1.57			2.09
Diluted:
	Income from continuing operations		2.66			2.48			2.33			1.50			2.07
	Net income		2.66			2.48			2.23			1.52			2.03
Cash dividends declared and paid			1.035			0.94			0.875			0.84			0.76
Book value			15.84			14.87			13.72			11.58			11.14
Common Shares Outstanding
Period-end			51,924			51,776			51,295			51,355			51,430
Weighted-average shares — basic			51,651			51,442			51,001			51,530			52,123
Dilutive effect of stock compensation			1,489			1,216			1,422			1,818			1,534
Weighted-average shares — diluted			53,140			52,658			52,423			53,348			53,657
Performance Ratios
Return on average assets:
	Income from continuing operations		1.47	%		1.36	%		1.46	%		1.02	%		1.56	%
	Net income		1.47			1.36			1.40			1.03			1.52
Return on average equity:
	Income from continuing operations		17.91			17.78			18.77			13.05			20.87
	Net income		17.91			17.78			17.96			13.18			20.41
Net interest income to average earning assets			4.05			3.98			4.58			4.89			5.32
Dividend pay-out ratio			38.06			37.15			38.24			53.51			36.35
Balance Sheet Data
Period-end:
	Loans	$	5,164,991		$	4,590,746		$	4,518,913		$	4,518,608		$	4,534,645
	Earning assets		8,891,859			8,132,479			7,709,980			6,811,284			6,421,753
	Total assets		9,952,787			9,672,114			9,536,050			8,375,461			7,665,006
	Non-interest-bearing demand deposits		2,969,387			3,143,473			3,229,052			2,669,829			2,118,624
	Interest-bearing deposits		5,136,291			4,925,384			4,399,091			4,428,178			4,381,066
	Total deposits		8,105,678			8,068,857			7,628,143			7,098,007			6,499,690
	Long-term debt and other borrowings		377,677			255,845			271,257			284,152			139,307
	Shareholders’ equity		822,395			770,004			703,790			594,919			573,026
Average:
	Loans	$	4,823,198		$	4,497,489		$	4,536,999		$	4,546,596		$	4,352,868
	Earning assets		8,352,334			8,011,081			6,961,439			6,564,678			6,148,154
	Total assets		9,618,849			9,583,829			8,353,145			7,841,823			7,154,300
	Non-interest-bearing demand deposits		2,914,520			3,037,724			2,540,432			2,186,690			1,897,172
	Interest-bearing deposits		4,852,166			4,539,622			4,353,878			4,364,667			4,154,498
	Total deposits		7,766,686			7,577,346			6,894,310			6,551,357			6,051,670
	Long-term debt and other borrowings		363,386			264,428			275,136			200,166			170,105
	Shareholders’ equity		789,073			733,994			651,273			614,010			533,125
Asset Quality
Allowance for possible loan losses		$	75,810		$	83,501		$	82,584		$	72,881		$	63,265
Allowance for possible loan losses to period-end loans			1.47	%		1.82	%		1.83	%		1.61	%		1.40	%
Net loan charge-offs		$	10,191		$	9,627		$	12,843		$	30,415		$	9,183
Net loan charge-offs to average loans			0.20	%		0.21	%		0.28	%		0.67	%		0.21	%
Non-performing assets		$	39,116		$	52,794		$	42,908		$	37,430		$	18,933
Non-performing assets to:
	Total loans plus foreclosed assets		0.76	%		1.15	%		0.95	%		0.83	%		0.42	%
	Total assets		0.39			0.55			0.45			0.45			0.25
Consolidated Capital Ratios
	Tier 1 risk-based capital ratio		12.83	%		11.41	%		10.46	%		10.14	%		10.08	%
	Total risk-based capital ratio		15.99			15.01			14.16			13.98			11.24
	Leverage ratio		9.18			7.83			7.25			7.21			7.54
	Average shareholders’ equity to average total assets		8.20			7.66			7.80			7.83			7.45

The following tables set forth unaudited consolidated selected quarterly statement of operations data for the years ended December 31, 2004 and 2003. Dollar amounts are in thousands, except per share data.



		Year Ended December 31, 2004

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


Interest income		$	107,458	$	99,993	$	94,762	$	91,331
Interest expense			19,570		16,017		13,520		12,999

Net interest income			87,888		83,976		81,242		78,332
Provision for possible loan losses			—		—		2,000		500
Non-interest income⁽¹⁾			55,751		55,634		56,336		57,389
Non-interest expense			86,735		86,499		85,199		86,597

Income before income taxes			56,904		53,111		50,379		48,624
Income taxes			18,573		17,140		16,261		15,719

Net income		$	38,331	$	35,971	$	34,118	$	32,905

Net income per common share:
	Basic	$	0.74	$	0.70	$	0.67	$	0.64
	Diluted		0.71		0.68		0.65		0.62



		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⁽¹⁾			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


(1)	Includes net losses on securities transactions of $1.7 million and $1.6 million during the first and third quarters of 2004. Net gains or losses on securities transactions were not significant during any quarter of 2003.


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, expenses, income or loss, earnings or loss per share, the payment or nonpayment of dividends, capital structure and other financial items; (ii) statements of plans, objectives and expectations 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”, “continue”, “remain”, “will”, “should”, “may” and other 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, national 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 the level of non-performing assets and charge-offs.

	•	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 and monetary and fiscal policies and laws, including the interest rate policies of the Federal Reserve Board.

	•	Inflation, interest rate, securities 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.

	•	Changes in the financial performance and/or condition of the Corporation’s borrowers.

	•	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 Public Company Accounting Oversight Board, 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 legal and regulatory developments including the resolution of legal proceedings or regulatory or other governmental inquiries and the results of regulatory examinations or reviews.


	•	Greater than expected costs or difficulties related to the integration of new products and 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 Corporation’s allowance for possible loan loss methodology is based on guidance provided in SEC Staff Accounting Bulletin No. 102, “Selected Loan Loss Allowance Methodology and Documentation Issues” and 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 stock awards is based on the market price of the stock on the date of grant and is recognized ratably over the service 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.

In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123, “Share-Based Payment (Revised 2004).” Among other things, SFAS 123R eliminates the ability to account for stock-based compensation using APB 25 and requires that such transactions be recognized as compensation cost in the income statement based on their fair values on the date of the grant. SFAS 123R is effective for the Corporation on July 1, 2005. See Note 22 — New Accounting Standards in the accompanying notes to consolidated financial statements included elsewhere in this report.

Overview

The following discussion and analysis presents the more significant factors affecting the Corporation’s financial condition as of December 31, 2004 and 2003 and results of operations for each of the three years in the period ended December 31, 2004. 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 Corporation’s 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.

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 20 — 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 $141.3 million, or $2.66 diluted per common share, in 2004 compared to $130.5 million, or $2.48 diluted per common share, in 2003 and $117.0 million, or $2.23 diluted per common share, in 2002. Income from continuing operations was equal to reported net income in 2004 and 2003, while income from continuing operations totaled $122.2 million, or $2.33 diluted per common share, in 2002. 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.

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


		2004			2003			2002


Taxable-equivalent net interest income		$	337,102		$	318,945		$	318,772
Taxable-equivalent adjustment			5,664			5,187			4,999

Net interest income			331,438			313,758			313,773
Provision for possible loan losses			2,500			10,544			22,546
Non-interest income			225,110			215,361			200,969
Non-interest expense			345,030			326,035			312,142

Income from continuing operations before income taxes			209,018			192,540			180,054
Income taxes			67,693			62,039			57,821

Income from continuing operations			141,325			130,501			122,233
Loss from discontinued operations, net of tax			—			—			(5,247	)

Net income		$	141,325		$	130,501		$	116,986

Basic per common share:
	Income from continuing operations	$	2.74		$	2.54		$	2.40
	Net income		2.74			2.54			2.29
Diluted per common share:
	Income from continuing operations	$	2.66		$	2.48		$	2.33
	Net income		2.66			2.48			2.23
Return on average assets:
	Income from continuing operations		1.47	%		1.36	%		1.46	%
	Net income		1.47			1.36			1.40
Return on average equity:
	Income from continuing operations		17.91	%		17.78	%		18.77	%
	Net income		17.91			17.78			17.96

Net income for 2004 increased $10.8 million, or 8.3%, compared to 2003. The increase was primarily due to a $17.7 million increase in net interest income, a $8.0 million decrease in the provision for possible loan losses and a $9.7 million increase in non-interest income. The impact of these items was partly offset by a $19.0 million increase in non-interest expense and increased income tax expense resulting from the higher level of earnings. As stated above, the 2002 net income amount includes the net after-tax effect of losses from the discontinued FSI operations. Because of the loss attributable to discontinued operations, management believes an analysis of income from continuing operations when comparing 2003 to 2002 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.

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 59.6% of total revenue during 2004. 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 2002 at 4.75% and remained unchanged 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%. During 2004, the prime rate increased 25 basis points at end of the second quarter, 50 basis points during the third quarter and 50 basis points during the fourth quarter to end 2004 at 5.25%. The federal funds rate, which is the cost of immediately available overnight funds, fluctuated in a similar manner. 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%. During 2004, the federal funds rate increased 25 basis points at the end of the second quarter, 50 basis points during the third quarter and 50 basis points during the fourth quarter to end 2004 at 2.25%.

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 or low 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. However, the prime interest rate and the federal funds rate increases discussed above are expected to have a positive impact on the Corporation’s net interest income and net interest margin. 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 income are presented on pages 98 and 99 of this report.



		2004 vs. 2003									2003 vs. 2002


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

		Rate			Volume			Total			Rate			Volume			Total


Interest-bearing deposits		$	(12	)	$	(29	)	$	(41	)	$	(29	)	$	(66	)	$	(95	)
Federal funds sold and resell agreements			3,871			(4,638	)		(767	)		(1,436	)		7,046			5,610
Securities:
	Taxable		(2,612	)		11,269			8,657			(20,492	)		25,751			5,259
	Tax-exempt		220			734			954			(779	)		1,270			491
Loans			(620	)		16,892			16,272			(29,732	)		(2,297	)		(32,029	)

	Total earning assets		847			24,228			25,075			(52,468	)		31,704			(20,764	)

Savings and interest checking			60			114			174			(968	)		84			(884	)
Money market deposits accounts			952			2,955			3,907			(6,693	)		3,434			(3,259	)
Time accounts			(1,067	)		(1,553	)		(2,620	)		(9,002	)		(2,972	)		(11,974	)
Public funds			(67	)		350			283			(1,782	)		(78	)		(1,860	)
Federal funds purchased and repurchase agreements			3,007			(1,291	)		1,716			(4,878	)		3,578			(1,300	)
Junior subordinated deferrable interest debentures			(2,132	)		5,541			3,409			—			—			—
Subordinated notes payable and other notes			343			(14	)		329			(1,193	)		(64	)		(1,257	)
Federal Home Loan Bank advances			392			(672	)		(280	)		(105	)		(298	)		(403	)

	Total interest-bearing liabilities		1,488			5,430			6,918			(24,621	)		3,684			(20,937	)

Changes in net interest income		$	(641	)	$	18,798		$	18,157		$	(27,847	)	$	28,020		$	173

Taxable-equivalent net interest income for 2004 increased $18.2 million, or 5.7%, compared to 2003 while taxable-equivalent net interest income for 2003 did not significantly change compared to 2002. The increase in taxable-equivalent net interest income during 2004 compared to 2003 was primarily due to the combined effect of a $341.3 million increase in the average volume of earning assets and a seven basis point increase in the net interest margin from 3.98% to 4.05%. Growth in average earning assets during 2004 was primarily in securities, which increased $279.4 million, or 10.4%, and loans, which increased $325.7 million, or 7.2%. These increases were partly offset by a $261.2 million, or 31.6%, decrease in average federal funds sold and resell agreements. The shift in the relative proportion of interest-earning assets to higher yielding loans and securities from federal funds sold and resell agreements combined with increases in market interest rates during 2004 helped improve the average yield on earning assets which, in turn, helped improve the Corporation’s net interest margin. The lack of significant fluctuation in net interest income for 2003 compared to 2002 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%. Growth in average earning assets during 2003 was primarily in federal funds sold and resell agreements and U.S. government agency securities. The decrease in the net interest margin in 2003 compared to 2002 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.

During 2003 and to a lesser extent in 2004, the net interest margin was also impacted by the use of dollar-roll repurchase agreements, as discussed below.

The Corporation has utilized dollar-roll repurchase agreement transactions to increase net interest income. 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. The Corporation funded investments in federal funds sold and resell agreements utilizing dollar-roll repurchase agreements. By doing this, the Corporation was able to capitalize on the spread between the yield earned on federal funds sold and resell agreements and the cost of the dollar-roll repurchase agreements. The spread had a positive effect on the dollar amount of net interest income, which increased by approximately $989 thousand and $4.9 million during 2004 and 2003, respectively, as a result of the dollar-roll transactions. However, because the funds were invested in lower yielding federal funds sold and resell agreements, the dollar-roll transactions had a negative impact on the Corporation’s net interest margin. The average volume of dollar-roll transactions decreased $313.9 million from $406.2 million in 2003 to $92.3 million in 2004. As a result, the average volume of federal funds sold and resell agreements during 2004 decreased $261.2 million, or 31.6%. The decline in the relative proportion of these short-term investments to total average earning assets during 2004 helped improve the average yield on earning assets. The average yield on earning assets increased from 4.67% for 2003 to 4.79% for 2004. At the same time, the average cost of interest-bearing liabilities increased from 0.98% for 2003 to 1.07% for 2004. As a result of these changes, the Corporation’s net interest margin increased from 3.98% in 2003 to 4.05% in 2004.

The above table, which presents changes in taxable-equivalent net interest income resulting from changes in the average volumes of earning assets and interest-bearing liabilities and changes in the average interest rates on those assets and liabilities, indicates that, despite the seven basis point increase in the net interest margin during 2004 compared to 2003, changes in interest rates resulted in a decrease in net interest income of $641 thousand. This primarily resulted from the Corporation’s use of dollar-roll repurchase agreements. Of the total $3.0 million increase in interest expense on federal funds purchased and repurchase agreements due to changes in interest rates, or the rate variance, $2.1 million related to dollar-roll repurchase agreements.

As detailed above, the Corporation has experienced significant fluctuations in the average volume of federal funds sold and resell agreements during the reported periods mainly due to the changes in the level of dollar-roll transactions. The average volume of securities increased $279.4 million in 2004 compared to 2003 and increased $513.8 million in 2003 compared to 2002. Securities growth during both years was primarily in U.S. government agency securities. The average yield on securities was 4.77% in 2004 compared to 4.87% in 2003 and 5.76% in 2002. The average volume of loans, the Corporation’s primary category of earning assets, increased $325.7 million during 2004 compared to 2003 while there was no significant fluctuation in the average volume of loans in 2003 compared to 2002. The average yield on loans was 5.19% in 2004 compared to 5.20% in 2003 and 5.86% in 2002.

The average volume of deposits increased $189.3 million in 2004 compared to 2003 and increased $683.0 million in 2003 compared to 2002. The growth in average deposits during 2004 compared to 2003 was primarily in interest-bearing deposits. Accordingly, the ratio of average interest-bearing deposits to total average deposits increased to 62.5% in 2004 from 59.9% in 2003. The average cost of interest-bearing deposits and total deposits was 0.81% and 0.50% during 2004 compared to 0.82% and 0.49% during 2003. The decline in the average cost of interest-bearing deposits was partly the result of a shift in the relative proportion of interest-bearing deposits to lower-cost savings, interest checking and money market accounts from higher-cost time deposits. Non-interest-bearing deposits made up 72.8% of the growth in average deposits during 2003 compared to 2002. Accordingly, the ratio of average interest-bearing deposits to total average deposits decreased to 59.9% in 2003 compared to 63.2% in 2002. The change in deposit mix, combined with a general decline in market rates, had the effect of reducing the average cost of interest-bearing deposits and total deposits from 1.27% and 0.80% in 2002 to 0.82% and 0.49% in 2003. This decrease in the average cost of deposits helped mitigate a portion of the impact of declining yields on earning assets on the Corporation’s net interest income.

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 3.72% in 2004 compared to 3.69% in 2003 and 4.16% in 2002. 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 17 — Derivative Financial Instruments in the accompanying notes to consolidated financial statements included elsewhere in this report. Information regarding the impact of fluctuations in interest rates on the Corporation’s derivative financial instruments is set forth in Item 7A. Quantitative and Qualitative Disclosures About Market Risk 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 $2.5 million in 2004 compared to $10.5 million in 2003 and $22.5 million in 2002. 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:


		2004			2003		2002


Trust fees		$	53,910		$	47,486	$	47,463
Service charges on deposit accounts			87,415			87,805		78,417
Insurance commissions and fees			30,981			28,660		25,912
Other charges, commissions and fees			19,353			18,668		16,860
Net gain (loss) on securities transactions			(3,377	)		40		88
Other			36,828			32,702		32,229

	Total	$	225,110		$	215,361	$	200,969

Total non-interest income for 2004 increased $9.7 million, or 4.5%, compared to 2003 while total non-interest income for 2003 increased $14.4 million, or 7.2%, compared to 2002. Changes in the various components of non-interest income are discussed in more detail below.

Trust Fees. Trust fee income for 2004 increased $6.4 million, or 13.5%, compared to 2003, while 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% of total trust fees in 2004, 2003 and 2002. Investment and other custodial account fees are generally based on the market value of assets within a trust account. Volatility in the equity and bond markets impacts the market value of trust assets and the related investment fees.

The increase in trust fee income during 2004 compared to 2003 was primarily the result of increases in investment fees (up $4.3 million), custody fees (up $743 thousand), oil and gas trust management fees (up $702 thousand), financial consulting fees (up $621 thousand), real estate fees (up $175 thousand), and tax fees (up $148 thousand). These increases were offset by a decrease in estate fees (down $285 thousand). The increase in investment fees was primarily due to better equity market conditions in 2004 compared to 2003 and growth in overall trust assets and the number of trust accounts.

Trust fee income for 2003 did not significantly fluctuate compared to 2002 as an increase in oil and gas trust management fees (up $1.1 million) and an increase in real estate trust management fees (up $167 thousand) were offset by a decline in investment fees (down $1.0 million) and a decline in estate fees (down $260 thousand). 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.

At December 31, 2004, trust assets, including both managed assets and custody assets, were primarily composed of equity securities (44.9% of trust assets), fixed income securities (37.9% of trust assets) and cash equivalents (10.8% of trust assets). The estimated fair value of trust assets was $17.1 billion (including managed assets of $7.8 billion and custody assets of $9.3 billion) at December 31, 2004, compared to $14.8 billion (including managed assets of $6.6 billion and custody assets of $8.2 billion) at December 31, 2003 and $12.6 billion (including managed assets of $5.9 billion and custody assets of $6.7 billion) at December 31, 2002.

Service Charges on Deposit Accounts. Service charges on deposit accounts for 2004 did not significantly fluctuate compared to 2003 as a decrease in service charges on consumer accounts (down $2.6 million) was offset by increases in overdraft fees on consumer accounts (up $806 thousand), service charges on commercial accounts (up $789 thousand), point-of-sale income from check-card usage (up $410 thousand) and non-sufficient funds charges on consumer accounts (up $384 thousand). The decline in service charges on consumer accounts primarily resulted from the reduction of certain maintenance and transaction fees applicable to all types of consumer checking accounts effective October 4, 2003. The increase in overdraft fees on consumer accounts was primarily due to the expanded use of the Corporation’s overdraft courtesy product. 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 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.

Insurance Commissions and Fees. Insurance commissions and fees for 2004 increased $2.3 million, or 8.1%, compared to 2003. The majority of the increase was related to higher commission income (up $1.5 million). Most of the increase (approximately $1.4 million) relates to an insurance agency acquired during the third quarter of 2004. Additional information related to the acquisition of the insurance agency is presented in Note 2 — Acquisitions in the accompanying notes to consolidated financial statements included elsewhere in this report. The increase in insurance commissions and fees during 2004 was also partly due to an increase in contingent commissions. Contingent commissions increased $782 thousand to $3.1 million during 2004 from $2.3 million during 2003. Contingent commissions primarily consist of amounts received from various property and casualty insurance carriers related to the loss performance of insurance policies previously placed. Such commissions are seasonal in nature and are generally received during the first quarter of each year. These commissions totaled $2.3 million and $1.9 million during 2004 and 2003. Contingent commissions also include amounts received from various benefit plan insurance companies related to the volume of business generated and/or the subsequent retention of such business. These commissions totaled $849 thousand and $495 thousand during 2004 and 2003.

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, total contingent commissions increased $1.1 million compared to 2002. The Corporation also acquired a small insurance agency during the first quarter of 2003.

Other Charges, Commissions and Fees. Other charges, commissions and fees for 2004 increased $685 thousand, or 3.7%, compared to 2003. The increase was primarily due to increases in mutual fund fees (up $660 thousand), income associated with the factoring of accounts receivable (up $311 thousand), corporate advisory services (up $211 thousand), and letters of credit fees (up $206 thousand). These increases were partly offset by a reduction in the accelerated realization of deferred loan fees (down $686 thousand) due to a decline in loan prepayments. During 2003, the Corporation accelerated the realization of certain deferred loan fees because of loan prepayments.

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. 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 22 — New Accounting Standards in the accompanying notes to consolidated financial statements included elsewhere in this report).

Net Gain (Loss) on Securities Transactions. The Corporation realized a net loss on securities transactions of $3.4 million during 2004. Net gains on securities transactions in 2003 and 2002 were not significant. During the third quarter of 2004, the Corporation sold $228.5 million (amortized cost) of callable U.S. government agency securities, which resulted in approximately $1.6 million of the net loss. After the sales, the Corporation had no callable U.S. government agency securities. The net loss on securities transactions also included a net loss of $1.7 million related to the sale of $366.4 million (amortized cost) of securities during the first quarter. The net loss was primarily related to $176.3 million (amortized cost) of securities sold in connection with a restructuring of the Corporation’s securities portfolio. The Corporation expects these actions to have a positive impact on future net interest income.

Other Non-Interest Income. Other non-interest income for 2004 increased $4.1 million, or 12.6%, compared to 2003. The increase was primarily due to increases in income from check card usage (up $1.4 million), securities trading activities (up $1.3 million), rental income (up $1.2 million), and other miscellaneous income, which included the reversal of certain previously accrued amounts (totaling $628 thousand) for legal and other contingencies. The Corporation also recognized $1.1 million in income related to the termination and settlement of an operational contract. The impact of these items was partly offset by decreases in gains realized from the sales of foreclosed assets and other assets (down $1.5 million), annuity income (down $588 thousand), and earnings on the cash surrender value of life insurance policies (down $497 thousand).

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 loans with realized gains totaling $1.8 million during 2003.

Non-Interest Expense

The components of non-interest expense were as follows:


		2004		2003		2002


Salaries and wages		$	158,039	$	146,622	$	139,227
Employee benefits			40,176		38,316		34,614
Net occupancy			29,375		29,286		28,883
Furniture and equipment			22,771		21,768		22,597
Intangible amortization			5,346		5,886		7,083
Other			89,323		84,157		79,738

	Total	$	345,030	$	326,035	$	312,142

Total non-interest expense for 2004 increased $19.0 million, or 5.8%, compared to 2003 while total non-interest expense for 2003 increased $13.9 million, or 4.5%, compared to 2002. Changes in the various components of non-interest expense are discussed below.

Salaries and Wages. Salaries and wages for 2004 increased $11.4 million, or 7.8%, compared to 2003 while salaries and wages expense for 2003 increased $7.4 million, or 5.3%, compared to 2002. The increases were primarily related to salary increases, both merit-based and market-driven, increases in headcount and increased commissions related to higher insurance revenues associated with Frost Insurance Agency.

Employee Benefits. Employee benefits for 2004 increased $1.9 million, or 4.9%, compared to 2003. The increase was primarily due to increases in payroll taxes (up $1.1 million) and medical insurance expense (up $372 thousand). Expense related to the Corporation’s defined benefit retirement and restoration plans decreased $875 thousand; however, this decrease was mostly offset by an $854 thousand increase in expense related to the Corporation’s 401(k) and profit sharing plans. The Corporation’s defined benefit retirement and restoration plans were frozen effective as of December 31, 2001 and were replaced by the 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 retirement and restoration plans totaled $2.3 million in 2004, $3.1 million in 2003 and $1.0 million in 2002. Future expense related to these plans is dependent upon a variety of factors, including the actual return on plan assets.

Employee benefits expense for 2003 increased $3.7 million, or 10.7%, compared to 2002. The increase was primarily related to increases in retirement plan expense, profit sharing plan expense and payroll taxes.

For additional information related to the Corporation’s employee benefit 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 2004 did not significantly fluctuate compared to 2003 as a decrease in rental income (down $482 thousand) combined with increases in depreciation expense related to buildings (up $332 thousand), other services expenses (up $312 thousand) and property taxes (up $290 thousand) offset a decrease in depreciation expense related to leasehold improvements (down $1.4 million). The depreciation of certain leasehold improvements was accelerated in 2003 in connection with the relocation of certain operations to a new office facility in downtown Austin, Texas.

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.

Furniture and Equipment. Furniture and equipment expense for 2004 increased $1.0 million, or 4.6%, compared to 2003. The increase was primarily due to increases in service contracts expense (up $449 thousand), software maintenance (up $434 thousand) and depreciation expense related to furniture and fixtures (up $369 thousand). These increases were partly offset by a decrease in equipment rental expense (down $199 thousand) and repairs expense (down $105 thousand).

Furniture and equipment expense for 2003 decreased $829 thousand, or 3.7%, compared to 2002. The decrease from 2002 was primarily related to a decrease in furniture and equipment depreciation (down $599 thousand), a decrease in software amortization (down $603 thousand) and a decrease in equipment rental expense (down $272 thousand) partly offset by an increase in software maintenance expense (up $587 thousand).

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 2004 decreased $540 thousand, or 9.2%, compared to 2003. The decreases were primarily related to the completion of the amortization of certain intangible assets, partly offset by additional amortization related to intangible assets recorded during the third quarter of 2004 in connection with the acquisition of an insurance agency. Intangible amortization for 2003 decreased $1.2 million, or 16.9%, compared to 2002. The decrease was 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. See Note 7 — Goodwill and Other Intangible Assets in the accompanying notes to consolidated financial statements included elsewhere in this report for additional information.

Other Non-Interest Expense. Other non-interest expense for 2004 increased $5.2 million, or 6.1%, compared to 2003. Significant components of the increase included increases in insurance expense related to director and officer liability policies (up $1.6 million), advertising/promotional expenses (up $1.2 million), expenses related to property leased to customers (up $1.0 million), outside computer services expenses (up $410 thousand), business development expenses (up $286 thousand), meals and entertainment (up $257 thousand) and travel (up $237 thousand). 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 legal and professional fees (down $578 thousand).

Other non-interest expense for 2003 increased $4.4 million, or 5.5%, compared to 2002. Significant components of the increase included legal and professional fees (up $1.2 million), expenses related to leased properties (up $1.1 million), advertising/promotional expenses (up $1.1 million), check card expenses (up $651 thousand), and higher Federal Reserve service charges (up $552 thousand). 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).

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 19 — Operating Segments in the accompanying notes to

consolidated financial statements included elsewhere in this report. Net income (loss) by operating segment is presented below:


		2004			2003			2002


Banking		$	137,744		$	128,329		$	116,489
Financial Management Group			10,997			7,801			11,158
Non-Banks			(7,416	)		(5,629	)		(5,414	)
Discontinued operations			—			—			(5,247	)

	Consolidated net income	$	141,325		$	130,501		$	116,986


	Banking

Net income for 2004 increased $9.4 million, or 7.3%, compared to 2003. The increase resulted primarily from a $19.6 million increase in net interest income, a $8.0 million decrease in the provision for possible loan losses and a $3.6 million increase in non-interest income. The impact of these items was partly offset by a $16.3 million increase in non-interest expense. Net income for 2003 increased $11.8 million, or 10.2%, compared to 2002. The increase primarily resulted from a $14.6 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 $10.6 million increase in non-interest expense.

Net interest income for 2004 increased $19.6 million, or 6.2%, compared to 2003. The increase resulted from the positive impact of increases in the average volume of earning assets and the net interest margin. Net interest income for 2003 increased $1.2 million compared to 2002. The lack of significant fluctuation 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 resell agreements, which also led to a decrease in net interest margins compared to 2002. 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 2004 totaled $2.5 million compared to $10.5 million in 2003 and $22.5 million in 2002. 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 2004 increased $3.6 million, or 2.3%, compared to 2003. The increase was primarily due to increases in other income and insurance commissions and fees partly offset by a $3.4 million net loss on securities transactions. 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 service charges and increased insurance commissions and fees. See the analysis of service charges on deposit accounts, other service charges, insurance commissions, the net loss on securities transactions and other income included in the section captioned “Non-Interest Income” included elsewhere in this discussion.

Non-interest expense for 2004 increased $16.3 million, or 6.0%, compared to 2003. The increase was primarily related to increases in salaries and wages, employee benefits and other non-interest expense. Combined, salaries and wages and employee benefits for 2004 increased $10.9 million from 2003. The increases were primarily the result of merit-based and market-driven salary increases, increased commissions related to higher insurance revenues, increased headcount, increased payroll taxes and increased medical insurance expenses. The increase in other non-interest expense was primarily due to increases in insurance expense related to director and officer liability policies, advertising/promotional expense and expenses related to property leased to customers, among other things. Non-interest expense for 2003 increased $10.6 million, or 4.0%, 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 $9.2 million from 2002. 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. See the analysis of salaries and wages, employee benefits and

other non-interest expense, included in the section captioned “Non-Interest Expense” included elsewhere in this discussion.

Frost Insurance Agency, which is included in the Banking segment, had gross revenues of $31.6 million in 2004 compared to $29.1 million in 2003 and $26.1 million in 2002. Insurance commissions, the largest component of these revenues, increased $2.3 million, or 8.0%, in 2004, compared to 2003 and increased $3.0 million, or 11.7%, in 2003 compared to 2002. Revenue growth over the comparable periods was partly due to the acquisition of insurance agencies during the third quarter of 2004 and the first quarter of 2003. See the analysis of insurance commissions and fees included in the section captioned “Non-Interest Income” included elsewhere in this discussion.


	Financial Management Group (FMG)

Net income for 2004 increased $3.2 million, or 41.0%, compared to 2003. The increase was primarily due to a $6.5 million increase in non-interest income and a $1.5 million increase in net interest income partly offset by a $3.0 million increase in non-interest expense and a $1.7 million increase in income taxes. 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 interest income for 2004 increased $1.5 million, or 41.3%, compared to 2003 primarily due to a higher interest rate environment during 2004. Net interest income for 2003 decreased $1.2 million, or 25.0%, compared to 2002 primarily because the lower interest rate environment over the comparable periods reduced the funds transfer price paid on FMG’s repurchase agreements.

Non-interest income for 2004 increased $6.5 million, or 11.1%, compared to 2003. The increase in 2004 was primarily due to increases in trust fees (up $6.5 million). 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.

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% of total trust fees during 2004, 2003 and 2002. Investment and other custodial account fees are generally based on the market value of assets within a trust account. Volatility in the equity and bond markets impacts the market value of trust assets and the related investment fees. FMG experienced an increase in investment fees during 2004 compared to 2003 primarily due to better equity market conditions in 2004 compared to 2003 and growth in overall trust assets and the number of trust accounts. 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. See the analysis of trust fees included in the section captioned “Non-Interest Income” included elsewhere in this discussion.

Non-interest expense for 2004 increased $3.0 million, or 6.0%, compared to 2003. The increase was primarily due to increases in other non-interest expense, salaries and wages and employee benefits. 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 salary increases, both merit-based and market-driven, increases in headcount, 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-Banks

The net loss for the Non-Banks segment increased $1.8 million during 2004 compared to 2003. The higher losses resulted from decreases in net interest income during 2004. The decrease in net interest income resulted from the added interest cost of the junior subordinated deferrable interest debentures issued during the first quarter, the proceeds of which were deposited in a demand account at Frost Bank. The net loss for the

Non-Banks operating segment increased $215 thousand during 2003 compared to 2002 primarily due to an increase in salaries, professional services expense and other miscellaneous expense items partly offset by an increase in royalty income from mineral interests and other miscellaneous income items.


	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.

Income Taxes

The Corporation recognized income tax expense on continuing operations of $67.7 million, for an effective rate of 32.4%, in 2004 compared to $62.0 million, for an effective rate of 32.2%, in 2003 and $57.8 million, for an effective rate of 32.1%, in 2002. 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.

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 2004 compared to $9.6 billion in 2003 and $8.4 billion in 2002.


			2004			2003			2002


Sources of Funds:
	Deposits:
		Non-interest-bearing		30.3	%		31.7	%		30.4	%
		Interest-bearing		50.4			47.3			52.1
	Federal funds purchased and repurchase agreements			5.9			8.9			4.8
	Long-term debt and other borrowings			3.8			2.8			3.3
	Other non-interest-bearing liabilities			1.4			1.7			1.6
	Equity capital			8.2			7.6			7.8

		Total		100.0	%		100.0	%		100.0	%

Uses of Funds:
	Loans			50.1	%		46.9	%		54.3	%
	Securities			30.8			27.9			25.9
	Federal funds sold, resell agreements and other interest-earning assets			5.9			8.7			3.1
	Other non-interest-earning assets			13.2			16.5			16.7

		Total		100.0	%		100.0	%		100.0	%

Deposits continue to be the Corporation’s primary source of funding. During 2004, the relative mix of deposits has shifted towards interest-bearing deposits; however, non-interest-bearing deposits remain a significant source of funding, which has been a key factor in maintaining the Corporation’s relatively low cost of funds. Non-interest-bearing deposits totaled 37.5% of total average deposits in 2004 compared to 40.1% in 2003 and 36.8% in 2002. The shift in the mix of deposits towards interest-bearing deposits during 2004 was partly due to a $379.1 million decrease in average correspondent bank deposits (see related information regarding this decrease in the section captioned “Deposits” included elsewhere in this discussion). Federal funds purchased and repurchase agreements fluctuated in relative proportion to total earning assets in 2004 and 2003 due to the use of dollar-roll repurchase agreements to leverage earning assets, primarily federal funds

sold and resell 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, limited the Corporation’s ability to significantly grow its loan portfolio in 2003 and 2002. During 2004, average loans increased $325.7 million, or 7.2%, as a result of improved loan demand that appears to be the result of improved economic conditions and the movement of business from other lenders to the Corporation. 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 information regarding the Corporation’s loan portfolio in the section captioned “Loans” included elsewhere in this discussion.

Loans

Year-end loans were as follows:


						Percentage
			2004			of Total			2003			2002			2001			2000


Commercial and industrial:
	Commercial		$	2,361,052			45.7	%	$	2,081,631		$	2,048,089		$	1,901,621		$	1,809,584
	Leases			114,016			2.2			77,909			57,642			35,242			33,246
	Asset-based			34,687			0.7			36,683			49,819			48,584			30,979

		Total commercial and industrial		2,509,755			48.6			2,196,223			2,155,550			1,985,447			1,873,809
Real estate:
	Construction:
		Commercial		419,141			8.1			349,152			315,340			373,431			342,944
		Consumer		37,234			0.7			23,399			45,152			44,623			44,078
	Land:
		Commercial		215,148			4.2			178,022			158,271			128,782			148,777
		Consumer		3,675			0.1			5,169			8,231			7,040			9,282
	Commercial mortgages			1,185,431			23.0			1,102,138			1,050,957			994,485			1,011,105
	1-4 family residential mortgages			86,098			1.7			113,756			179,077			244,897			310,946
	Home equity and other consumer			387,864			7.4			292,255			276,429			278,849			267,790

		Total real estate		2,334,591			45.2			2,063,891			2,033,457			2,072,107			2,134,922
Consumer:
	Indirect			3,648			0.1			8,358			25,262			65,217			136,921
	Student loans held for sale			63,568			1.2			58,280			43,430			102,887			99,688
	Other			247,025			4.8			246,173			245,760			243,012			241,858
Other				21,819			0.4			28,962			23,295			54,943			54,796
Unearned discount				(15,415	)		(0.3	)		(11,141	)		(7,841	)		(5,005	)		(7,349	)

	Total		$	5,164,991			100.0	%	$	4,590,746		$	4,518,913		$	4,518,608		$	4,534,645

Overview. Loans totaled $5.2 billion at December 31, 2004 increasing $574.2 million, or 12.5%, compared to December 31, 2003. Excluding 1-4 family residential mortgages, the indirect lending portfolio and student loans, loans increased 13.6% from December 31, 2003. 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, these loans are considered “held for sale.”

The majority of the Corporation’s loan portfolio is comprised of commercial and industrial loans and real estate loans. Commercial and industrial loans made up 48.6% and 47.8% of total loans while real estate loans

made up 45.2% and 45.0% of total loans at December 31, 2004 and 2003, respectively. Real estate loans include both commercial and consumer balances.

Loan Origination/ Risk Management. The Corporation 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, 2004, 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. Commercial and industrial loans at December 31, 2004 increased 14.3% from December 31, 2003 to $2.5 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 as well as purchased shared national credits (“SNCs”), which are discussed in more detail below.

Industry Concentrations. As of December 31, 2004 and 2003, 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 loan portfolio, as segregated by SIC code. Industry concentrations are stated as a percentage of year-end total loans as of December 31, 2004 and 2003:


			2004			2003


Industry concentrations:
	Energy			7.6	%		7.1	%
	Medical services			5.5			4.4
	Services			4.2			4.3
	Building construction			4.0			3.7
	General and specific trade contractors			3.5			3.8
	Public finance			3.2			2.9
	Legal services			3.2			3.4
	Restaurants			2.9			2.8
	Manufacturing, other			2.8			3.2
	All other (35 categories in 2004 and 2003)			63.1			64.4

		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:


			2004		2003


Energy loans:
	Production		$	210,879	$	210,162
	Service			76,622		45,128
	Traders			51,504		28,125
	Manufacturing			35,552		21,471
	Refining			15,582		18,640

		Total energy loans	$	390,139	$	323,526

Large Credit Relationships. The market areas served by the Corporation include three of the top ten most populated cities in the United States. These market areas 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.



		2004						2003


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


Large credit relationships:
	$20.0 million and greater		48	$	1,355,958	$	704,276		28	$	760,275	$	386,516
	$10.0 million to $19.9 million		87		1,263,806		744,059		90		1,230,510		751,559

Growth in outstanding balances related to credit relationships in excess of $20.0 million resulted from an increase in commitments. Approximately 80% of the increase in these commitments was related to the expansion of previously existing credit relationships with the remainder related to newly developed credit relationships. The average commitment in excess of $20 million per large credit relationship did not significantly fluctuate and totaled $28.2 million at December 31, 2004 and $27.2 million at December 31, 2003. The average outstanding balance per large credit relationship in excess of $20.0 million totaled $14.7 million at December 31, 2004 and $13.8 million at December 31, 2003.

Purchased Shared National Credits. Purchased SNCs are participations purchased from upstream financial organizations and tend to be larger in size than the Corporation’s originated portfolio. The Corporation’s purchased SNC portfolio totaled $214.9 million at December 31, 2004, increasing from $153.9 million at December 31, 2003. At December 31, 2004, 44.2% of outstanding purchased SNCs was related to the energy industry, 22.8% of outstanding SNCs was related to the beer and liquor distribution industry and 16.1% was related to the restaurant 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 within the following 12 to 24 months. SNCs are reviewed at least quarterly for credit quality and business development successes The following table provides additional information about certain credits within the Corporation’s purchased SNCs portfolio as of year-end.



		2004						2003


				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		8	$	183,250	$	81,835		5	$	114,546	$	21,673
	$10.0 million to $19.9 million		18		247,805		111,654		20		262,328		114,946

Real Estate Loans. Real estate loans totaled $2.3 billion at December 31, 2004, an increase of $270.7 million, or 13.1%, compared to $2.1 billion at December 31, 2003. Excluding 1-4 family residential mortgage loans, which are discussed below, total real estate loans increased $298.4 million, or 15.3%, from December 31, 2003. Commercial real estate loans totaled $1.8 billion and $1.6 billion at December 31, 2004 and 2003 and represented 77.9% and 78.9% 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.

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, 2004 and 2003:


			2004			2003


Property type:
	Office building			18.3	%		19.6	%
	Office/warehouse			15.3			14.5
	1-4 family			8.9			8.9
	Retail			6.7			5.6
	Medical offices and services			6.7			4.9
	Non-farm/nonresidential			4.3			5.6
	All other			39.8			40.9

		Total commercial real estate loans		100.0	%		100.0	%

Geographic region:
	Houston			25.9	%		25.9	%
	Fort Worth			21.2			22.4
	San Antonio			20.3			20.3
	Austin			10.1			10.8
	Dallas			10.0			8.3
	Corpus Christi			7.0			7.1
	Rio Grande Valley			5.5			5.2

		Total commercial real estate loans		100.0	%		100.0	%

Consumer Loans. The consumer loan portfolio, including all consumer real estate, totaled $829.1 million at December 31, 2004, increasing $81.7 million, or 10.9%, from $747.4 million at December 31, 2003. However, excluding 1-4 family residential mortgages, indirect loans and student loans, total consumer loans increased $108.8 million, or 19.2%, from December 31, 2003.

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.


		2004		2003


Construction		$	37,234	$	23,399
Land			3,675		5,169
Home equity loans			228,143		212,930
Home equity lines of credit			64,863		8,549
Other consumer real estate			94,858		70,776

	Total consumer real estate		428,773		320,823
Consumer non-real estate			247,025		246,173
Student loans held for sale			63,568		58,280
Indirect			3,648		8,358
1-4 family residential mortgages			86,098		113,756

	Total consumer loans	$	829,112	$	747,390

Consumer real estate loans, excluding 1-4 family mortgages, increased $108.0 million, or 33.6%, from December 31, 2003. Home equity loans were first permitted in the State of Texas beginning January 1, 1998. During September 2003, Texas voters approved an amendment to the Texas constitution that permitted financial institutions to offer home equity lines of credit. As a result, the Corporation added home equity lines of credit to its loan offerings and began originating such lines in the fourth quarter of 2003. Combined, home equity loans and lines of credit made up 68.3% and 69.0% of the consumer real estate loans total at

December 31, 2004 and 2003. 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.

The consumer non-real estate loan portfolio primarily consists of automobile loans, unsecured revolving credit products, personal loans secured by cash and cash equivalents, and other similar types of credit facilities.

The Corporation primarily originates student loans for resale. Accordingly, these loans are considered “held for sale.” Student loans are included in total loans in the consolidated balance sheet. Student loans are generally sold on a non-recourse basis 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. Student loans increased 9.1% from December 31, 2003 despite the fact that the Corporation sold approximately $55.9 million of student loans during 2004 compared to $49.0 million during 2003.

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, 2004, the majority of the portfolio was comprised of purchased home improvement and home equity loans.

The Corporation also discontinued originating 1-4 family residential mortgage loans in 2000. 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, 2004 or 2003.

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, 2004. 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,
		One Year		but Within		After
		or Less		Five Years		Five Years		Total


Commercial and industrial		$	1,170,281	$	1,146,815	$	192,659	$	2,509,755
Real estate construction			215,836		154,665		85,874		456,375
Commercial real estate and land			210,457		616,991		573,131		1,400,579
Consumer and other			126,891		163,861		373,279		664,031

	Total	$	1,723,465	$	2,082,332	$	1,224,943	$	5,030,740

Loans with fixed interest rates		$	432,569	$	596,158	$	728,324	$	1,757,051
Loans with floating interest rates			1,290,896		1,486,174		496,619		3,273,689

	Total	$	1,723,465	$	2,082,332	$	1,224,943	$	5,030,740

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:


			2004			2003			2002			2001			2000


Non-accrual loans:
	Commercial and industrial		$	27,089		$	35,914		$	19,878		$	23,552		$	13,072
	Real estate			2,471			10,766			7,167			7,231			3,458
	Consumer and other			883			771			7,816			2,413			132

		Total non-accrual loans		30,443			47,451			34,861			33,196			16,662
Restructured loans				—			—			—			—			—
Foreclosed assets:
	Real estate			7,369			5,054			8,005			4,094			1,843
	Other			1,304			289			42			140			428

		Total foreclosed assets		8,673			5,343			8,047			4,234			2,271

	Total non-performing assets		$	39,116		$	52,794		$	42,908		$	37,430		$	18,933

Ratio of non-performing assets to:
	Total loans and foreclosed assets			0.76	%		1.15	%		0.95	%		0.83	%		0.42	%
	Total assets			0.39			0.55			0.45			0.45			0.25
Accruing past due loans:
	30 to 89 days past due		$	20,895		$	24,419		$	30,766		$	35,549		$	43,671
	90 or more days past due			5,231			14,462			9,081			13,601			7,972

		Total accruing past due loans	$	26,126		$	38,881		$	39,847		$	49,150		$	51,643

Ratio of accruing past due loans to total loans:
	30 to 89 days past due			0.41	%		0.53	%		0.68	%		0.79	%		0.96	%
	90 or more days past due			0.10			0.32			0.20			0.30			0.18

		Total accruing past due loans		0.51	%		0.85	%		0.88	%		1.09	%		1.14	%

Non-performing assets include non-accrual loans, restructured loans and foreclosed assets. Non-performing assets at December 31, 2004 decreased 25.9% from December 31, 2003. The decrease during 2004 was primarily related to a decrease in non-accrual real estate loans and commercial and industrial loans, partly offset by an increase in foreclosed assets.

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 $1.6 million in 2004 compared to $1.5 million in 2003 and $2.2 million in 2002.

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, 2004, the Corporation had $1.3 million in loans of this type which are not included in either of the non-accrual or 90 days past due loan categories. The balance is made up of four credit relationships of similar size. Weakness in these companies’ operating performance has caused the Corporation to heighten the attention given to these credits.

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 Corporation’s allowance for possible loan loss methodology is based on guidance provided in SEC Staff Accounting Bulletin No. 102, “Selected Loan Loss Allowance Methodology and Documentation Issues” and 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 calculated in accordance with SFAS No. 5, “Accounting for Contingencies.” Accordingly, the methodology is based on historical loss experience by type of credit and internal risk grade, specific homogeneous risk pools, and specific loss allocations, with adjustments for current events and conditions. The Corporation’s process for determining the appropriate level of the allowance for possible loan losses is designed to account for credit deterioration as it occurs. The provision for possible loan losses reflects loan quality trends, including the levels of and trends related to non-accrual loans, past due loans, potential problem loans, criticized loans and net charge-offs or recoveries, among other factors. The provision for possible loan losses also reflects the totality of actions taken on all loans for a particular period. In other words, the amount of the provision reflects not only the necessary increases in the allowance for possible loan losses related to newly identified criticized loans, but it also reflects actions taken related to other loans including, among other things, any necessary increases or decreases in required allowances for specific loans or loan pools.

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 determined in accordance with SFAS 114 based on probable losses on specific loans; (ii) historical valuation allowances determined in accordance with SFAS 5 based on historical loan loss experience for similar loans with similar characteristics and trends; and (iii) general valuation allowances determined in accordance with SFAS 5 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 ability 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.

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 the 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:



		2004					2003					2002					2001					2000

		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		$	49,696		48.4	%	$	42,504		47.6	%	$	45,618		47.6	%	$	35,490		43.9	%	$	28,829		41.3	%
Real estate			12,393		45.1			19,752		45.0			13,928		44.9			13,376		45.8			14,165		47.0
Consumer			4,436		6.1			3,920		6.8			4,609		7.0			13,175		9.1			14,383		10.5
Other			1,081		0.4			1,217		0.6			1,801		0.5			571		1.2			458		1.2
Unallocated			8,204		—			16,108		—			16,628		—			10,269		—			5,430		—

	Total	$	75,810		100.0	%	$	83,501		100.0	%	$	82,584		100.0	%	$	72,881		100.0	%	$	63,265		100.0	%

Despite a decline in the level of criticized commercial and industrial loans, reserve allocations for these loans increased during 2004. The increase in reserve allocations was the result of portfolio growth and increases in historical valuation allowances determined in accordance with SFAS 5 based on historical loan loss experience for similar loans with similar characteristics and trends. Specific valuation allowances determined in accordance with SFAS 114 related to commercial and industrial loans decreased in 2004. The reserve allocations related to real estate loans increased in 2003 primarily due to increases in specific valuation allowances. These allocations were reduced in 2004 as many of the loans were repaid, charged-off or reclassified due to improved performance. 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. During 2004, improving economic conditions have appeared to reduce the overall risk environment for loan portfolios. Furthermore, the Corporation began to experience positive trends in several important credit quality measures including the levels of past due loans, potential problem loans and criticized assets. As a result, the level of unallocated reserve was decreased in 2004 through a reduction in the provision for loan losses, as further discussed below, and a reallocation of amounts to commercial and industrial loans as discussed above.

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.


			2004			2003			2002			2001			2000


Balance of allowance for possible
	loan losses at beginning of year		$	83,501		$	82,584		$	72,881		$	63,265		$	58,345
Provision for possible loan losses				2,500			10,544			22,546			40,031			14,103
Charge-offs:
	Commercial and industrial			(12,570	)		(11,627	)		(13,112	)		(32,074	)		(6,999	)
	Real estate			(2,724	)		(1,607	)		(2,249	)		(336	)		(465	)
	Consumer and other			(4,721	)		(3,761	)		(3,363	)		(4,370	)		(5,698	)

		Total charge-offs		(20,015	)		(16,995	)		(18,724	)		(36,780	)		(13,162	)

Recoveries:
	Commercial and industrial			6,219			5,581			3,940			3,658			1,549
	Real estate			718			272			452			917			388
	Consumer and other			2,887			1,515			1,489			1,790			2,042

		Total recoveries		9,824			7,368			5,881			6,365			3,979

Net charge-offs				(10,191	)		(9,627	)		(12,843	)		(30,415	)		(9,183	)

Balance at end of year			$	75,810		$	83,501		$	82,584		$	72,881		$	63,265

Net charge-offs as a percentage of average loans				0.20	%		0.21	%		0.28	%		0.67	%		0.21	%
Allowance for possible loan losses as a percentage of year-end loans				1.47			1.82			1.83			1.61			1.40
Allowance for possible loan losses as a percentage of year-end non-accrual loans				249.0			176.0			236.9			219.5			379.7
Average loans outstanding during the year			$	4,823,198		$	4,497,489		$	4,536,999		$	4,546,596		$	4,352,868
Loans outstanding at year-end				5,164,991			4,590,746			4,518,913			4,518,608			4,534,645
Non-accrual loans outstanding at year-end				30,443			47,451			34,861			33,196			16,662

As stated above, 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 $8.0 million from $10.5 million in 2003 to $2.5 million in 2004. Higher provisions were considered necessary during 2003 due to the relative economic conditions prevailing at the time. The decrease in the provision during 2004 reflects the fact that the Corporation has recently experienced positive trends in several important credit quality measures including the levels of past due loans, potential problem loans and criticized assets. The Corporation did not record a provision for possible loan losses in the third or fourth quarters of 2004 primarily due to a reduction in the overall level of criticized loans.

The provision for loan losses decreased $12.0 million from $22.5 million in 2002 to $10.5 million in 2003, as higher provisions were considered necessary during 2002 due to the overall uncertainty in the economy. The decrease in provision occurred despite the increase in year-end non-accrual loans. The increase in year-end non-accrual loans was primarily related to two loans. At December 31, 2003, non-accrual loans totaled $47.5 million, which included $18.9 million related to the two loans. Excluding the two loans, non-accrual loans totaled $28.6 million at December 31, 2003, which was $6.3 million, or 18.0%, less than the $34.9 million of non-accrual loans at December 31, 2002. The two loans were placed on non-accrual status and considered to be impaired under SFAS 114 during the fourth quarter of 2003. At that time, the Corporation calculated the required specific loss allocations for these loans in accordance with SFAS 114. Under SFAS 114, specific loss allowances are allocated to an impaired loan, if necessary, so that the loan is reported net, at the present value of estimated future cash flows discounted at the loan’s existing interest rate or at the fair value of the collateral if repayment is expected from conversion of the collateral. In determining the necessary specific loss allocations for the two loans, the Corporation considered the loans to be collateral dependent and calculated the specific loss allocations based upon management’s assessment of the collateral

underlying these loans. The specific loss allocations approximated the amounts by which the loan balances exceeded the estimated fair value of collateral. The calculated specific loss allocations approximated the previously allocated allowances related to these two loans that were calculated in accordance with SFAS 5. Accordingly, there was no significant change in the necessary amount of the allowance for possible loan losses (and thus no significant impact to the provision for possible loan losses) due to the placement of these two loans on non-accrual status and their classification as impaired.

Net charge-offs in 2004 increased $564 thousand compared to 2003 while net charge-offs in 2003 decreased $3.2 million compared to 2002. Net charge-offs as a percentage of average loans decreased 1 basis point in 2004 compared to 2003 and 7 basis points in 2003 compared to 2002. The general decline in net charge-offs as a percentage of average loans during the comparable periods is reflective of the more stringent credit standards implemented as a result of credit quality issues experienced in 2001. 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, 2004. 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:



			2004					2003					2002

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


Held to maturity:
	U.S. government agencies and corporations		$	15,614		0.6	%	$	21,850		0.7	%	$	33,556		1.4	%
	States and political subdivisions			—		—			2,113		0.1			2,454		0.1
	Other			1,100		—			1,125		—			125		—

		Total		16,714		0.6			25,088		0.8			36,135		1.5
Available for sale:
	U.S. Treasury			—		—			—		—			17,003		0.7
	U.S. government agencies and corporations			2,676,796		89.9			2,701,847		90.9			2,166,669		88.1
	States and political subdivisions			252,145		8.5			204,685		6.9			199,039		8.1
	Other			28,355		0.9			34,206		1.2			34,415		1.4

		Total		2,957,296		99.3			2,940,738		99.0			2,417,126		98.3
Trading:
	U.S. Treasury			4,671		0.1			3,091		0.1			—		—
	U.S. government agencies and corporations			—		—			2,498		0.1			4,995		0.2

		Total		4,671		0.1			5,589		0.2			4,995		0.2

		Total securities	$	2,978,681		100.0	%	$	2,971,415		100.0	%	$	2,458,256		100.0	%

The following tables summarize the maturity distribution schedule with corresponding weighted-average yields of securities held to maturity and securities available for sale as of December 31, 2004. 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		$	—		—	%	$	1,568		8.31	%	$	313		10.19	%	$	13,733		3.86	%	$	15,614		4.43	%
	Other			100		7.30			1,000		4.10			—		—			—		—			1,100		4.39

		Total	$	100		7.30		$	2,568		6.67		$	313		10.19		$	13,733		3.86		$	16,714		4.43

Available for Sale:
	U.S. government agencies and corporations		$	80,053		2.18	%	$	18,478		5.39	%	$	79		10.01	%	$	2,578,186		4.68	%	$	2,676,796		4.61	%
	States and political subdivisions			8,212		5.81			47,484		6.47			141,393		6.22			55,056		6.45			252,145		6.30
	Other			—		—			—		—			—		—			—		—			28,355		—

		Total	$	88,265		2.52		$	65,962		6.17		$	141,472		6.22		$	2,633,242		4.71		$	2,957,296		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, 2004 or 2003.

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, 2004, there were no holdings of any one issuer, other than the U.S. government and its agencies, in an amount greater than 10% of the Corporation’s shareholders’ equity.

The average taxable-equivalent yield of the securities portfolio was 4.77% in 2004 compared to 4.87% in 2003 and 5.76% in 2002. 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:



			2004					2003					2002

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


Non-interest-bearing:
	Commercial and individual		$	2,395,663				$	2,133,906				$	1,942,228
	Correspondent banks			469,635					848,737					553,318
	Public funds			49,222					55,081					44,886

		Total		2,914,520					3,037,724					2,540,432
Interest-bearing:
	Private accounts:
		Savings and interest checking		1,171,883		0.09	%		1,052,637		0.09	%		1,003,713		0.18	%
		Money market deposit accounts		2,444,734		1.00			2,153,489		0.96			1,857,130		1.28
		Time accounts of $100,000 or more		471,200		1.28			557,248		1.31			649,920		2.03
		Time accounts under $100,000		393,976		1.05			444,333		1.24			505,826		2.28
	Public funds			370,373		0.91			331,915		0.93			337,289		1.47

		Total		4,852,166		0.81			4,539,622		0.82			4,353,878		1.27

		Total deposits	$	7,766,686		0.50	%	$	7,577,346		0.49	%	$	6,894,310		0.80	%

The average volume of deposits increased $189.3 million in 2004 compared to 2003 and increased $683.0 million in 2003 compared to 2002. The growth in average deposits during 2004 compared to 2003 was primarily in interest-bearing deposits. Accordingly, the ratio of average interest-bearing deposits to total average deposits increased to 62.5% in 2004 from 59.9% in 2003. The average cost of interest-bearing deposits and total deposits was 0.81% and 0.50% during 2004 compared to 0.82% and 0.49% during 2003. The decline in the average cost of interest-bearing deposits was partly the result a shift in the relative proportion of interest-bearing deposits to lower-cost savings, interest checking and money market accounts from higher-cost time deposits. Non-interest-bearing deposits made up 72.8% of the growth in average deposits during 2003 compared to 2002. Accordingly, the ratio of average interest-bearing deposits to total average deposits decreased to 59.9% in 2003 compared to 63.2% in 2002. The change in deposit mix, combined with a general decline in market rates, had the effect of reducing the average cost of interest-bearing deposits and total deposits from 1.27% and 0.80% in 2002 to 0.82% and 0.49% in 2003. This decrease in the average cost of deposits helped mitigate 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:


		2004			2003			2002


Commercial and individual			82.2	%		70.3	%		76.4	%
Correspondent banks			16.1			27.9			21.8
Public funds			1.7			1.8			1.8

	Total		100.0	%		100.0	%		100.0	%

During 2004, average non-interest-bearing deposits decreased $123.2 million, or 4.1%, compared to 2003. The decline was mostly due to a $379.1 million, or 44.7%, decrease in average correspondent bank deposits. The decrease in average correspondent bank deposits was primarily related to two large customers. Balances related to these customers are not expected to significantly increase in the foreseeable future. Average non-interest-bearing deposits increased $497.3 million, or 19.6%, in 2003 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. This customer was one of the aforementioned customers partly responsible for the decrease in the average correspondent bank balances in 2004

Average commercial and individual non-interest-bearing demand deposit balances increased $261.8 million, or 12.3%, in 2004 compared to 2003 and $191.7 million, or 9.9%, in 2003 compared to 2002. In 2004, the increase was primarily attributable to an increase in the number of accounts and the maintenance of higher cash balances by customers. In 2003, the increase was primarily attributable 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:


		2004			2003			2002


Private accounts:
	Savings and interest checking		24.2	%		23.2	%		23.1	%
	Money market deposit accounts		50.4			47.4			42.7
	Time accounts of $100,000 or more		9.7			12.3			14.9
	Time accounts under $100,000		8.1			9.8			11.6
Public funds			7.6			7.3			7.7

	Total		100.0	%		100.0	%		100.0	%

Total average interest-bearing deposits increased $312.5 million, or 6.9%, in 2004 compared to 2003 and increased $185.7 million, or 4.3%, in 2003 compared to 2002. The growth in average deposits during the comparable periods was primarily in money market deposit accounts and savings and interest checking accounts partly offset by declines in time accounts. 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 have been less inclined to invest their funds for extended periods and have chosen 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.


		2004			2003			2002


San Antonio			38.7	%		37.8	%		40.2	%
Houston			18.1			17.0			18.1
Fort Worth			13.7			12.5			12.7
Austin			10.6			9.6			9.7
Corpus Christi			7.7			7.3			7.6
Dallas			3.8			3.4			2.7
Rio Grande Valley			1.5			1.4			1.4
Statewide			5.9			11.0			7.6

	Total		100.0	%		100.0	%		100.0	%

The Corporation experienced deposit growth in all regions during 2004 with the exception of the Statewide region. Average deposits for the Statewide region decreased $371.2 million, or 44.7%. The decrease was primarily related to the two large correspondent bank customers discussed above. The San Antonio region had the largest dollar volume increase, increasing $134.3 million, or 4.7%. In terms of percentage growth, the Dallas and Austin regions had the largest increases, increasing $39.9 million, or 15.5%, and $99.1 million, or 13.6%, respectively. This growth is the result of the Corporation’s continued efforts to expand in these regions.

The Corporation experienced deposit growth in all regions during 2003. The most significant growth occurred in the Statewide region, increasing $307.2 million, or 58.7%, primarily due to an increase in correspondent bank deposits. A single correspondent bank customer accounted for $184.9 million of the increase in average volume. This customer was one of the customers partly responsible for the aforementioned decrease in the Statewide region’s deposits in 2004. Despite decreasing in proportion to total deposits, the San Antonio region had the second largest increase in average deposits in 2003, increasing $95.3 million, or 3.4%. 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.

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 $666.3 million in 2004, $678.7 million in 2003 and $703.9 million in 2002.

Short-Term Borrowings

The Corporation’s primary source of short-term borrowings is federal funds purchased from correspondent banks and repurchase agreements in the natural trade territory of the Corporation, as well as from upstream banks. Federal funds purchased and repurchase agreements totaled $506.3 million, $421.8 million and $811.2 million at December 31, 2004, 2003 and 2002. The maximum amount of these borrowings outstanding at any month-end was $792.8 million in 2004, $1.1 billion in 2003, and $811.2 million in 2002. The weighted-average interest rate on federal funds purchased was 2.14%, 0.83% and 1.18% at December 31, 2004, 2003 and 2002. Generally, the interest rates on 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:



		2004						2003						2002

		Average			Average			Average			Average			Average			Average
		Balance			Rate			Balance			Rate			Balance			Rate


Federal funds sold and resell agreements		$	564,286			1.57	%	$	825,452			1.16	%	$	244,790			1.63	%
Federal funds purchased and repurchase agreements			(564,489	)		1.02			(854,517	)		0.48			(400,511	)		1.34

	Net funds position	$	(203	)				$	(29,065	)				$	(155,721	)

The change in the average funds purchased position during the comparable periods was primarily related to the use of dollar-roll repurchase agreements. Average dollar-roll repurchase agreements outstanding totaled $92.3 million in 2004, $406.2 million during 2003 and $21.9 million during 2002. 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 resell 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 resell 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, 2004. 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		3 years
				1 year		or more
		1 year		but less than		but less than		5 years
		or less		3 years		5 years		or more		Total


Contractual obligations:
	Subordinated notes payable	$	—	$	—	$	—	$	150,000	$	150,000
	Junior subordinated deferrable interest debentures		—		—		—		226,805		226,805
	Federal Home Loan Bank advances		259		472		102		39		872
	Operating leases		12,979		22,281		16,536		22,692		74,488
	Deposits with stated maturity dates		867,127		122,078		93		64		989,362

			880,365		144,831		16,731		399,600		1,441,527
Other commitments:
	Loan commitments		18,368		2,067,345		277,041		400,374		2,763,128
	Standby letters of credit		1,873		219,306		17,816		847		239,842

			20,241		2,286,651		294,857		401,221		3,002,970

	Total contractual obligations and other commitments	$	900,606	$	2,431,482	$	311,588	$	800,821	$	4,444,497

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, 2004 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, 2004 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 $17.1 billion (including managed assets of $7.8 billion and custody assets of $9.3 billion) at December 31, 2004. These assets were

primarily composed of equity securities (44.9% of trust assets), fixed income securities (37.9% of trust assets) and cash equivalents (10.8% 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 $1.7 billion at December 31, 2004. At December 31, 2004, the Corporation held liquid assets with a fair value of $1.7 billion as collateral for these agreements.

Capital and Liquidity

Capital. At December 31, 2004, shareholders’ equity totaled $822.4 million compared $770.0 million at December 31, 2003. In addition to net income of $141.3 million, other significant changes in shareholders’ equity during 2004 included $65.2 million in treasury stock repurchases, $53.8 million of dividends paid and $36.0 million in proceeds from stock option exercises and the related tax benefits of $11.5 million. The accumulated other comprehensive loss component of shareholders’ equity totaled $10.8 million at December 31, 2004 compared to accumulated other comprehensive income of $8.1 million at December 31, 2003. 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 $0.24, $0.265, $0.265 and $0.265 per common share during the first, second, third and fourth quarters of 2004, respectively, and 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. This equates to a dividend payout ratio of 38.1% in 2004 and 37.2% in 2003.

Liquidity. 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 its balance sheet structure, its ability to liquidate assets, and its access to 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 resell 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 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. Banking regulations may limit the amount of dividends that may be paid by Frost Bank. See Note 12 — Regulatory Maters in the accompanying notes to consolidated financial statements included elsewhere in this report regarding such dividends. At December 31, 2004, Cullen/Frost had liquid assets, including cash and resell agreements, totaling $184.5 million. Cullen/Frost also had outside funding sources available including 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, 2004.

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 22 — 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 measures the impact on net interest income relative to a base case scenario of hypothetical fluctuations in interest 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 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.

As of December 30, 2004, the model simulations projected that 100 and 200 basis point increases in interest rates would result in positive variances in net interest income of 2.2% and 4.4%, respectively, relative to the base case over the next 12 months, while decreases in interest rates of 100 and 200 basis points would result in negative variances in net interest income of 2.5% and 5.3%, respectively, relative to the base case over the next 12 months. As of December 31, 2003, the model simulations projected that a 200 basis point increase in rates would 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 (due to the already low level of short-term rates) would result in a negative variance in net interest income of 1.6% relative to the base case over the next 12 months.

The impact of hypothetical fluctuations in interest rates on the Corporation’s derivative holdings was not a significant portion of these variances in any of the reported periods. As of December 31, 2004, the effect of a

200 basis point increase in interest rates on the Corporation’s derivative holdings would result in a 0.02% negative variance in net interest income while the effect of a 200 basis point decrease in interest rates on the Corporation’s derivative holdings would result in a 0.03% positive variance in net interest income.

The effects of hypothetical fluctuations in interest rates on the Corporation’s securities classified as “trading” under SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities,” are not significant, and, as such, separate quantitative disclosure is not presented.


ITEM 8.	FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Report of Ernst & Young LLP

Independent Registered Public Accounting Firm

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, 2004 and 2003, 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, 2004. 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 the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our 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, 2004 and 2003, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Cullen/ Frost Bankers, Inc.’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 4, 2005 expressed an unqualified opinion thereon.

San Antonio, Texas

February 4, 2005

Cullen/ Frost Bankers, Inc.
Consolidated Statements of Income

(Dollars in thousands, except per share amounts)



				Year Ended December 31,

				2004			2003		2002


Interest income:
	Loans, including fees			$	249,612		$	233,463	$	265,514
	Securities:
		Taxable			125,999			117,342		112,079
		Tax-exempt			9,036			8,436		8,142
	Interest-bearing deposits				63			104		172
	Federal funds sold and resell agreements				8,834			9,601		3,991

			Total interest income		393,544			368,946		389,898
Interest expense:
	Deposits				39,150			37,406		55,384
	Federal funds purchased and repurchase agreements				5,775			4,059		5,359
	Junior subordinated deferrable interest debentures				12,143			8,735		8,735
	Subordinated notes payable and other borrowings				5,038			4,988		6,647

			Total interest expense		62,106			55,188		76,125

			Net interest income		331,438			313,758		313,773
Provision for possible loan losses					2,500			10,544		22,546

			Net interest income after provision for possible loan losses		328,938			303,214		291,227
Non-interest income:
	Trust fees				53,910			47,486		47,463
	Service charges on deposit accounts				87,415			87,805		78,417
	Insurance commissions and fees				30,981			28,660		25,912
	Other charges, commissions and fees				19,353			18,668		16,860
	Net gain (loss) on securities transactions				(3,377	)		40		88
	Other				36,828			32,702		32,229

			Total non-interest income		225,110			215,361		200,969
Non-interest expense:
	Salaries and wages				158,039			146,622		139,227
	Employee benefits				40,176			38,316		34,614
	Net occupancy				29,375			29,286		28,883
	Furniture and equipment				22,771			21,768		22,597
	Intangible amortization				5,346			5,886		7,083
	Other				89,323			84,157		79,738

			Total non-interest expense		345,030			326,035		312,142

Income from continuing operations before income taxes					209,018			192,540		180,054
Income taxes					67,693			62,039		57,821

Income from continuing operations					141,325			130,501		122,233
Loss from discontinued operations, net of tax					—			—		(5,247	)

			Net income	$	141,325		$	130,501	$	116,986

Basic per common share:
	Income from continuing operations			$	2.74		$	2.54	$	2.40
	Net income				2.74			2.54		2.29
Diluted per common share:
	Income from continuing operations			$	2.66		$	2.48	$	2.33
	Net income				2.66			2.48		2.23

See accompanying Notes to Consolidated Financial Statements.

Cullen/ Frost Bankers, Inc.

Consolidated Balance Sheets

(Dollars in thousands, except per share amounts)



				December 31,

				2004			2003


Assets:
Cash and due from banks				$	545,602		$	1,067,888
Interest-bearing deposits					3,512			2,793
Federal funds sold and resell agreements					744,675			567,525

	Total cash and cash equivalents				1,293,789			1,638,206
Securities held to maturity, at amortized cost					16,714			25,088
Securities available for sale, at estimated fair value					2,957,296			2,940,738
Trading account securities					4,671			5,589
Loans, net of unearned discounts					5,164,991			4,590,746
	Less: Allowance for possible loan losses				(75,810	)		(83,501	)

		Net loans			5,089,181			4,507,245
Premises and equipment, net					170,026			168,611
Goodwill					102,367			98,873
Other intangible assets, net					14,149			16,001
Cash surrender value of life insurance policies					105,223			105,978
Accrued interest receivable and other assets					199,371			165,785

		Total assets		$	9,952,787		$	9,672,114

Liabilities:
Deposits:
	Non-interest-bearing demand deposits			$	2,969,387		$	3,143,473
	Interest-bearing deposits				5,136,291			4,925,384

			Total deposits		8,105,678			8,068,857
Federal funds purchased and repurchase agreements					506,342			421,801
Subordinated notes payable and other borrowings					150,872			152,752
Junior subordinated deferrable interest debentures					226,805			103,093
Accrued interest payable and other liabilities					140,695			155,607

			Total liabilities		9,130,392			8,902,110
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
Additional paid-in capital					212,910			200,844
Retained earnings					697,872			625,405
Deferred compensation					(5,567	)		(3,771	)
Accumulated other comprehensive income (loss), net of tax					(10,784	)		8,063
Treasury stock, 1,637,764 shares in 2004 and 1,785,523 shares in 2003, at cost					(72,572	)		(61,073	)

			Total shareholders’ equity		822,395			770,004

			Total liabilities and shareholders’ equity	$	9,952,787		$	9,672,114

See accompanying Notes to Consolidated Financial Statements.

Cullen/ Frost Bankers, Inc.

Consolidated Statements of Cash Flows

(Dollars in thousands)



				Year Ended December 31,

				2004			2003			2002


Operating Activities:
Net income				$	141,325		$	130,501		$	116,986
Adjustments to reconcile net income to net cash from operating activities:
	Provision for possible loan losses				2,500			10,544			22,546
	Deferred tax expense (benefit)				5,319			(3,778	)		(7,817	)
	Accretion of loan discounts				(6,102	)		(4,127	)		(4,512	)
	Securities premium amortization (discount accretion), net				1,815			1,167			1,203
	Net (gain) loss on securities transactions				3,377			(40	)		(88	)
	Depreciation and amortization				24,482			25,751			27,072
	Origination of loans held for sale, net of principal collected				(61,035	)		(63,828	)		(58,352	)
	Proceeds from sales of loans held for sale				58,139			50,813			117,810
	Net gain on sale of loans held for sale and other assets				(2,274	)		(3,465	)		(2,102	)
	Tax benefit from stock option exercises				11,524			3,638			4,361
	Amortization of deferred compensation				1,377			833			4,838
	Charge for discontinued operations				—			—			3,035
	Earnings on life insurance policies				(4,128	)		(4,624	)		(4,968	)
	Net change in:
		Trading account securities			918			(594	)		(4,877	)
		Accrued interest receivable and other assets			(30,480	)		25,334			96,789
		Accrued interest payable and other liabilities			(17,976	)		34,237			(29,459	)

			Net cash from operating activities		128,781			202,362			282,465
Investing Activities:
	Securities held to maturity:
		Purchases			—			(1,000	)		—
		Maturities, calls and principal repayments			8,466			12,023			15,049
	Securities available for sale:
		Purchases			(8,518,256	)		(8,603,817	)		(7,933,246	)
		Sales			597,369			6,768,029			6,992,946
		Maturities, calls and principal repayments			7,873,115			1,272,290			721,200
	Net change in loans				(581,043	)		(65,555	)		(67,523	)
	Net cash (paid) received in acquisitions				(7,063	)		(750	)		19,163
	Proceeds from sales of premises and equipment				276			1,070			2,202
	Purchases of premises and equipment				(15,398	)		(12,512	)		(43,147	)
	Benefits received on life insurance policies				4,883			3,296			3,747
	Proceeds from sales of repossessed properties				4,247			7,211			2,926

			Net cash from investing activities		(633,404	)		(619,715	)		(286,683	)
Financing Activities:
	Net change in deposits				36,821			440,714			508,391
	Net change in short-term borrowings				84,541			(389,417	)		505,834
	Principal payments on notes payable and other borrowings				(1,880	)		(15,412	)		(12,895	)
	Proceeds from junior subordinated deferrable interest debentures				123,712			—			—
	Proceeds from stock option exercises				36,006			15,294			10,754
	Purchase of treasury stock				(65,212	)		(11,082	)		(29,884	)
	Cash dividends paid				(53,782	)		(48,485	)		(44,737	)

			Net cash from financing activities		160,206			(8,388	)		937,463

Net change in cash and cash equivalents					(344,417	)		(425,741	)		933,245
Cash and cash equivalents at beginning of year					1,638,206			2,063,947			1,130,702

Cash and cash equivalents at end of year				$	1,293,789		$	1,638,206		$	2,063,947

See accompanying Notes to Consolidated Financial Statements

Cullen/ Frost Bankers, Inc.

Consolidated Statement of Changes in Shareholders’ Equity

(Dollars in thousands, except per share amounts)


													Accumulated
													Other
													Comprehensive
					Additional								Income
			Common		Paid-In		Retained			Deferred			(Loss),			Treasury
			Stock		Capital		Earnings			Compensation			Net of Tax			Stock			Total


Balance at January 1, 2002			$	536	$	191,856	$	482,258		$	(3,826	)	$	(14,005	)	$	(61,900	)	$	594,919
Comprehensive income:
	Net income			—		—		116,986			—			—			—			116,986
	Net other comprehensive income			—		—		—			—			46,553			—			46,553

		Total comprehensive income																		163,539

Stock option exercises (684,832 shares)				—		—		(5,088	)		—			—			15,842			10,754
Tax benefit from stock compensation				—		4,361		—			—			—			—			4,361
Purchase of treasury stock (842,137 shares)				—		—		3			157			—			(30,044	)		(29,884	)
Non-vested stock awards (97,545 shares)				—		613		—			(3,126	)		—			2,513			—
Amortization of deferred compensation				—		—		—			4,838			—			—			4,838
Cash dividends ($0.875 per share)				—		—		(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
	Net other comprehensive loss			—		—		—			—			(24,485	)		—			(24,485	)

		Total comprehensive income																		106,016

Stock option exercises (688,280 shares)				—		—		(6,033	)		—			—			21,327			15,294
Tax benefit from stock compensation				—		3,638		—			—			—			—			3,638
Purchase of treasury stock (277,137 shares)				—		—		—			—			—			(11,082	)		(11,082	)
Non-vested stock awards (69,475 shares)				—		376		—			(2,647	)		—			2,271			—
Amortization of deferred compensation				—		—		—			833			—