UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                              WASHINGTON, DC 20549
                            -------------------------
                                    FORM 10-K

      FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 or 15(d) OF
                       THE SECURITIES EXCHANGE ACT OF 1934
(Mark One)

[X]   ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
      OF 1934

For the fiscal year ended September 30, 2003

                                      OR

[ ]   TRANSITIONAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE
      ACT OF 1934

For the transition period from                to
                               --------------    --------------

                           Commission File No. 0-25859
                                               -------

                             1st STATE BANCORP, INC.
--------------------------------------------------------------------------------
             (Exact Name of Registrant as Specified in Its Charter)

          VIRGINIA                                              56-2130744
-------------------------------                              -------------------
(State or Other Jurisdiction of                               (I.R.S. Employer
Incorporation or Organization)                               Identification No.)

445 S. MAIN STREET, BURLINGTON, NORTH CAROLINA                     27215
-----------------------------------------------              -------------------
(Address of Principal Executive Offices)                         (Zip Code)

       Registrant's telephone number, including area code: (336) 227-8861
                                                           --------------

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

                                      NONE
                                      ----

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

                     COMMON STOCK, PAR VALUE $.01 PER SHARE
                     --------------------------------------
                                (Title of Class)

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

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

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

     As of December 12, 2003, the aggregate market value of the 1,524,779 shares
of Common Stock of the registrant  issued and outstanding  held by nonaffiliates
on such date was approximately  $45.0 million based on the closing sale price of
$29.50  per share of the  registrant's  Common  Stock as  listed  on the  Nasdaq
National  Market on December 12, 2003. For purposes of this  calculation,  it is
assumed that directors, executive officers and beneficial owners of more than 5%
of the registrant's outstanding voting stock are affiliates.

     Number of shares of Common  Stock  outstanding  as of  December  12,  2003:
2,971,902

                       DOCUMENTS INCORPORATED BY REFERENCE

     The following lists the documents incorporated by reference and the Part of
the Form 10-K into which the document is incorporated:

     1.   Portions  of the Annual  Report to  Stockholders  for the fiscal  year
          ended September 30, 2003. (Parts II and IV)

     2.   Portions of Proxy  Statement for 2004 Annual Meeting of  Stockholders.
          (Part III)




                                     PART I

ITEM 1.  BUSINESS
-----------------

GENERAL

     1st  State  Bancorp,  Inc.  We  organized  1st  State  Bancorp,  Inc.  (the
"Company")  in  November  1998 to be the  holding  company  for 1st State  Bank,
Burlington,  North Carolina (the "Bank"),  following the Bank's  conversion from
mutual  to stock  form  (the  "Stock  Conversion"),  and then as a bank  holding
company   of  1st   State   Bank   following   its   conversion   from  a  North
Carolina-chartered  savings bank to a North Carolina  commercial bank (the "Bank
Conversion").  1st State Bancorp acquired all the outstanding stock of 1st State
Bank in connection  with the Stock  Conversion on April 23, 1999.  Prior to that
time,  the  Company did not own assets or conduct  operations.  Portions of this
discussion  as of dates and for  periods  prior to April 23,  1999 relate to the
financial  condition  and results of  operations  of 1st State  Bank.  1st State
Bancorp  is  primarily  engaged  in the  business  of  directing,  planning  and
coordinating the business activities of 1st State Bank. In the future, 1st State
Bancorp  may  conduct   operations  or  acquire  or  organize  other   operating
subsidiaries,  including other financial institutions, though we have no current
plans in this regard.  Currently,  1st State  Bancorp does not maintain  offices
separate  from those of 1st State Bank nor  employ  any  persons  other than its
officers who are not separately compensated for their service.

     1st State Bank. Founded in 1914, 1st State Bank is a community and customer
oriented North  Carolina-chartered  commercial bank headquartered in Burlington,
North  Carolina.  We have seven full service  offices  located in north  central
North  Carolina on the  Interstate  85 corridor  between the Piedmont  Triad and
Research  Triangle  Park.  We conduct most of our  business in Alamance  County,
North Carolina.

     Our business consists  principally of attracting  deposits from the general
public and investing these funds in loans secured by  single-family  residential
and commercial real estate,  secured and unsecured commercial loans and consumer
loans. Our profitability  depends primarily on our net interest income, which is
the  difference  between  the  income  we  receive  on our loan  and  investment
securities  portfolios and our cost of funds,  which consists of the interest we
pay on deposits and borrowed funds. We also earn income from  miscellaneous fees
related to our loans and deposits,  mortgage banking income and commissions from
sales of annuities and mutual funds.

MARKET AREA

     We conduct most of our business in Alamance  County in north  central North
Carolina,  located on the Interstate 85 corridor  between the Piedmont Triad and
Research  Triangle.  Historically,  the Alamance County economy has been heavily
dependent  on the textile  industry.  During the past 20 years,  the economy has
diversified  to  some  extent,  with  increasing  employment  in  the  areas  of
insurance,  banking,  manufacturing  and services.  Major  employers in the area
include LabCorp,  Burlington  Industries,  Alamance - Burlington  Schools,  Glen
Raven Mills. Great American Knitting,  Culp, Elon University and Alamance Health
Services.  Nevertheless,  the economy in Alamance County continues to be heavily
dependent on the textile industry.




                                       2




LENDING ACTIVITIES

     Loan Portfolio Composition. At September 30, 2003, our gross loan portfolio
totaled  $234.5  million and  represented  64.7% of total assets.  The following
table sets forth  information  relating to the composition of our loan portfolio
by type of loan  at the  dates  indicated.  At  September  30,  2003,  we had no
concentrations  of loans  exceeding  10% of gross loans other than as  disclosed
below.  Excluded  from this table are  mortgage  loans held for sale,  which are
presented  separately  on our  consolidated  balance  sheets  and  in  "Selected
Consolidated  Financial  Information  and Other  Data" in the  Annual  Report to
Stockholders for the fiscal year ended September 30, 2003 (the "Annual Report").



                                                                            At September 30,
                                    -----------------------------------------------------------------------------------------------
                                         2003               2002               2001                 2000                1999
                                    ---------------   ----------------   -----------------   ------------------ --------------------
                                     Amount     %      Amount       %     Amount        %     Amount      %       Amount       %
                                     ------   -----    ------     -----   ------      -----   ------     ----     ------     ----
                                                                          (Dollars in thousands)
                                                                                                
Real estate loans:
  Single-family residential........$  47,728   20.35%  $  66,708   28.00% $  86,886   37.33%  $  97,989   41.27% $  90,883   44.06%
  Commercial.......................   35,214   15.01      34,431   14.45     40,957   17.60      46,525   19.59     40,816   19.79
  Home equity......................   29,188   12.45      24,878   10.44     22,167    9.52      21,225    8.94     18,888    9.16
  Construction.....................   16,580    7.07      33,080   13.88     19,230    8.26      21,991    9.26     16,496    8.00
                                    --------  ------   ---------  ------  ---------  ------    --------  ------  ---------  ------
    Total real estate loans........  128,710   54.88     159,097   66.77    169,240   72.71     187,730   79.06    167,083   81.01
Commercial.........................  100,149   42.70      72,061   30.24     56,938   24.46      42,949   18.09     32,502   15.76
Consumer...........................    5,684    2.42       7,117    2.99      6,583    2.83       6,782    2.85      6,658    3.23
                                    --------  ------   ---------  ------  ---------  ------    --------  ------  ---------  ------
                                     234,543  100.00%    238,275  100.00%   232,761  100.00%    237,461  100.00%   206,243  100.00%
                                    --------  ======   ---------  ======  ---------  ======    --------  ======  ---------  ======
Less:
  Construction loans in process....   (4,870)            (14,273)            (6,573)             (9,972)            (7,289)
  Deferred fees and discounts......      (92)               (223)              (291)               (358)              (208)
  Allowance for loan losses........   (3,856)             (3,732)            (3,612)             (3,536)            (3,454)
                                    --------           ---------          ---------             --------         ---------
    Total.......................... $225,725           $ 220,047          $ 222,285             $223,595         $ 195,292
                                    ========           =========          =========             ========         =========



                                       3



     Loan Maturity Schedule.  The following table sets forth certain information
at  September  30, 2003  regarding  the dollar  amount of loans  maturing in our
portfolio  based on their  contractual  terms to maturity,  including  scheduled
repayments  of  principal.  Demand  loans,  loans  having no stated  schedule of
repayments,  such as lines of credit,  and overdrafts are reported as due in one
year or less.  The table does not include  any  estimate  of  prepayments  which
significantly  shorten  the  average  life of  mortgage  loans and may cause our
repayment experience to differ from that shown below.



                                                            Due After 1
                                       Due During              Through                Due After
                                     the Year Ending        5 Years After           5 Years After
                                   September 30, 2004    September 30, 2003      September 30, 2003         Total
                                   ------------------    ------------------      ------------------         -----
                                                           (In thousands)
                                                                                                  
Real estate loans:
  Single-family residential.........  $     2,350             $     4,796             $    40,582         $   47,728
  Commercial........................        6,792                  16,057                  12,365             35,214
  Home equity.......................          719                   2,890                  25,579             29,188
  Construction......................        7,600                   4,078                      32             11,710
Commercial..........................       47,307                  32,171                  20,671            100,149
Consumer............................        2,543                   3,075                      66              5,684
                                      -----------             -----------             -----------         ----------
    Total...........................  $    67,311             $    63,067             $    99,295         $  229,673
                                      ===========             ===========             ===========         ==========




     The following  table sets forth at September 30, 2003, the dollar amount of
all loans due one year or more after September 30, 2003 which have predetermined
interest rates and have floating or adjustable interest rates.



                                                     Predetermined        Floating or
                                                          Rate          Adjustable Rates      Total
                                                     -------------      ----------------      -----
                                                                        (In thousands)
                                                                                       
Real estate loans:
  Single-family residential........................  $    21,720          $   23,658      $   45,378
  Commercial.......................................        8,705              19,717          28,422
  Home equity......................................           93              28,376          28,469
  Construction.....................................          989               3,121           4,110
Commercial.........................................       12,634              40,208          52,842
Consumer ..........................................        2,535                 606           3,141
                                                     -----------          ----------      ----------
    Total..........................................  $    46,676          $  115,686      $  162,362
                                                     ===========          ==========      ==========


     Scheduled  contractual  principal  repayments  of loans do not  reflect the
actual life of the loans.  The average life of loans can be  substantially  less
than their  contractual terms because of prepayments.  In addition,  due-on-sale
clauses on loans  generally give us the right to declare a loan  immediately due
and payable in the event that,  among other things,  the borrower sells the real
property subject to the mortgage and the loan is not repaid. The average life of
mortgage  loans tends to increase  when current  mortgage  loan market rates are
substantially  higher than rates on  existing  mortgage  loans and,  conversely,
decrease when current  mortgage loan market rates are  substantially  lower than
rates on existing mortgage loans.

     Originations,  Purchases and Sales of Loans. We generally have authority to
originate  and purchase  loans  secured by real estate  located  throughout  the
United  States.  Consistent  with our  emphasis  on  being a  community-oriented
financial institution, we concentrate our lending activities in Alamance County.


                                       4


     The following table sets forth certain information with respect to our loan
origination, purchase and sale activity for the periods indicated.



                                                                          Year Ended September 30,
                                                                   2003              2002               2001
                                                                  ------            ------             ------
                                                                                (In thousands)
                                                                                                 
Loans originated:
  Real estate loans:
    Single-family residential.................................  $  100,076          $  69,434          $  54,284
    Commercial................................................      16,505             17,613              4,735
    Home equity...............................................      20,469             15,989             11,855
    Construction..............................................       9,808             23,565             13,393
                                                                ----------          ---------          ---------
    Total real estate loans...................................     146,858            126,601             84,267
  Commercial..................................................      33,830             26,398             36,147
  Consumer....................................................       5,730              7,310              6,918
                                                                ----------          ---------          ---------
      Total loans originated..................................  $  186,418          $ 160,309          $ 127,332
                                                                ==========          =========          =========
Loans purchased:
  Real estate loans...........................................  $       50          $     100          $     345
  Other loans.................................................          --                 --                 --
                                                                ----------          ---------          ---------

     Total loans purchased....................................  $       50          $     100          $     345
                                                                ==========          =========          =========

Proceeds from loans sold (1):.................................  $  103,739          $  62,712          $  47,936
                                                                ==========          =========          =========


------------------
(1) All loans sold were whole loans.

     We  obtain  our loan  originations  from a  number  of  sources,  including
referrals from depositors, borrowers and realtors, repeat customers, advertising
and calling officers,  as well as walk-in customers.  We also advertise in local
media and participate in various community organizations and events. Real estate
loans are originated by our loan officers. All of our loan officers are salaried
and are eligible to receive  commissions  for loans  originated.  We accept loan
applications at our offices and do not originate loans on an indirect basis such
as through  arrangements  with automobile  dealers.  In all cases, we have final
approval of the application.  Historically, we have purchased limited quantities
of loans.  During the years ended September 30, 2003,  2002 and 2001,  virtually
all  loans  purchased  were  small   participation   interests  in  multi-family
residential real estate loans to finance low income housing.

     In recent years, and particularly during the years ended September 30, 2003
and 2002, we have sold the majority of fixed-rate,  single-family mortgage loans
that we originated. During the years ended September 30, 2003, 2002 and 2001, we
sold $103.7  million,  $62.7 million and $47.9  million,  respectively,  of such
loans.  Typically,  in the current low interest rate  environment,  we have been
selling fixed-rate,  single-family mortgage loans with terms of 15 years or more
except in cases where the interest  rate is  sufficient to compensate us for the
risk of retaining a long-term, fixed-rate loan in our portfolio. Most loans have
been sold to private purchasers with servicing released.  In addition, we sell a
smaller  amount  of loans in the  secondary  market  to the  Federal  Home  Loan
Mortgage Corporation. We retain servicing on loans sold to the Federal Home Loan
Mortgage Corporation.

     Loan Underwriting Policies. We have established written, non-discriminatory
underwriting standards and loan origination procedures.  We obtain detailed loan
applications to determine the borrower's  ability to repay,  and verify the more
significant  items on these  applications  through  the use of  credit  reports,
financial  statements and confirmations.  Individual  officers have been granted
authority by the board of directors to approve mortgage, consumer and commercial
loans up to varying specified dollar amounts, depending upon the type of loan. A
loan committee  consisting of our President,  Executive  Vice  President,  Chief
Financial  Officer,  senior  credit  officer  and head of  mortgage  lending has
authority  to  approve  any  loan  in an  amount  exceeding  individual  lending
authorities  where our total loans to that borrower  would not exceed  $350,000.
Our  executive  committee,  which  consists of the  Chairman  of the Board,  the
President,  two additional board members that serve on a permanent basis and one
board member selected on a rotating basis that serves for a three-month  period,
has authority to approve any loan where our total loans to that  borrower  would
not exceed $1.0 million. Loans above that amount may not be made unless



                                       5


approved  by the  full  board  of  directors.  These  authorities  are  based on
aggregate  borrowings  of an  individual  or  entity.  On a monthly  basis,  the
executive committee reviews the actions taken by the loan committee and the full
board of directors reviews the actions taken by the executive committee.

     Applications  for  single-family  real estate  loans are  underwritten  and
closed  in  accordance   with  the  standards  of  Federal  Home  Loan  Mortgage
Corporation.  Generally,  upon receipt of a loan  application from a prospective
borrower,  we  order a credit  report  and  verifications  to  confirm  specific
information  relating  to the loan  applicant's  employment,  income  and credit
standing.  If a proposed loan is to be secured by a mortgage on real estate,  we
usually obtain an appraisal of the real estate from an appraiser  approved by us
and  licensed by the State of North  Carolina.  Except when we become aware of a
particular  risk of  environmental  contamination,  we generally do not obtain a
formal environmental report on real estate at the time a loan is made.

     Our  policy is to record a lien on the real  estate  securing a loan and to
obtain  title  insurance  which  insures  that  the  property  is free of  prior
encumbrances and other possible title defects. Borrowers must also obtain hazard
insurance  policies  prior to closing and, when the property is in a flood plain
as designated  by the  Department  of Housing and Urban  Development,  pay flood
insurance policy premiums.

     On single-family  residential  mortgage loans, we make a loan commitment of
between 30 and 60 days for each loan approved.  If the borrower desires a longer
commitment,  we may extend the  commitment  for good  cause.  We  guarantee  the
interest rate for the commitment period.

     We are permitted to lend up to 95% of the lesser of the appraised  value or
the purchase price of the real property  securing a mortgage loan.  However,  if
the amount of a residential  loan  originated  or refinanced  exceeds 80% of the
appraised value, our policy generally is to obtain private mortgage insurance at
the borrower's  expense on that portion of the principal amount of the loan that
exceeds 80% of the appraised value of the property. We will make a single-family
residential  mortgage loan with up to a 95% loan-to-value  ratio if the required
private  mortgage  insurance is obtained.  We generally limit the  loan-to-value
ratio  on  commercial   real  estate   mortgage  loans  to  80%,   although  the
loan-to-value ratio on commercial real estate loans in limited circumstances has
been  as  high  as  90%.  We  limit  the  loan-to-value  ratio  on  multi-family
residential real estate loans to 80%.

     Under applicable law, with certain limited exceptions, loans and extensions
of credit by a financial institution to a person outstanding at one time and not
fully secured by  collateral  having a market value at least equal to the amount
of the loan or  extension  of credit  shall not exceed 15% of net worth plus the
general loan loss  reserve.  Loans and  extensions  of credit  fully  secured by
readily  marketable  collateral  may  comprise an  additional  10% of net worth.
Applicable law additionally  authorizes financial  institutions to make loans to
one borrower, for any purpose:

     o    in an amount not to exceed $500,000;

     o    in an amount  not to exceed the  lesser of  $30,000,000  or 30% of net
          worth to develop residential housing,  provided (a) the purchase price
          of each  single-family  dwelling  in the  development  does not exceed
          $500,000  and (b) the  aggregate  amount  of  loans  made  under  this
          authority does not exceed 150% of net worth; or

     o    loans to finance the sale of real  property in  satisfaction  of debts
          previously contracted in good faith, not to exceed 50% of net worth.

     Under these limits,  our loans to one borrower were limited to $8.6 million
at September 30, 2003. At that date, we had no lending  relationships  in excess
of the  loans-to-one-borrower  limit.  At September  30,  2003,  our ten largest
lending relationships ranged in size from $3.3 million to $7.0 million.

     Single-Family  Residential Real Estate Lending.  We historically  have been
and continue to be an originator of single-family, residential real estate loans
in our market area. At September 30, 2003,  single-family,  residential mortgage
loans, excluding home equity loans, totaled $47.7 million, or 20.3% of our gross
loan portfolio.

                                       6


     We originate  fixed-rate  mortgage loans at competitive  interest rates. At
September 30, 2003,  $21.9  million,  or 9.3%,  of our gross loan  portfolio was
comprised of fixed-rate, single-family mortgage loans. Generally, in the current
interest rate  environment,  we have been  retaining  fixed-rate  mortgages with
maturities of ten years or less while  fixed-rate  loans with longer  maturities
may be retained in the portfolio or sold in the secondary market.

     We   also   offer   adjustable-rate   residential   mortgage   loans.   The
adjustable-rate  loans we currently offer have interest rates which adjust every
one, three or five years from the closing date of the loan or on an annual basis
commencing  after  an  initial  fixed-rate  period  of  three  or five  years in
accordance with a designated index, plus a stipulated  margin. The primary index
we utilize is the weekly average yield on the one year U.S. Treasury  securities
adjusted to a constant  comparable maturity equal to the loan adjustment period,
as made  available  by the Federal  Reserve  Board (the  "Treasury  Rate").  The
maximum  adjustment on the bulk of our loans is 2% per adjustment  period with a
maximum  aggregate  adjustment  of 6%  over  the  life  of the  loan.  We  offer
adjustable-rate  mortgage  loans that  provide  for  initial  rates of  interest
slightly below the rates that would prevail when the index used for repricing is
applied, i.e., "teaser" rates. All of our adjustable-rate loans require that any
payment  adjustment  resulting  from  a  change  in  the  interest  rate  of  an
adjustable-rate loan be sufficient to result in full amortization of the loan by
the end of the loan term and,  thus, do not permit any of the increased  payment
to be  added  to  the  principal  amount  of the  loan,  or  so-called  negative
amortization.   At  September  30,  2003,  $25.8  million,   or  54.1%,  of  our
single-family residential mortgage loans were adjustable-rate loans.

     The retention of  adjustable-rate  loans in our portfolio  helps reduce our
exposure to increases or decreases in prevailing market interest rates. However,
there are  unquantifiable  credit risks  resulting from  potential  increases in
costs to borrowers in the event of upward repricing of adjustable-rate loans. It
is possible that during periods of rising interest rates, the risk of default on
adjustable-rate  loans  may  increase  due to  increases  in  interest  costs to
borrowers.  Further,  although  adjustable-rate  loans allow us to increase  the
sensitivity of our  interest-earning  assets to changes in interest  rates,  the
extent of this interest  sensitivity is limited by the initial fixed-rate period
before  the  first   adjustment  and  the  lifetime   interest  rate  adjustment
limitations.  Accordingly,  yields  on our  adjustable-rate  loans may not fully
adjust to compensate for increases in our cost of funds.

     Commercial Real Estate  Lending.  Our commercial real estate loan portfolio
includes  loans secured by small office  buildings,  commercial  and  industrial
buildings and small  apartment  buildings.  These loans  generally range in size
from $100,000 to $4.2 million. At September 30, 2003, our commercial real estate
loans  totaled  $35.2  million,  which  amounted  to 15.0%,  of our  gross  loan
portfolio. We originate commercial real estate loans for terms of up to 15 years
and with  interest  rates  that  adjust  daily  based on the  prime  rate plus a
negotiated margin typically up to 1% or that carry predetermined rates fixed for
one, three or five years.

     Commercial  real estate lending  entails  significant  additional  risks as
compared with single-family residential property lending. Commercial real estate
loans  typically  involve larger loan balances to single  borrowers or groups of
related  borrowers.  The payment experience on such loans typically is dependent
on the successful  operation of the real estate project,  retail  establishment,
apartment  building or business.  These risks can be  significantly  affected by
supply and demand  conditions in the market for office,  retail and  residential
space, and, as such, may be subject to a greater extent to adverse conditions in
the economy  generally.  To minimize these risks,  we generally  originate loans
secured by collateral  located in our market area or to borrowers  with which we
have prior  experience or who are otherwise  known to us. It has been our policy
to obtain  annual  financial  statements  of the business of the borrower or the
project for which  commercial  real estate loans are made.  In addition,  in the
case of commercial  mortgage loans made to a partnership  or a  corporation,  we
seek,  whenever  possible,  to obtain personal  guarantees and annual  financial
statements of the principals of the partnership or corporation.

     Home Equity  Loans.  At September  30,  2003,  we had  approximately  $29.2
million in home equity line of credit loans, representing approximately 12.5% of
our  gross  loan  portfolio.  Our home  equity  lines of credit  generally  have
adjustable  interest rates tied to our prime  interest rate plus a margin.  Home
equity  lines of credit must be repaid in 15 years or less and  require  monthly
interest  payments.  Home  equity  lines of  credit  generally  are  secured  by
subordinate  liens against  residential real property.  We require that fire and
extended coverage casualty  insurance and, if appropriate,  flood insurance,  be
maintained in an amount at least sufficient to cover the loan. Home equity loans
generally  are limited so that the amount of such  loans,  along with any senior
indebtedness, does not exceed 90% of the value of the real estate security.

                                       7


     Construction  Lending.  We offer  residential  and commercial  construction
loans, with a significant portion of such loans originated to date being for the
construction  of  owner-occupied,  single-family  dwellings  in our market area.
Residential  construction  loans are offered  primarily to individuals  building
their primary or secondary residence, as well as to selected local developers to
build single-family dwellings. In addition, on occasion, we make acquisition and
development  loans to local  developers  to acquire and develop land for sale to
builders who will  construct  single-family  residences.  At September 30, 2003,
$16.6 million,  or 7.1%, of our gross loan portfolio  consisted of  construction
loans.

     Generally,  we originate loans to  owner/occupants  for the construction of
owner-occupied,  single-family  residential  properties in  connection  with the
permanent loan on the property,  and these loans have a construction term of six
to 12  months.  Interest  rates on  residential  construction  loans made to the
owner/occupant  have interest rates during the construction  period equal to the
prime rate.  Upon  completion  of  construction,  the loan is  converted  into a
one-year  adjustable-rate  loan, and the owner may lock in a fixed-rate  loan at
any time during the  one-year  period,  or for a fee the  borrower may lock in a
market rate fixed rate loan upon completion of the house.

     We make construction  loans to builders on either a pre-sold or speculative
basis.  However,  we limit the number of outstanding loans on unsold homes under
construction to individual builders,  with the amount dependent on the financial
strength of the builder,  the present  exposure of the builder,  the location of
the property and prior sales of homes in the development. At September 30, 2003,
speculative  construction  loans  amounted to $7.2  million or 3.1% of our gross
loan portfolio.  At September 30, 2003, the largest exposure to one borrower for
speculative  construction  was  $2.5  million.  Interest  rates  on  residential
construction loans to builders are typically set at our prime rate plus a margin
typically up to 1% and adjust with  changes in the prime rate,  and are made for
terms of up to 24 months.

     Interest rates on commercial construction loans are based on the prime rate
plus a  negotiated  margin  typically  up to 1%, and adjust with  changes in our
prime rate, and are made for terms of up to 24 months,  with construction  terms
generally not exceeding 12 months.

     We make  acquisition  and  development  loans at a rate that adjusts daily,
based on our  prime  rate  plus a  negotiated  margin,  for terms of up to three
years.  Interest  only is paid  during the term of the loan,  and the  principal
balance  of the loan is paid down as  developed  lots are sold to  builders.  At
September  30,  2003,  $6.1  million of our gross loan  portfolio  consisted  of
acquisition and development  loans. We had eight such loans. All acquisition and
development loans were performing in accordance with their terms at such date.

     Prior to making a commitment  to fund a  construction  loan,  we require an
appraisal of the property by appraisers  approved by our board of directors.  We
also review and inspect each project at the  commencement  of  construction  and
periodically  during  the  term  of  the  construction  loan.  We may  charge  a
construction  fee and/or an inspection fee on construction  loans.  Advances are
made on a percentage of completion basis.

     We consider construction  financing generally to involve a higher degree of
risk of loss than long-term financing on improved, occupied real estate. Risk of
loss on a  construction  loan is  dependent  largely  upon the  accuracy  of the
initial  estimate of the  property's  value at  completion  of  construction  or
development and the estimated cost, including interest, of construction.  During
the  construction  phase,  a number of factors  could  result in delays and cost
overruns.  If the estimate of construction costs proves to be inaccurate and the
borrower is unable to meet our  requirements  of putting up additional  funds to
cover  extra costs or change  orders,  then we will demand that the loan be paid
off and, if necessary,  institute foreclosure proceedings or refinance the loan.
If the estimate of value proves to be  inaccurate,  the  collateral may not have
sufficient value to assure full repayment.  We have sought to minimize this risk
by limiting  construction  lending to  borrowers  based in  Alamance  County who
satisfy all credit  requirements and whose loans satisfy all other  underwriting
standards  which would apply to our permanent  mortgage  loan  financing for the
subject property. On loans to builders, we work only with selected builders with
whom we have  experience  and  carefully  monitor  the  creditworthiness  of the
builders.

     Commercial Lending. We originate commercial loans to small and medium-sized
businesses in our market area.  Our  commercial  borrowers  are generally  small
businesses engaged in manufacturing, distribution or retailing, or professionals
in  healthcare,  accounting  and law.  Commercial  loans  generally  are made to
finance the purchase of inventory,  new or used equipment or commercial vehicles
and for  short-term  working  capital.  Such  loans  generally

                                       8


are secured by equipment and inventory,  and, if possible,  cross-collateralized
by a real estate mortgage, although commercial loans are sometimes granted on an
unsecured basis.  Commercial loans generally are made for terms of five years or
less,  depending  on the purpose of the loan and the  collateral,  with loans to
finance  operating  expenses made for one year or less, with interest rates that
adjust  at least  annually  at a rate  equal  to the  prime  rate  plus a margin
typically  up to 2%.  Generally,  we make  commercial  loans in amounts  ranging
between  $50,000 and $1.0  million.  At  September  30, 2003,  commercial  loans
totaled $100.1 million, or 42.7%, of our gross loan portfolio.

     We underwrite commercial loans on the basis of the borrower's cash flow and
ability to service the debt from earnings rather than on the basis of underlying
collateral  value,  and we seek to  structure  such  loans to have more than one
source of  repayment.  The  borrower is  required to provide us with  sufficient
information to allow us to make our lending  determination.  In most  instances,
this  information  consists  of at least two years of  financial  statements,  a
statement  of  projected  cash  flows,  current  financial  information  on  any
guarantor  and any  additional  information  on the  collateral.  For loans with
maturities  exceeding one year, we require that borrowers and guarantors provide
updated financial information at least annually throughout the term of the loan.

     Our commercial loans may be structured as term loans or as lines of credit.
Commercial  term loans are generally  made to finance the purchase of assets and
have maturities of five years or less.  Commercial lines of credit are typically
made for the purpose of providing working capital and are usually reviewed on an
annual  basis but may be called on  demand.  We also  offer  standby  letters of
credit for  commercial  borrowers.  Standby  letters of credit are written for a
maximum term of one year.

     Commercial  loans are often larger and may involve  greater risk than other
types of lending.  Because  payments on commercial  loans are often dependent on
successful  operation of the business  involved,  repayment of such loans may be
subject to a greater  extent to adverse  conditions  in the economy.  We seek to
minimize these risks through our underwriting guidelines, which require that the
loan be supported by adequate  cash flow of the borrower,  profitability  of the
business, collateral and personal guarantees of the individuals in the business.
In  addition,  we limit this type of lending to our market area and to borrowers
with which we have prior experience or who are otherwise well known to us.

     Consumer  Lending.  Our consumer loans include  automobile  loans,  savings
account loans, unsecured lines of credit and miscellaneous other consumer loans,
including  unsecured  loans.  At September 30, 2003,  our consumer loans totaled
$5.7 million, or 2.4%, of our gross loan portfolio.

     We generally underwrite automobile loans in amounts up to 80% of the lesser
of the purchase price of the  automobile  or, with respect to used  automobiles,
the loan value as published by the National Automobile Dealers Association.  The
terms of most such loans do not exceed 60 months.  We require  that the vehicles
be insured and that we be listed as loss payee on the insurance policy.

         We make savings account loans for up to 90% of the depositor's savings
account balance. The interest rate is normally 2.5% above the annual percentage
yield paid on the savings account. The account must be pledged as collateral to
secure the loan. Interest generally is paid on a monthly basis.

     Consumer  lending  affords us the  opportunity  to earn yields  higher than
those obtainable on single-family  residential lending.  However, consumer loans
entail greater risk than do residential mortgage loans, particularly in the case
of loans which are unsecured, as is the case with lines of credit, or secured by
rapidly  depreciable  assets such as automobiles.  Repossessed  collateral for a
defaulted  consumer loan may not provide an adequate  source of repayment of the
outstanding loan balance as a result of the greater  likelihood of damage,  loss
or  depreciation.  The  remaining  deficiency  often  does not  warrant  further
substantial collection efforts against the borrower. In addition,  consumer loan
collections are dependent on the borrower's continuing financial stability,  and
thus are more  likely  to be  adversely  affected  by  events  such as job loss,
divorce,  illness or personal  bankruptcy.  Further,  the application of various
state and federal laws,  including  federal and state  bankruptcy and insolvency
law,  may limit the amount  which may be  recovered.  In  underwriting  consumer
loans, we consider the borrower's credit history,  an analysis of the borrower's
income and ability to repay the loan, and the value of the collateral.

     Loan Fees and Servicing.  We receive fees in connection  with late payments
and for miscellaneous services related to our loans and deposits. We also charge
fees  in  connection  with  loan   originations.   These  fees  can  consist

                                       9


of origination,  discount,  application,  construction  and/or  commitment fees,
depending  on the type of loan.  We  generally  do not service  loans for others
except  for  mortgage  loans we  originate  and sell  with  servicing  retained.
Mortgage  servicing  rights were $547,000 and $370,000 at September 30, 2003 and
2002, respectively. See Note 1 of Notes to Consolidated Financial Statements.

     Nonperforming  Loans and Other Problem Assets.  We continually  monitor our
loan  portfolio to anticipate  and address  potential and actual  delinquencies.
When a borrower  fails to make a payment on a loan, we take  immediate  steps to
have the delinquency cured and the loan restored to current status.  Loans which
are delinquent  more than 15 days incur a late fee of 4% of the monthly  payment
of  principal  and  interest  due.  As a matter of policy,  we will  contact the
borrower after the loan has been  delinquent 15 days. If payment is not promptly
received,  we contact the borrower again, and we try to formulate an affirmative
plan to cure the delinquency. Generally, after any loan is delinquent 45 days or
more,  we send a default  letter to the  borrower.  If the  default is not cured
after 30 days, we commence formal legal proceedings to collect amounts owed.

     Generally we charge off, or reserve  through an allowance  for  uncollected
interest  account,  interest  on  loans,  including  impaired  loans,  that  are
contractually  90 days or more past due. The allowance for uncollected  interest
is established by a charge to interest  income equal to all interest  previously
accrued. In certain  circumstances,  interest on loans that are contractually 90
days or more past due is not charged off or reserved  through an  allowance  for
uncollected  interest account when we believe that the loan is both well secured
and in the process of collection. If amounts are received on loans for which the
accrual of interest has been  discontinued,  we decide whether payments received
should be recorded as a reduction of the principal balance or as interest income
depending  on our  analysis  of the  collectibility  of  principal.  The loan is
returned to accrual  status when we believe the  borrower has  demonstrated  the
ability to make periodic interest and principal payments on a timely basis.

     We classify real estate  acquired as a result of foreclosure as real estate
acquired in settlement of loans until such time as it is sold and is recorded at
the lower of the estimated fair value of the underlying real estate,  less costs
to sell the  property,  or the  carrying  amount of the loan.  Subsequent  costs
directly  related to development  and  improvement of property are  capitalized,
whereas  costs  related to holding  the  property  are  expensed.  We charge any
required  write-down of the loan to its fair value less estimated  selling costs
upon foreclosure  against the allowance for loan losses.  See Note 1 of Notes to
Consolidated Financial Statements.

     The   following   table  sets  forth   information   with  respect  to  our
nonperforming  assets at the dates  indicated.  At the  dates  shown,  we had no
restructured  loans  within the meaning of  Statement  of  Financial  Accounting
Standards No. 114, as amended.



                                                                       At September 30,
                                                -----------------------------------------------------------
                                                  2003         2002         2001         2000        1999
                                                --------     --------     --------     --------    --------
                                                                     (Dollars in thousands)
                                                                                       
Loans accounted for on a nonaccrual basis (1)   $  4,153     $  4,204     $    878     $  2,893    $    366
                                                ========     ========     ========     ========    ========

Accruing loans which are contractually past due
  90 days or more ...........................   $     --     $     --     $     --     $     --    $     --
                                                ========     ========     ========     ========    ========

    Total nonperforming loans................   $  4,153     $  4,204     $    878     $  2,893    $    366
                                                ========     ========     ========     ========    ========

Total loans..................................   $229,581     $ 223,779    $ 225,897    $227,131    $ 198,746
                                                ========     =========    =========    ========    =========
Percentage of total loans....................       1.81%         1.88%        0.39%       1.27%        0.18%
                                                ========     =========    =========    ========    =========
Other nonperforming assets (2)...............   $     95     $     183    $   1,981    $     --    $      --
                                                ========     =========    =========    ========    =========
Loans modified in troubled debt restructuring   $     --     $      --    $      --    $     --    $      --
                                                ========     =========    =========    ========    =========


--------------
(1)  Payments   received  on  a  nonaccrual  loan  are  either  applied  to  the
     outstanding principal balance or recorded as interest income,  depending on
     management's assessment of the collectibility of the loan.
(2)  Other nonperforming assets consist of property acquired through foreclosure
     or repossession.

     During the year ended September 30, 2003, gross interest income of $281,000
would have been  recorded on loans  accounted  for on a nonaccrual  basis if the
loans had been current  throughout the year.  Interest on such loans included in
income during the year ended September 30, 2003 amounted to $244,000.


                                       10



     At  September  30,  2003  there  were no  loans  which  are  not  currently
classified  as  nonaccrual,  90 days past due or  restructured,  but where known
information  about possible  credit problems of borrowers  causes  management to
have serious  concerns as to the ability of the borrowers to comply with present
loan repayment  terms and may result in disclosure as  nonaccrual,  90 days past
due or  restructured.  See "--  Classified  Assets"  for  information  regarding
classified assets.

     At September  30,  2003,  we had $4.2 million of  nonaccrual  loans,  which
consisted of two  one-to-four  family  mortgage  loans,  two home equity  loans,
twelve  commercial and commercial  real estate loans and two consumer  loans. At
September  30,  2003,  real estate  owned  totaled  $95,000.  Real estate  owned
consists of one duplex in Burlington,  North Carolina and one residential lot in
Graham, North Carolina. The Bank is actively marketing both properties.

     At September 30, 2003, we had impaired loans with three unrelated borrowers
of $3.8 million of which all were on nonaccrual  status.  The related  allowance
for loan  losses on these loans was  $210,000.  The  average  carrying  value of
impaired  loans was $3.7 million for the year ended  September  30, 2003.  These
loans are  primarily  secured by business  assets and real estate  properties in
Alamance County.

     Classified  Assets.  Regulations  require  that we classify our assets on a
regular  basis.  In  addition,   in  connection  with  examinations  of  insured
institutions,  examiners  have  authority  to  identify  problem  assets  and if
appropriate,  classify  them in their  reports of  examination.  There are three
regulatory  classifications  for problem assets:  "substandard,"  "doubtful" and
"loss."  Substandard  assets  have  one  or  more  defined  weaknesses  and  are
characterized  by the distinct  possibility  that the insured  institution  will
sustain some loss if the  deficiencies  are not corrected.  Doubtful assets have
the weaknesses of substandard assets with the additional characteristic that the
weaknesses  make  collection or  liquidation  in full, on the basis of currently
existing  facts,  conditions  and  values,  questionable,  and  there  is a high
possibility of loss. An asset classified as loss is considered uncollectible and
of such little  value that  continuance  as an asset of the  institution  is not
warranted.  Assets  classified as  substandard  or doubtful  require a financial
institution  to establish  general  allowances  for loan losses.  If an asset or
portion  thereof is  classified  as loss,  a financial  institution  must either
establish a specific  allowance  for loan losses in the amount of the portion of
the asset classified  loss, or charge off such amount.  1st State Bank regularly
reviews its assets to determine  whether any assets  require  classification  or
re-classification.  At  September  30, 2003,  we had $4.9 million in  classified
assets,  consisting  of $4.8 million in  substandard  loans and $95,000 in other
real estate owned.

     In  addition to  regulatory  classifications,  we also  classify as special
mention and watch assets that are currently  performing in accordance with their
contractual  terms but may be classified or become  nonperforming  assets in the
future.  At September 30, 2003,  we have  identified  approximately  $953,000 in
assets classified as special mention and $35.6 million as watch. Included in the
total of watch list assets are five loans with an aggregate  outstanding balance
of $4.5 million at September  30, 2003 to a company  affiliated  with one of our
directors.  In addition,  the  director has the ability to borrow an  additional
$172,000  from us under a line of credit.  All the loans are  secured by a first
lien  on  all  assets,  including  accounts  receivable,  inventory,  equipment,
furniture and real property occupied by the borrower. In addition,  the director
and his spouse have personally  guaranteed  repayment of the loans. At September
30,  2003,  such loans were current  with  respect to their  payment  terms and,
except for the waiver of certain debt covenants by the Bank,  were performing in
accordance  with  the  related  loan  agreements.  Based on an  analysis  of the
borrower's current financial  statements  received in December 2003,  management
has concerns that the borrower may have difficulty in complying with the present
loan repayment terms on an ongoing basis.  Accordingly,  this loan may become an
impaired loan in future periods. Management will continue to closely monitor the
performance of these loans in future periods.

     Allowance  for Loan Losses.  We maintain the allowance for loan losses at a
level we believe to be adequate to absorb probable losses in the portfolio.  Our
determination  of the adequacy of the allowance is based on an evaluation of the
portfolio, past loss experience, current economic conditions, volume, growth and
composition  of the  portfolio,  and other  relevant  factors.  The allowance is
increased by provisions for loan losses which are charged against income.

     Although  we  believe  we  use  the  best  information  available  to  make
determinations  with respect to the  allowance  for loan losses and believe such
allowances  are  adequate,  future  adjustments  may be  necessary  if  economic
conditions differ  substantially from the economic conditions in the assumptions
used in making the initial




determinations.  We anticipate  that our allowance for loan losses will increase
in the  future  through  provisions  as we  implement  the  board of  directors'
strategy of continuing existing lines of business while gradually increasing our
credit risk profile by expanding  commercial and consumer  lending,  which loans
generally entail greater risks than single-family residential mortgage loans.

     We charge  provisions  for loan losses to  earnings  to maintain  the total
allowance  for loan  losses  at a level we  consider  adequate  to  provide  for
probable loan losses, based on prior loss experience, volume and type of lending
we conduct,  industry  standards and past due loans in our loan  portfolio.  Our
policies  require  the review of assets on a regular  basis,  and we assign risk
grades to loans  based on the  relative  risk of the  credit,  considering  such
factors as  repayment  experience,  value of  collateral,  guarantors,  etc.  We
believe  we use the best  information  available  to make a  determination  with
respect to the allowance for loan losses,  recognizing  that future  adjustments
may be necessary depending upon a change in economic  conditions.  The provision
for loan losses was  $240,000,  charge-offs  were $117,000 and  recoveries  were
$1,000 for the year ended  September  30,  2003  compared  with a  provision  of
$240,000,  charge-offs of $121,000 and recoveries were $1,000 for the year ended
September 30, 2002.

     The  allowance  for loan losses was $3.9 million at September  30, 2003 and
$3.7  million  at  September  30,  2002,  which we think is  adequate  to absorb
probable losses in the loan portfolio. As a result of our continued shift toward
higher risk commercial,  consumer and home equity loans as well as the continued
recession in the local and regional economy, the ratio of the allowance for loan
losses to total loans,  net of loans in process and deferred loan fees was 1.68%
at September 30, 2003 compared to 1.67% at September 30, 2002.  While management
uses the best information  available to make evaluations,  future adjustments to
the  allowance  may  be  necessary  based  on  changes  in  economic  and  other
conditions.  Additionally,  various regulatory agencies,  as an integral part of
their examination process,  periodically review the Company's allowance for loan
losses.  Such  agencies  may  require  the  recognition  of  adjustments  to the
allowance for loan losses based on their  judgments of information  available to
them at the time of their examinations.

     Banking  regulatory  agencies,  including  the FDIC,  have adopted a policy
statement  regarding  maintenance  of an adequate  allowance  for loan and lease
losses and an effective loan review system.  This policy  includes an arithmetic
formula for checking the  reasonableness of an institution's  allowance for loan
loss  estimate  compared to the average  loss  experience  of the  industry as a
whole.  Examiners  will  generally  review an  institution's  allowance for loan
losses and compare it against the sum of:

     o    50% of the portfolio that is classified doubtful;

     o    15% of the portfolio that is classified as substandard; and

     o    for the  portions  of the  portfolio  that  have not been  classified,
          including those loans designated as special mention,  estimated credit
          losses over the upcoming 12 months  given the facts and  circumstances
          as of the evaluation date.

This amount is considered  neither a "floor" nor a "safe harbor" of the level of
allowance for loan losses an  institution  should  maintain,  but examiners will
view a shortfall relative to the amount as an indication that they should review
management's  policy on allocating these  allowances to determine  whether it is
reasonable based on all relevant factors.

     We have our own  allowance for loan loss model which is similar to the FDIC
model,  but uses different  factors and  assumptions to arrive at an estimate of
the allowance for loan losses under accounting  principles generally accepted in
the United States of America.  Our model  indicated  that the allowance for loan
losses was adequate at September 30, 2003.


                                       12






     The following table sets forth an analysis of our allowance for loan losses
for the periods indicated.


                                                                       Year   Ended   September   30,
                                                -------------------------------------------------------------
                                                  2003         2002           2001         2000        1999
                                                --------     --------       --------     --------    --------
                                                                      (Dollars in thousands)
                                                                                         
Balance at beginning of period...............   $    3,732   $   3,612    $   3,536    $   3,454   $    3,228
                                                ----------   ---------    ---------    ---------   ----------

Loans charged off:
   Commercial real estate....................           --          --          125           --           --
   1-4 family residential....................           --          85           19          159           --
   Commercial................................           96          --           --           --           --
   Consumer..................................           21          36           24            5           23
                                                ----------   ---------    ---------    ---------   ----------
      Total..................................          117         121          168          164           23

Recoveries...................................            1           1            4            6            4
                                                ----------   ---------    ---------    ---------   ----------

Net loans charged off........................          116         120          164          158           19
                                                ----------   ---------    ---------    ---------   ----------

Provision for loan losses....................          240         240          240          240          245
                                                ----------   ---------    ---------    ---------   ----------
Balance at end of period.....................   $    3,856   $   3,732    $   3,612    $   3,536   $    3,454
                                                ==========   =========    =========    =========   ==========

Average loans outstanding....................   $  227,951   $ 219,071    $ 229,058    $ 219,381   $  198,603
                                                ==========   =========    =========    =========   ==========

Ratio of net loans charged off to average
  loans outstanding during the period........       0.0509%     0.0548%      0.0716%      0.0720%      0.0096%
                                                ==========   =========    =========    =========   ==========



                                       13



     The  following  table  allocates  the  allowance  for loan  losses  by loan
category  at the  dates  indicated.  The  allocation  of the  allowance  to each
category is not  necessarily  indicative  of future losses and does not restrict
the use of the allowance to absorb losses in any category.


                                                                       At September 30,
                                        2003                2002                2001                2000                1999
                               ------------------    -------------------  ------------------  ------------------  ------------------
                                       Percent of            Percent of          Percent of          Percent of          Percent of
                                       Loans in              Loans in            Loans in            Loans in            Loans in
                                       Category to           Category to         Category to         Category to         Category to
                               Amount  Total Loans   Amount  Total Loans  Amount Total Loans  Amount Total Loans  Amount Total Loans
                               ------  -----------   ------  -----------  ------ -----------  ------ -----------  ------ -----------
                                                                       (Dollars in thousands)
                                                                                              
Real estate mortgage:
  Single-family residential....$   222      20.35%   $  240     28.00%    $   253     37.33% $  320     41.27%   $   559     44.06%
  Commercial...................  1,084      15.01     1,054     14.45         932     17.60   1,084     19.59        934     19.79
  Home equity..................    182      12.45       128     10.44         131      9.52     179      8.94        244      9.16
  Construction.................    240       7.07       348     13.88         231      8.26     213      9.26        275      8.00
Commercial.....................  1,987      42.70     1,838     30.24       1,970     24.46   1,616     18.09      1,273     15.76
Consumer.......................    141       2.42       124      2.99          95      2.83     124      2.85        169      3.23
                               -------     ------    ------    ------     -------    ------  ------    ------    -------     -----
    Total allowance for
     loan losses...............$ 3,856     100.00%   $3,732    100.00%    $ 3,612    100.00% $3,536    100.00%   $ 3,454     100.00%
                               =======     ======    ======    ======     =======    ======  ======    ======    =======     ======



                                       14


INVESTMENT ACTIVITIES

     General.  Interest income from investment securities generally provides our
second largest source of income after interest on loans.  Our board of directors
has  authorized  investment  in U.S.  Government  and agency  securities,  state
government   obligations,   municipal  securities,   obligations  of  the  FHLB,
mortgage-backed securities issued by Federal National Mortgage Association,  the
Government  National  Mortgage   Association  and  Federal  Home  Loan  Mortgage
Corporation.  Our objective is to use these  investments to reduce interest rate
risk, enhance yields on assets and provide liquidity. At September 30, 2003, the
amortized  cost  of our  investment  securities  portfolio  amounted  to  $112.4
million, which included $109.4 million of U.S. Government and agency securities,
$3.0 million of North Carolina  municipal bonds,  and $10,000 of  collateralized
mortgage  obligations  ("CMOs").  At that  date,  we had an  unrealized  loss of
$768,000,  net of deferred  taxes,  with  respect to our  investment  securities
classified as available for sale.

     The board of directors has established an investment policy that sets forth
investment and aggregate investment limitations and credit quality parameters of
each class of investment  security.  Securities  transactions are subject to the
oversight  of our  Executive  Committee.  The  President  has  authority to make
specific investment  decisions within the parameters  determined by the board of
directors.

     We  had  securities  with  an  aggregate  cost  of  $93.0  million  and  an
approximate  fair value of $91.7  million at September  30, 2003  classified  as
available  for sale.  The impact on our  financial  statements  was an after-tax
decrease in stockholders'  equity of approximately  $768,000 as of September 30,
2003.  The net  unrealized  losses at  September  30, 2003 in our  portfolio  of
investment  securities  were due to increases in interest rates and a steepening
of the yield curve after we bought the securities. Upon acquisition, we classify
securities  as to our intent.  Securities  designated  as "held to maturity" are
those assets which we have the ability and intent to hold to maturity.  The held
to maturity  investment  portfolio is not used for  speculative  purposes and is
carried at amortized  cost.  Securities  designated as "available  for sale" are
those  assets  which we may not hold to  maturity  and thus are  carried at fair
value  with  unrealized  gains  or  losses,  net of tax  effect,  recognized  in
stockholders' equity.

     At September 30, 2003, we had $93.0 million of U.S.  Government  and agency
securities  classified as available for sale, which carry  unrealized  after-tax
losses of $768,000,  and $19.5  million of investment  securities  classified as
held to  maturity.  We attempt to  maintain a high  degree of  liquidity  in our
investment  securities  portfolio by choosing those  securities that are readily
marketable. As of September 30, 2003, the estimated weighted average life of our
U.S.  Government  and agency  securities  classified  as available  for sale was
approximately  six  years,  and  the  average  yield  on our  portfolio  of U.S.
Government and agency securities  classified as available for sale was 4.21%. In
addition, at September 30, 2003, we had $1.7 million of FHLB of Atlanta stock.

     See Notes 1 and 3 of the Notes to Consolidated  Financial  Statements for a
description of our accounting policies.

     The  following  table  sets  forth  the  carrying  value of our  investment
securities portfolio at the dates indicated.



                                                                                At September  30,
                                                                 ---------------------------------------------
                                                                   2003              2002               2001
                                                                  -----             ------             -------
                                                                                (In thousands)
                                                                                               
Securities available for sale:
   U.S. government and agency securities......................   $  91,709         $   78,572        $  54,632
   Federal Home Loan Mortgage Corporation.....................          --                 --              227
   Government National Mortgage Association...................          --                 --              668
                                                                 ---------         ----------        ---------
      Total...................................................   $  91,709         $   78,572        $  55,527
                                                                 =========         ==========        =========
Securities held to maturity:
   U.S. government and agency securities......................   $  16,408         $    8,430        $  10,986
   Municipal bonds............................................       3,044              2,670            1,164
   CMOs.......................................................          10                 14               19
                                                                 ---------         ----------        ---------
      Total...................................................   $  19,462         $   11,114        $  12,169
                                                                 =========         ==========        =========



                                       15


     The following table sets forth the scheduled  maturities,  carrying values,
amortized cost and average yields for our investment securities at September 30,
2003.



                                   One Year or         One to Five      Five to Ten         More than      Total Investment
                                        Less              Years            Years            Ten Years           Portfolio
                                   --------------    ---------------  ---------------    -------------   -----------------------
                                   Carrying Average  Carrying Average  Carrying Average  Carrying Average Carrying Market Average
                                     Value   Yield    Value    Yield    Value    Yield    Value    Yield   Value    Value  Yield
                                   -------- -------  -------- ------- --------- -------  -------- ------- -------- ------ -------
                                                                        (Dollars in thousands)
                                                                                            
Securities available for sale:
   U.S. government and agency
      securities..................  $    --    --%   $17,133   3.79%  $71,595    4.24%   $2,981   5.89%  $91,709  $91,709  4.21%
                                    =======          =======          =======            ======          =======  =======
Securities held to maturity:
   U.S. government and agency
      securities..................    2,422  5.68      2,992   4.38     5,994    5.34     5,000   5.81    16,408   16,216  5.36
   CMOs...........................       --    --         --     --        --      --        10   1.92        10       10  1.92
   Municipal bonds................       --    --      1,010   3.79     1,681    3.98       353   4.60     3,044    3,171  3.99
                                    -------  ----    -------   ----   -------    ----    ------   ----   -------  -------  ----
        Total.....................  $ 2,422  5.68%   $ 4,002   4.23%  $ 7,675    5.04%   $5,363   5.72%  $19,462  $19,397  5.14%
                                    =======  ====    =======   ====   =======    ====    ======   ====   =======  =======  ====


                                       16


DEPOSIT ACTIVITY AND OTHER SOURCES OF FUNDS

     General.  Deposits are our primary source of funds for lending,  investment
activities and general operational  purposes. In addition to deposits, we derive
funds from loan  principal  and interest  repayments,  maturities  of investment
securities  and  interest  payments  thereon.  Although  loan  repayments  are a
relatively   stable   source  of  funds,   deposit   inflows  and  outflows  are
significantly  influenced by general interest rates and money market conditions.
Borrowings may be used on a short-term basis to compensate for reductions in the
availability  of  funds,  or on a longer  term  basis  for  general  operational
purposes. We have access to FHLB of Atlanta advances as a source of borrowings.

     Deposits.  We attract  deposits  principally from within Alamance County by
offering a variety of deposit  instruments,  including checking accounts,  money
market accounts, passbook and statement savings accounts,  Individual Retirement
Accounts, and certificates of deposit which range in maturity from seven days to
five years.  Deposit terms vary according to the minimum balance  required,  the
length  of time  the  funds  must  remain  on  deposit  and the  interest  rate.
Maturities,  terms,  service  fees  and  withdrawal  penalties  for our  deposit
accounts  are  established  by us on a periodic  basis.  We review  our  deposit
pricing on a weekly basis.  In determining  the  characteristics  of our deposit
accounts, we consider the rates offered by competing  institutions,  lending and
liquidity requirements,  growth goals and applicable regulations.  We believe we
price our deposits  comparably  to rates offered by our  competitors.  We do not
accept brokered deposits.

     We compete  for  deposits  with other  institutions  in our market  area by
offering competitively priced deposit instruments that are tailored to the needs
of our customers.  Additionally,  we seek to meet customers'  needs by providing
convenient  customer  service to the community,  efficient  staff and convenient
hours  of  service.  Substantially  all of our  depositors  are  North  Carolina
residents.  To provide  additional  convenience,  we participate in the STAR and
CIRRUS  Automatic  Teller  Machine  networks at locations  throughout the world,
through which customers can gain access to their accounts at any time. To better
serve our customers,  we have installed  automatic  teller machines at all seven
office locations.


                                       17



     Our  deposits at  September  30,  2003  consisted  of the various  types of
programs described below.



Weighted
Average
Interest       Minimum                                                      Minimum      Balance (in    Percentage of
  Rate           Term                     Category                          Amount       Thousands)   Total Deposits
--------       -------                    --------                          --------     -----------   --------------
                                                                                               
   --%          None                 Noninterest bearing accounts          $    100     $   13,579          5.17%
 0.22           None                 Checking accounts                          300         35,468         13.50
 0.60           None                 Passbook and statement savings accounts    100         30,534         11.62
 0.67           None                 Money market accounts                    1,000         18,496          7.04


                                    Certificates of Deposit
                                    -----------------------

0.90           3 months             Fixed-term, fixed-rate                      500          3,153           1.20
1.25           6 months             Fixed-term, fixed-rate                      500          6,536           2.49
1.25           7 months (1)         Fixed-term, fixed-rate                    5,000         54,933          20.90
1.54           9 months             Fixed-term, fixed-rate                      500            527           0.20
1.37           10 months            Fixed-term, fixed-rate                    5,000          1,333           0.51
1.48           12 months            Fixed-term, fixed-rate                      500         20,731           7.89
2.01           15 months            Fixed-term, fixed-rate                    5,000          9,569           3.64
1.00           18 months            Floating rate individual retirement
                                     account                                     50            746           0.28
2.43           18 months            Fixed-term, fixed-rate                      500          1,672           0.64
1.68           20 months            Fixed-term, fixed-rate                      500             29           0.01
3.59           21 months            Fixed-term, fixed-rate                   10,000         12,603           4.80
2.42           24 months            Fixed-term, fixed-rate                      500          4,830           1.84
2.69           30 months            Fixed-term, fixed-rate                      500          3,581           1.36
3.21           36 months            Fixed-term, fixed-rate                      500          6,058           2.31
4.84           48 months            Fixed-term, fixed-rate                      500          3,298           1.26
4.57           60 months            Fixed-term, fixed-rate                      500         17,785           6.77
1.23           7 to 365 days        Fixed-term, fixed-rate                  100,000         17,251           6.57%
                                                                                        ----------       --------
                                                                                        $  262,712         100.00%
                                                                                        ==========       ========


---------------------
(1)  These  certificates of deposit do not carry a penalty for early withdrawal.
     As a result,  we believe that should  interest  rates  increase  materially
     after  September 30, 2003,  borrowers may withdraw  funds invested in these
     certificates prior to maturity, causing our cost of funds to increase.


                                       18


     The following table sets forth the  distribution of our deposit accounts at
the dates  indicated  and the change in dollar amount of deposits in the various
types of accounts we offer between the dates indicated.




                                      Balance                                Balance at                         Balance at
                                    September 30,   % of       Increase    September 30,    % of     Increase September 30,   % of
                                       2003        Deposit    (Decrease)       2002       Deposits  (Decrease)    2001      Deposits
                                    -------------  -------    ----------   -------------  -------- ---------- ------------- --------
                                                                             (Dollars in thousands)
                                                                                                      
Noninterest bearing accounts........$  13,579      5.2%       $       52    $   13,527      5.2%   $    2,542    $   10,985    4.42%
Interest bearing checking accounts..   35,468     13.5             3,036        32,432     12.4         2,486        29,946   12.06
Money market accounts ..............   18,496      7.0            (2,864)       21,360      8.2          (271)       21,631    8.71
Passbook and statement savings
 accounts...........................   30,534     11.6             1,306        29,228     11.2         3,108        26,120   10.52
Certificates of deposit.............  164,635     62.7               515       164,120     63.0         4,432       159,688   64.29
                                    ---------   ------        ----------    ----------    -----    ----------    ----------  ------
                                    $ 262,712    100.0%       $    2,045    $  260,667    100.0%   $   12,297    $  248,370  100.00%
                                    ==========  ======        ==========    ==========    =====    ==========    ==========  ======



                                       19


     The following  table sets forth the average  balances and average  interest
rates  based on daily  balances  for  various  types of  deposits  at the  dates
indicated for each category of deposits presented.



                                                          Year Ended September 30,
                                          -----------------------------------------------------------------------
                                                     2003                     2002                  2001
                                          -------------------       -------------------       -------------------
                                          Average    Average        Average    Average        Average    Average
                                          Balance      Rate         Balance      Rate         Balance      Rate
                                          -------    --------       -------    --------       -------    --------
                                                                    (Dollars in thousands)
                                                                                         
Noninterest bearing accounts............  $  13,508      0.00%       $12,976       0.00%        $13,170     0.00%
Interest bearing checking accounts......     33,894      0.36         31,805       0.48          30,040     1.38
Money market accounts...................     22,042      0.91         26,374       1.36          21,185     3.77
Passbook and statement savings accounts.     30,024      0.91         27,656       1.50          26,580     2.25
Certificates of deposit.................    156,116      2.48        158,335       3.61         167,481     5.59
                                          ---------                 --------                  ---------
    Total...............................  $ 255,584      1.75%      $257,146       2.58%      $ 258,456     4.32%
                                          =========                 ========                  =========


     The following table sets forth our time deposits classified by rates at the
dates indicated.



                                                                               At September 30,
                                                                 -------------------------------------------
                                                                 2003               2002               2001
                                                                 -----             ------             ------
                                                                                 (In thousands)
                                                                                              
Rate
-----
 0.00 -  1.99%................................................   $ 110,007         $   16,772         $      --
 2.00 -  3.99%................................................      37,615            118,554            45,066
 4.00 -  5.99%................................................      13,160             23,125            80,465
 6.00 -  7.99%................................................       3,853              5,525            34,024
 8.00 -  9.99%................................................          --                144               133
                                                                 ---------         ----------         ---------
                                                                 $ 164,635         $  164,120         $ 159,688
                                                                 =========         ==========         =========


     The  following  table  sets forth the  amount  and  maturities  of our time
deposits at September 30, 2003.



                                                                    Amount Due
                                  ---------------------------------------------------------------------------------
                                  Less Than                                         After
Rate                              One Year        1-2 Years        2-3 Years       3 Years         Total
----                              --------        ---------        ---------       -------         -----
                                                             (In thousands)
                                                                                      
0.00 -  1.99%...................  $ 105,294       $  4,134       $      579      $       --       $  110,007
2.00 -  3.99%...................     22,314          4,046            5,639           5,616           37,615
4.00 -  5.99%...................      3,884          1,682            2,716           4,878           13,160
6.00 -  7.99%...................      1,713          1,259              881              --            3,853
                                  ---------       --------       ----------      ----------       ----------
                                  $ 133,205       $ 11,121       $    9,815      $   10,494       $  164,635
                                  =========       ========       ==========      ==========       ==========


     The following table indicates the amount of our  certificates of deposit of
$100,000 or more by time  remaining  until maturity as of September 30, 2003. At
that date, such deposits  represented 22.6% of total deposits and had a weighted
average rate of 1.79%.



                                                                         Certificates
                            Maturity Period                               of Deposit
                            ---------------                              ------------
                                                                         (In thousands)
                                                                         
                            Three months or less.......................  $25,516
                            Over three through six months..............   13,901
                            Over six through 12 months.................   10,722
                            Over 12 months.............................    7,531
                                                                         -------
                                  Total................................  $57,670
                                                                         =======



                                       20


     We  estimate  that more than $32.9  million of  certificates  of deposit in
amounts of $100,000 or more maturing  within one year of September 30, 2003 were
held by our  retail  and  commercial  customers,  while  the  remainder  of such
deposits were from schools,  municipalities  and other public  entities and were
obtained through  competitive rate bidding.  We believe  certificates of deposit
held by our retail and  commercial  customers are more likely to be renewed upon
maturity than certificates of deposit obtained through competitive bidding.

     The  following  table sets forth our  savings  activities  for the  periods
indicated.



                                                                         Year  Ended  September 30,
                                                                ---------------------------------------------
                                                                  2003               2002               2001
                                                                  ----              ------             ------
                                                                                (In thousands)
                                                                                                
Net increase (decrease) before interest credited..............  $  (1,636)         $  6,729          $ (15,271)
Interest credited.............................................      3,681             5,568              9,236
                                                                ---------          --------          ---------
    Net increase (decrease) in deposits.......................  $   2,045          $ 12,297          $  (6,035)
                                                                =========          ========          =========


     Borrowings.  Savings deposits  historically have been the primary source of
funds for our lending,  investments  and general  operating  activities.  We are
authorized,  however, to use advances from the FHLB of Atlanta to supplement our
supply of lendable funds and to meet deposit withdrawal  requirements.  The FHLB
of Atlanta  functions  as a central  reserve  bank  providing  credit for member
financial  institutions.  As a member of the FHLB system, we are required to own
stock in the FHLB of Atlanta and are authorized to apply for advances.  Advances
are obtained pursuant to several different  programs,  each of which has its own
interest rate and range of maturities.  We have a blanket agreement for advances
with the FHLB under  which we may  borrow up to 16% of assets  subject to normal
collateral and underwriting requirements.  Advances from the FHLB of Atlanta are
secured by our stock in the FHLB of Atlanta and other  eligible  assets.  During
the year ended September 30, 2003 we used short term FHLB advances to fund LIBOR
based loans as part of our asset liability strategy.

     The following table sets forth certain information regarding our short-term
borrowings at the dates and for the periods indicated:



                                                                         At or for the
                                                                     Year Ended September 30,
                                                              ---------------------------------------
                                                                2003        2002         2001
                                                               ------      ------       ------
                                                                     (Dollars in thousands)
                                                                                  
 Amounts outstanding at end of period:
  FHLB advances.............................................  $  31,500    $  20,000    $  20,000
Weighted average rate paid on:
  FHLB advances.............................................      4.98%         5.18%        5.50%




                                                                            For the Year
                                                                          Ended September 30,
                                                              ------------------------------------
                                                               2003         2002         2001
                                                               -----       ------       ------
                                                                     (Dollars in thousands)
                                                                                  
Maximum amount of borrowings outstanding at any month end:
  FHLB advances.............................................  $  39,500    $  35,000    $  25,000

Average amounts outstanding:
  FHLB advances.............................................  $  23,115    $  21,811    $  20,521
Approximate weighted average rate paid on (1):
  FHLB advances.............................................      4.84%         5.05%        5.42%


------------------
(1) Based on month-end balances.




                                       21


SUBSIDIARY ACTIVITIES

     In prior years,  we had one  subsidiary,  First Capital  Services,  Inc., a
North  Carolina  corporation  ("First  Capital"),   that  engaged  in  sales  of
annuities,  mutual funds and insurance products on an agency basis. In September
1997, that corporation  transferred its assets and liabilities to a newly formed
North Carolina limited liability  company,  First Capital Services Company,  LLC
(the  "LLC"),  and the  corporation  was  dissolved.  1st State Bank is the sole
member of the LLC, and since the transfer of assets and liabilities, the LLC has
conducted  the  activities  previously  conducted  by First  Capital.  We earned
$258,000,  $258,000 and $391,000 on a pre-tax  basis from the  activities of the
LLC during the years ended September 30, 2003, 2002 and 2001, respectively.

COMPETITION

     We face strong competition in originating real estate,  commercial business
and consumer  loans and in attracting  deposits.  We compete for real estate and
other loans  principally on the basis of interest  rates,  the types of loans we
originate,  the deposit products we offer and the quality of services we provide
to our customers. We also compete by offering products which are tailored to the
local  community.  Our  competition  in  originating  real  estate  loans  comes
primarily from savings  institutions,  commercial  banks,  mortgage  bankers and
mortgage brokers.  Commercial banks, credit unions and finance companies provide
vigorous  competition in consumer lending.  Competition may increase as a result
of the continuing  reduction of  restrictions  on the  interstate  operations of
financial institutions.

     We attract our deposits through our branch offices primarily from the local
communities.  Consequently, competition for deposits is principally from savings
institutions,  commercial banks, credit unions and brokers in our primary market
area.  We compete for  deposits  and loans by  offering  what we believe to be a
variety of deposit accounts at competitive rates,  convenient  business hours, a
commitment to outstanding  customer service and a well-trained staff. We believe
we have developed strong  relationships with local realtors and the community in
general.

     We consider our primary market area for gathering  deposits and originating
loans to be Alamance County in north central North Carolina, which is the county
in which our offices are located.  Based on data provided by a private marketing
firm,  we estimate  that at June 30, 2003,  we had 14.4% of deposits held by all
banks and savings institutions in our market area.

EMPLOYEES

     As of September 30, 2003,  we had 77 full-time and 13 part-time  employees,
none of whom were represented by a collective bargaining  agreement.  We believe
that our relationship with our employees is good.

DEPOSITORY INSTITUTION REGULATION

     General. We are a North Carolina-chartered  commercial bank and a member of
the FHLB of  Atlanta,  and our  deposits  are  insured by the FDIC  through  the
Savings  Association  Insurance Fund administered by the FDIC. 1st State Bank is
subject to supervision, examination and regulation by the North Carolina Banking
Commission  and the  FDIC  and to  North  Carolina  and  federal  statutory  and
regulatory  provisions  governing  such matters as capital  standards,  mergers,
subsidiary  investments and establishment of branch offices. We are also subject
to the FDIC's  authority  to  conduct  special  examinations.  1st State Bank is
required to file reports with the North Carolina Banking Commission and the FDIC
concerning  its  activities  and  financial  condition and is required to obtain
regulatory  approvals  prior to entering  into certain  transactions,  including
mergers with, or acquisitions of, other depository institutions.

     As a federally insured depository institution, 1st State Bank is subject to
various  regulations   promulgated  by  the  Federal  Reserve  Board,  including
Regulation B (Equal Credit  Opportunity),  Regulation D (Reserve  Requirements),
Regulation  E  (Electronic  Fund  Transfers),  Regulation  Z (Truth in Lending),
Regulation CC (Availability of Funds and Collection of Checks) and Regulation DD
(Truth in Savings).


                                       22


     The system of regulation  and  supervision  applicable to us  establishes a
comprehensive  framework for our  operations  and is intended  primarily for the
protection of the FDIC and our depositors.  Changes in the regulatory  framework
could have a material effect on us and our operations.

     Financial Modernization Legislation.  On November 12, 1999, legislation was
enacted  which  could  have a  far-reaching  impact  on the  financial  services
industry. The Gramm-Leach-Bliley  ("G-L-B") Act authorizes  affiliations between
banking,  securities and insurance firms and authorizes  bank holding  companies
and national banks to engage in a variety of new financial activities. Among the
new activities  that will be permitted to bank holding  companies are securities
and insurance brokerage,  securities  underwriting,  insurance  underwriting and
merchant banking.  The Federal Reserve Board, in consultation with the Secretary
of the Treasury,  may approve additional  financial  activities.  The G-L-B Act,
however,  prohibits  future  acquisitions  of existing  unitary savings and loan
holding companies by firms which are engaged in commercial activities and limits
the  permissible  activities of unitary  holding  companies  formed after May 4,
1999.

     The G-L-B Act imposes  new  requirements  on  financial  institutions  with
respect to customer  privacy.  The G-L-B Act generally  prohibits  disclosure of
customer  information  to  non-affiliated  third parties unless the customer has
been given the  opportunity  to object and has not objected to such  disclosure.
Financial  institutions  are further required to disclose their privacy policies
to customers  annually.  Financial  institutions,  however,  will be required to
comply  with state law if it is more  protective  of customer  privacy  than the
G-L-B Act. The privacy provisions became effective in July 2001.

     The G-L-B Act contains significant  revisions to the Federal Home Loan Bank
("FHLB") System. The G-L-B Act imposes new capital requirements on the FHLBs and
authorizes them to issue two classes of stock with differing  dividend rates and
redemption requirements.  The G-L-B Act deletes the current requirement that the
FHLBs  annually  contribute  $300 million to pay interest on certain  government
obligations in favor of a 20% of net earnings formula. The G-L-B Act expands the
permissible  uses of FHLB advances by community  financial  institutions  (under
$500  million in assets) to include  funding  loans to small  businesses,  small
farms and small agri-businesses.

     The  G-L-B  Act  contains  a  variety  of  other  provisions   including  a
prohibition  against ATM surcharges  unless the customer has first been provided
notice of the  imposition  and  amount of the fee.  The  G-L-B Act  reduces  the
frequency of Community  Reinvestment Act  examinations for smaller  institutions
and imposes certain reporting requirements on depository  institutions that make
payments  to   non-governmental   entities  in  connection  with  the  Community
Reinvestment  Act.  The  G-L-B  Act  also  eliminated  the  Savings  Association
Insurance Fund special reserve.

     Capital  Requirements.   The  Federal  Reserve  Board  and  the  FDIC  have
established  guidelines with respect to the maintenance of appropriate levels of
capital by bank holding  companies with  consolidated  assets of $150 million or
more and state non-member banks,  respectively.  The regulations impose two sets
of capital adequacy  requirements:  minimum  leverage rules,  which require bank
holding  companies and state  non-member  banks to maintain a specified  minimum
ratio of capital to total assets,  and risk-based  capital rules,  which require
the  maintenance  of  specified  minimum  ratios of capital  to  "risk-weighted"
assets.  The  regulations of the FDIC and the Federal Reserve Board require bank
holding  companies  and state  non-member  banks,  respectively,  to  maintain a
minimum  leverage  ratio of "Tier 1  capital"  to total  assets of 3%.  Although
setting a minimum 3% leverage ratio, the capital regulations state that only the
strongest bank holding companies and banks, with composite  examination  ratings
of 1 under the rating  system  used by the  federal  bank  regulators,  would be
permitted  to operate at or near such minimum  level of capital.  All other bank
holding  companies  and banks are  expected to  maintain a leverage  ratio of at
least Tier 1 capital to total  assets of not less than 4%. Tier 1 capital is the
sum of common  stockholders'  equity,  certain perpetual  preferred stock, which
must be noncumulative with respect to banks,  including any related surplus, and
minority  interests in consolidated  subsidiaries;  minus all intangible  assets
other than certain purchased mortgage servicing rights and purchased credit card
receivables, identified losses and investments in certain subsidiaries.

     As  a   Savings   Association   Insurance   Fund   of   the   FDIC-insured,
state-chartered bank, we must also deduct from Tier 1 capital an amount equal to
our  investments  in,  and  extensions  of credit  to,  subsidiaries  engaged


                                       23


in activities that are not  permissible for national banks,  other than debt and
equity investments in subsidiaries engaged in activities undertaken as agent for
customers  or  in  mortgage  banking  activities  or  in  subsidiary  depository
institutions  or their  holding  companies.  Any bank or bank holding  companies
experiencing  or anticipating  significant  growth would be expected to maintain
capital well above the minimum  levels.  In addition,  the Federal Reserve Board
has indicated that whenever  appropriate,  and in particular when a bank holding
company  is  undertaking  expansion,  seeking  to  engage in new  activities  or
otherwise facing unusual or abnormal risks, it will consider,  on a case-by-case
basis, the level of an organization's  ratio of tangible Tier 1 capital to total
assets in making an overall assessment of capital.

     In addition to the leverage  ratio,  the regulations of the Federal Reserve
Board and the FDIC require bank holding companies and state-chartered  nonmember
banks to maintain a minimum ratio of qualifying  total capital to  risk-weighted
assets  of at least 8% of which at least 4% must be Tier 1  capital.  Qualifying
total capital consists of Tier 1 capital plus Tier 2 or "supplementary"  capital
items which  include  allowances  for loan losses in an amount of up to 1.25% of
risk-weighted  assets,  cumulative  preferred  stock and preferred  stock with a
maturity of 20 years or more, certain other capital instruments and up to 45% of
unrealized gains on equity  securities.  The includable amount of Tier 2 capital
cannot  exceed the  institution's  Tier 1 capital.  Qualifying  total capital is
further  reduced by the amount of the bank's  investments in banking and finance
subsidiaries  that  are  not  consolidated  for  regulatory   capital  purposes,
reciprocal  cross-holdings  of  capital  securities  issued  by other  banks and
certain other  deductions.  The risk-based  capital  regulations  assign balance
sheet  assets and the credit  equivalent  amounts of certain  off-balance  sheet
items to one of four broad risk weight  categories.  The aggregate dollar amount
of each  category is  multiplied  by the risk weight  assigned to that  category
based principally on the degree of credit risk associated with the obligor.  The
sum of these  weighted  values  equals  the bank  holding  company or the bank's
risk-weighted assets.

     The federal bank  regulators,  including the Federal  Reserve Board and the
FDIC,  have revised their  risk-based  capital  requirements to ensure that such
requirements provide for explicit consideration of interest rate risk. Under the
rule, a bank's interest rate risk exposure would be quantified  using either the
measurement  system  set  forth in the rule or the  bank's  internal  model  for
measuring  such  exposure,  if such model is  determined  to be  adequate by the
bank's  examiner.  If the dollar amount of a bank's interest rate risk exposure,
as measured  under  either  measurement  system,  exceeds 1% of the bank's total
assets,  the bank would be required  under the rule to hold  additional  capital
equal to the dollar amount of the excess. We believe that the interest rate risk
component does not have a material effect on our capital.  Further, the FDIC has
adopted a regulation that provides that the FDIC may take into account whether a
bank has  significant  risks from  concentrations  of credit or  non-traditional
activities in determining the adequacy of its capital.  We have not been advised
that  we will  be  required  to  maintain  any  additional  capital  under  this
regulation.  The  interest  rate risk  component  does not apply to bank holding
companies on a consolidated basis.

     In addition to FDIC  regulatory  capital  requirements,  the North Carolina
Commissioner  of Banks  requires  us to have  adequate  capitalization  which is
determined  based  upon each  bank's  particular  set of  circumstances.  We are
subject to the North Carolina Bank  Commissioner's  capital  surplus  regulation
which requires commercial banks to maintain a capital surplus of at least 50% of
common  capital.  Common  capital  is  defined  as the total of the par value of
shares times the number of shares outstanding.

     At September 30, 2003, we complied with each of the capital requirements of
the FDIC and the North Carolina Banking Commission.

     Prompt Corrective  Regulatory  Action.  Under the Federal Deposit Insurance
Corporation  Improvement  Act  ("FDICIA"),  the federal  banking  regulators are
required to take prompt corrective action if an insured  depository  institution
fails to satisfy  certain  minimum  capital  requirements,  including a leverage
limit,  a  risk-based  capital   requirement,   and  any  other  measure  deemed
appropriate by the federal banking regulators for measuring the capital adequacy
of an insured  depository  institution.  All  institutions,  regardless of their
capital levels,  are restricted  from making any capital  distribution or paying
any management  fees if the  institution  would  thereafter  fail to satisfy the
minimum levels for any of its capital requirements. An institution that fails to
meet the minimum level for any relevant  capital  measure (an  "undercapitalized
institution")  may be: (i) subject to increased  monitoring  by the  appropriate
federal  banking  regulator;  (ii)  required  to  submit an  acceptable  capital
restoration plan within 45 days; (iii) subject to asset growth limits;  and (iv)
required to obtain prior regulatory approval for acquisitions, branching and new
lines of businesses.  The capital  restoration  plan must include a guarantee by
the institution's holding company that the institution will comply with the plan
until  it has been  adequately  capitalized  on  average  for  four


                                       24


consecutive quarters,  under which the holding company would be liable up to the
lesser of 5% of the institution's  total assets or the amount necessary to bring
the institution into capital  compliance as of the date it failed to comply with
its capital restoration plan. A "significantly undercapitalized" institution, as
well as any  undercapitalized  institution  that does not  submit an  acceptable
capital   restoration   plan,   may  be  subject  to   regulatory   demands  for
recapitalization,  broader  application of  restrictions  on  transactions  with
affiliates,  limitations  on interest  rates paid on deposits,  asset growth and
other  activities,   possible   replacement  of  directors  and  officers,   and
restrictions on capital  distributions  by any bank holding company  controlling
the institution. Any company controlling the institution may also be required to
divest  the  institution  or  the  institution   could  be  required  to  divest
subsidiaries.  The senior executive officers of a significantly undercapitalized
institution may not receive  bonuses or increases in compensation  without prior
approval and the  institution is prohibited from making payments of principal or
interest on its  subordinated  debt. In their  discretion,  the federal  banking
regulators  may also  impose  the  foregoing  sanctions  on an  undercapitalized
institution if the regulators determine that such actions are necessary to carry
out the purposes of the prompt corrective provisions.  If an institution's ratio
of tangible  capital to total assets falls below the  "critical  capital  level"
established by the appropriate  federal banking regulator,  the institution will
be subject to conservatorship or receivership within specified time periods.

     Under  the  implementing  regulations,   the  federal  banking  regulators,
including the FDIC,  generally measure an institution's  capital adequacy on the
basis of its total  risk-based  capital ratio (the ratio of its total capital to
risk-weighted  assets),  Tier 1 risk-based  capital ratio (the ratio of its core
capital  to  risk-weighted  assets)  and  leverage  ratio (the ratio of its core
capital to adjusted total assets).  The following table shows the capital ratios
required for the various prompt corrective action categories.



                                                     Adequately                                     Significantly
                           Well Capitalized          Capitalized         Undercapitalized        Undercapitalized
                           ----------------          -----------         ----------------        ----------------
                                                                                              
Total risk-based
    capital ratio          10.0% or more             8.0% or more        Less than 8.0%          Less than 6.0%
Tier 1 risk-based
    capital ratio           6.0% or more             4.0% or more        Less than 4.0%          Less than 3.0%
Leverage ratio              5.0% or more             4.0% or more *      Less than 4.0% *        Less than 3.0%


-----------
*  3.0% if institution has a composite 1 CAMELS rating.

A "critically undercapitalized" savings institution is defined as an institution
that  has a ratio of  "tangible  equity"  to total  assets  of less  than  2.0%.
Tangible equity is defined as core capital plus cumulative  perpetual  preferred
stock  (and  related  surplus)  less  all  intangibles   other  than  qualifying
supervisory  goodwill and certain purchased  mortgage servicing rights. The FDIC
may reclassify a well capitalized savings institution as adequately  capitalized
and may require an adequately  capitalized  or  undercapitalized  institution to
comply with the supervisory actions applicable to institutions in the next lower
capital  category  (but  may not  reclassify  a  significantly  undercapitalized
institution as critically undercapitalized) if the FDIC determines, after notice
and an  opportunity  for a  hearing,  that the  institution  is in an  unsafe or
unsound  condition or that the  institution  has  received  and not  corrected a
less-than-satisfactory rating for any CAMELS rating category.

     The Bank meets the definition of "well-capitalized" under the FDIC's prompt
corrective action regulations.

     Safety and Soundness  Guidelines.  Under  FDICIA,  as amended by the Riegle
Community  Development and Regulatory  Improvement Act of 1994 (the "CDRI Act"),
each  federal  banking  agency was required to  establish  safety and  soundness
standards for  institutions  under its  authority.  The  interagency  guidelines
require  depository  institutions to maintain  internal controls and information
systems and internal audit systems that are appropriate for the size, nature and
scope of the institution's business. The guidelines also establish certain basic
standards  for loan  documentation,  credit  underwriting,  interest  rate  risk
exposure,  and asset growth.  The  guidelines  further  provide that  depository
institutions  should maintain safeguards to prevent the payment of compensation,
fees and benefits  that are  excessive or that could lead to material  financial
loss,  and should take into  account  factors  such as  comparable  compensation
practices at comparable institutions.  If the appropriate federal banking agency
determines  that a depository  institution is not in compliance  with the safety
and soundness guidelines, it may require the institution to submit an acceptable
plan to achieve  compliance with the guidelines.  A depository  institution must
submit an acceptable  compliance plan to its primary federal regulator within 30
days of receipt of a request for such


                                       25


a plan.  Failure  to submit or  implement  a  compliance  plan may  subject  the
institution  to regulatory  sanctions.  Management  believes that 1st State Bank
meets all the standards adopted in the interagency guidelines.

     Community   Reinvestment   Act.  1st  State  Bank,   like  other  financial
institutions,  is subject to the Community Reinvestment Act ("CRA"). The purpose
of the CRA is to encourage financial  institutions to help meet the credit needs
of their entire  communities,  including  the needs of low- and  moderate-income
neighborhoods.

     The federal  banking  regulatory  agencies have  implemented  an evaluation
system that rates  institutions  based on their  actual  performance  in meeting
community credit needs.  Under the  regulations,  a bank will first be evaluated
and rated under three  categories:  a lending  test,  an  investment  test and a
service test. For each of these three tests,  the bank will be given a rating of
either   "outstanding,"  "high  satisfactory,"  "low  satisfactory,"  "needs  to
improve," or "substantial non-compliance." A set of criteria for each rating has
been developed and is included in the  regulation.  If an institution  disagrees
with a  particular  rating,  the  institution  has the burden of  rebutting  the
presumption  by  clearly  establishing  that the  quantitative  measures  do not
accurately present its actual  performance,  or that  demographics,  competitive
conditions or economic or legal limitations  peculiar to its service area should
be  considered.  The  ratings  received  under the three  tests  will be used to
determine the overall  composite CRA rating.  The  composite  ratings  currently
given are:  "outstanding,"  "satisfactory,"  "needs to improve" or  "substantial
non-compliance."

     During our last compliance examination, we received a "satisfactory" rating
for CRA compliance.

     Our CRA rating would be a factor  considered  by the Federal  Reserve Board
and the FDIC in considering  applications  to acquire  branches or to acquire or
combine with other  financial  institutions  and take other actions and, if such
rating  was  less  than  "satisfactory,"  could  result  in the  denial  of such
applications.

     Federal  Home Loan Bank  System.  The FHLB  System  consists of 12 district
FHLBs subject to supervision and regulation by the Federal Housing Finance Board
("FHFB").  The FHLBs  provide a central  credit  facility  primarily  for member
institutions. As a member of the FHLB of Atlanta, we are required to acquire and
hold shares of capital  stock in the FHLB of Atlanta in an amount at least equal
to 1% of the aggregate  unpaid  principal of home mortgage loans,  home purchase
contracts,  and similar  obligations  at the  beginning of each year, or 1/20 of
advances from the FHLB of Atlanta,  whichever is greater.  We were in compliance
with this  requirement with investment in FHLB of Atlanta stock at September 30,
2003 of $1.7  million.  The FHLB of Atlanta  serves as a reserve or central bank
for its member institutions within its assigned district. It is funded primarily
from  proceeds  derived from the sale of  consolidated  obligations  of the FHLB
System. It offers advances to members in accordance with policies and procedures
established  by the FHFB  and the  board of  directors  of the FHLB of  Atlanta.
Long-term  advances  may only be made for the  purpose  of  providing  funds for
residential   housing  finance,   small   businesses,   small  farms  and  small
agri-businesses.  At  September  30,  2003,  we had $31.5  million  in  advances
outstanding from the FHLB of Atlanta.

     Reserves. Under Federal Reserve Board regulations, we must maintain average
daily reserves equal to 3% on transaction accounts up to $41.3 million, plus 10%
on the  remainder.  This  percentage  is subject to  adjustment  by the  Federal
Reserve Board. Because required reserves must be maintained in the form of vault
cash or in a non-interest  bearing account at a Federal Reserve Bank, the effect
of the  reserve  requirement  is to  reduce  the  amount  of  the  institution's
interest-earning   assets.  As  of  September  30,  2003,  we  met  our  reserve
requirements.

     We  are  also  subject  to  the  reserve  requirements  of  North  Carolina
commercial  banks.  North  Carolina  law  requires  state  non-member  banks  to
maintain,  at all times,  a reserve fund in an amount set by  regulation  of the
North Carolina Banking Commission.  As of September 30, 2003, we met our reserve
requirements.

     Deposit Insurance. We are required to pay assessments based on a percentage
of insured  deposits to the FDIC for  insurance  of our  deposits by the Savings
Association  Insurance  Fund of the FDIC.  Under the FDIC's  risk-based  deposit
insurance  assessment  system,  the  assessment  rate for an insured  depository
institution  depends  on the  assessment  risk  classification  assigned  to the
institution by the FDIC, which is determined by the institution's  capital level
and  supervisory  evaluations.  Based on the data reported to regulators for the
date  closest to the last day of the seventh  month  preceding  the  semi-annual
assessment period,  institutions are assigned to one of three capital groups ---
well capitalized,  adequately  capitalized or undercapitalized -- using the same
percentage  criteria as in the prompt


                                       26


corrective action regulations.  See "-- Prompt Corrective Regulatory Action" for
definitions  and percentage  criteria for the capital group  categories.  Within
each capital group,  institutions  are assigned to one of three subgroups on the
basis  of  supervisory  evaluations  by the  institution's  primary  supervisory
authority and such other  information  as the FDIC  determines to be relevant to
the  institution's  financial  condition  and  the  risk  posed  to the  deposit
insurance fund.  Subgroup A consists of financially sound institutions with only
a few minor  weaknesses.  Subgroup B consists of institutions  that  demonstrate
weaknesses which, if not corrected, could result in significant deterioration of
the  institution  and  increased  risk of loss to the  deposit  insurance  fund.
Subgroup C consists of institutions that pose a substantial  probability of loss
to the deposit insurance fund unless effective corrective action is taken.

     The assessment rate for SAIF members ranges from zero for well  capitalized
institutions   in  Subgroup  A  to  0.27%  of  deposits   for   undercapitalized
institutions  in Subgroup C. In addition,  both Bank  Insurance Fund of the FDIC
and Savings  Association  Insurance  Fund of the FDIC  members  are  assessed an
amount  for  interest   payments  on  certain  bonds  issued  by  the  Financing
Corporation,  an  agency of the  federal  government  to  finance  takeovers  of
insolvent thrifts.

     Liquidity Requirements. FDIC policy requires that banks maintain an average
daily balance of liquid  assets in an amount which it deems  adequate to protect
safety and  soundness of the bank.  Liquid  assets  include  cash,  certain time
deposits, bankers' acceptances and specified United States government, state, or
federal  agency  obligations.  The FDIC currently has no specific level which it
requires.

     North Carolina banks must maintain a reserve fund in an amount and/or ratio
set by the  North  Carolina  Banking  Commission  to  account  for the  level of
liquidity  necessary  to assure the safety and  soundness  of the State  banking
system.  At September 30, 2003, our liquidity  ratio exceeded the North Carolina
regulations.

     Dividend  Restrictions.  Under FDIC  regulations,  we are  prohibited  from
making any capital  distributions  if after  making the  distribution,  we would
have:

     o    a total risk-based capital ratio of less than 8%;

     o    a Tier 1 risk-based capital ratio of less than 4%; or

     o    a leverage ratio of less than 4%.

     Our  earnings  appropriated  to bad debt  reserves and deducted for Federal
income tax purposes  are not  available  for payment of cash  dividends or other
distributions  to stockholders  without payment of taxes at the then current tax
rate on the amount of  earnings  removed  from the  pre-1988  reserves  for such
distributions. We intend to make full use of this favorable tax treatment and do
not  contemplate  use of any earnings in a manner which would create federal tax
liabilities.

     We may not pay  dividends on our capital  stock if our  regulatory  capital
would  thereby be reduced  below the amount then  required  for the  liquidation
account  established  for the benefit of certain  depositors  at the time of the
conversion.

     1st State  Bancorp is subject to  limitations  on dividends  imposed by the
Federal Reserve Board.

     Transactions with Related Parties.  Transactions between a state non-member
bank and any  affiliate  are  governed  by  Sections  23A and 23B of the Federal
Reserve Act. An affiliate  of a state  non-member  bank is any company or entity
which  controls,  is  controlled  by or is under  common  control with the state
non-member bank. In a holding company  context,  the parent holding company of a
state  non-member  bank, such as 1st State Bancorp,  and any companies which are
controlled  by  the  parent  holding  company  are  affiliates  of  the  savings
institution or state non-member bank. Generally,  Sections 23A and 23B (i) limit
the extent to which an  institution or its  subsidiaries  may engage in "covered
transactions"  with  any  one  affiliate  to an  amount  equal  to 10%  of  such
institution's  capital stock and surplus,  and contain an aggregate limit on all
such  transactions with all affiliates to an amount equal to 20% of such capital
stock and  surplus,  and (ii)  require  that all such  transactions  be on terms
substantially  the  same,  or at  least  as  favorable,  to the  institution  or
subsidiary as those provided to a non-affiliate.  The term "covered


                                       27


transaction"  includes  the making of loans,  purchase of assets,  issuance of a
guarantee  and  similar  other  types  of  transactions.   In  addition  to  the
restrictions  imposed by Sections 23A and 23B, no state  non-member bank may (i)
loan or otherwise extend credit to an affiliate,  except for any affiliate which
engages only in activities which are permissible for bank holding companies,  or
(ii)  purchase  or invest in any  stocks,  bonds,  debentures,  notes or similar
obligations of any affiliate,  except for affiliates  which are  subsidiaries of
the state non-member bank.

     Loans to Directors,  Executive Officers and Principal  Stockholders.  State
non-member banks also are subject to the restrictions contained in Section 22(h)
of the  Federal  Reserve  Act and  the  Federal  Reserve  Board's  Regulation  O
thereunder on loans to executive officers, directors and principal stockholders.
Under Section  22(h),  loans to a director,  executive  officer and to a greater
than 10% stockholder of a state non-member bank and certain affiliated interests
of such persons,  may not exceed,  together with all other  outstanding loans to
such person and affiliated  interests,  the institution's  loans-to-one-borrower
limit and all loans to such persons may not exceed the institution's  unimpaired
capital and  unimpaired  surplus.  Section  22(h) also  prohibits  loans,  above
amounts  prescribed by the appropriate  federal  banking  agency,  to directors,
executive   officers  and  greater  than  10%   stockholders   of  a  depository
institution,  and their respective  affiliates,  unless such loan is approved in
advance by a majority  of the board of  directors  of the  institution  with any
"interested"  director not participating in the voting.  Regulation O prescribes
the loan amount,  which includes all other  outstanding loans to such person, as
to which such prior board of director  approval is required as being the greater
of $25,000 or 5% of capital and surplus up to $500,000.  Further,  Section 22(h)
requires that loans to directors,  executive officers and principal stockholders
be made on terms substantially the same as offered in comparable transactions to
other persons.  Section 22(h) also generally prohibits a depository  institution
from paying the overdrafts of any of its executive officers or directors.

     State   non-member   banks  also  are  subject  to  the   requirements  and
restrictions  of Section 22(g) of the Federal  Reserve Act on loans to executive
officers.  Section 22(g) of the Federal  Reserve Act requires loans to executive
officers of depository  institutions  not be made on terms more  favorable  than
those afforded to other borrowers,  requires  approval by the board of directors
of a depository  institution for such extensions of credit to executive officers
of the  institution,  and  imposes  reporting  requirements  for and  additional
restrictions  on the type,  amount  and terms of credits  to such  officers.  In
addition,  Section 106 of the BHCA  prohibits  extensions of credit to executive
officers,   directors,  and  greater  than  10%  stockholders  of  a  depository
institution  by  any  other  institution  which  has  a  correspondent   banking
relationship  with the  institution,  unless  such  extension  of  credit  is on
substantially  the same  terms as those  prevailing  at the time for  comparable
transactions  with other  persons and does not involve more than the normal risk
of repayment or present other unfavorable features.

     Additionally,  North Carolina  statutes set forth  restrictions on loans to
executive  officers of  state-chartered  banks,  which  provide that no bank may
extend  credit to any of its  executive  officers nor a firm or  partnership  of
which such executive officers is a member, nor a company in which such executive
officer owns a controlling  interest,  unless the extension of credit is made on
substantially the same terms, including interest rates and collateral,  as those
prevailing at the time for comparable  transactions by the bank with persons who
are not employed by the bank, and provided  further that the extension of credit
does not involve more than the normal risk of repayment.

     Restrictions  on Certain  Activities.  State-chartered  banks with deposits
insured by the FDIC are generally  prohibited  from  engaging in activities  and
investments  that  are  not  permissible  for a  national  bank.  The  foregoing
limitation,  however,  does not prohibit FDIC-insured state banks from acquiring
or  retaining  an  equity  investment  in a  subsidiary  in which  the bank is a
majority  owner.  State  chartered  banks are also prohibited from engaging as a
principal in any type of activity that is not  permissible  for a national bank.
Further subsidiaries of state chartered, FDIC-insured state banks may not engage
as a principal in any type of activity that is not  permissible for a subsidiary
of a national bank, unless in either case, the FDIC determines that the activity
would pose no significant risk to the appropriate deposit insurance fund and the
bank is, and continues to be, in compliance with applicable capital standards.

     The FDIC has adopted  regulations to clarify the foregoing  restrictions on
activities of FDIC-insured  state-chartered banks and their subsidiaries.  Under
the  regulations,  the term  "activity"  refers to the conduct of business by an
insured state bank and includes acquiring or retaining any investment other than
an equity  investment as defined by regulation.  An activity  permissible  for a
national bank includes any activity  expressly  authorized for national banks by
statute  or  recognized  as  permissible  in  regulations,  official  circulars,
bulletins,  orders  or  written  interpretations  issued  by the  Office  of the
Comptroller of the Currency. In its regulations, the FDIC indicates that it


                                       28


will not  permit  state  banks to  directly  engage in  commercial  ventures  or
directly or indirectly engage in any insurance  underwriting activity other than
to the extent such  activities are permissible for a national bank or a national
bank  subsidiary  or  except  for  certain  other  limited  forms  of  insurance
underwriting  permitted under the  regulations.  FDIC  regulations  permit state
banks that meet applicable  minimum capital  requirements to engage as principal
in certain  activities  that are not  permissible  to national  banks  including
guaranteeing  obligations of others,  activities which the Federal Reserve Board
has found by  regulation  or order to be closely  related to banking and certain
securities activities conducted through subsidiaries.

     Patriot  Act.  The  Patriot  Act  is  intended  to   strengthen   U.S.  law
enforcement's and the intelligence  communities' abilities to work cohesively to
combat terrorism on a variety of fronts. The potential impact of the Patriot Act
on financial  institutions  of all kinds is  significant  and wide ranging.  The
Patriot Act contains sweeping anti-money  laundering and financial  transparency
laws and imposes various  regulations  including  standards for verifying client
identification  at  account  opening,  and rules to  promote  cooperation  among
financial  institutions,  regulators and law enforcement entities in identifying
parties that may be involved in terrorism or money laundering.

REGULATION OF 1st STATE BANCORP, INC.

     General. 1st State Bancorp, as the sole shareholder of 1st State Bank, is a
bank holding  company and is registered as such with the Federal  Reserve Board.
Bank holding  companies are subject to  comprehensive  regulation by the Federal
Reserve  Board  under the Bank  Holding  Company  Act of 1956,  as amended  (the
"BHCA"),  and the  regulations of the Federal  Reserve Board.  As a bank holding
company,  1st State  Bancorp is required to file with the Federal  Reserve Board
annual reports and such additional  information as the Federal Reserve Board may
require,  and is subject to regular  examinations  by the Federal Reserve Board.
The Federal  Reserve Board also has extensive  enforcement  authority  over bank
holding  companies,  including,  among other things, the ability to assess civil
money penalties, to issue cease and desist or removal orders and to require that
a holding company divest of subsidiaries,  including its bank  subsidiaries.  In
general,  enforcement  actions  may be  initiated  for  violations  of  law  and
regulations and unsafe or unsound practices.  1st State Bancorp is also required
to file certain  reports with, and comply with the rules and  regulations of the
Securities and Exchange Commission under the federal securities laws.

     Under the BHCA, a bank holding  company must obtain  Federal  Reserve Board
approval before:

     o    acquiring, directly or indirectly,  ownership or control of any voting
          shares  of  another  bank or  bank  holding  company  if,  after  such
          acquisition,  it would own or  control  more  than 5% of such  shares,
          unless it already owns or controls the majority of such shares;

     o    acquiring  all or  substantially  all of the assets of another bank or
          bank holding company; or

     o    merging or consolidating with another bank holding company.

Satisfactory financial condition, particularly with respect to capital adequacy,
and a satisfactory CRA rating generally are  prerequisites to obtaining  federal
regulatory approval to make acquisitions.

     The BHCA also prohibits a bank holding  company,  with certain  exceptions,
from  acquiring  direct or indirect  ownership or control of more than 5% of the
voting  shares of any company  which is not a bank or bank holding  company,  or
from engaging  directly or indirectly in activities other than those of banking,
managing or controlling banks, or providing  services for its subsidiaries.  The
principal  exceptions to these prohibitions  involve certain non bank activities
which,  by statute or by Federal  Reserve Board  regulation or order,  have been
identified as activities  closely related to the business of banking or managing
or controlling  banks.  The list of activities  permitted by the Federal Reserve
Board includes, among other things:

     o    operating a savings  institution,  mortgage company,  finance company,
          credit card company or factoring company;

     o    performing certain data processing operations;


                                       29


     o    providing certain investment and financial advice;

     o    underwriting  and acting as an  insurance  agent for certain  types of
          credit-related insurance;

     o    leasing property on a full-payout, non-operating basis;

     o    selling money  orders,  travelers'  checks and United  States  Savings
          Bonds;

     o    real estate and personal property appraising;

     o    providing tax planning and preparation services; and,

     o    subject  to  certain   limitations,   providing  securities  brokerage
          services for customers.

Other than the sales of money orders and travelers' checks to our customers,  we
have no plans to engage in any of these activities.

     Acquisition  of Bank  Holding  Companies  and  Banks.  Under the BHCA,  any
company  must obtain  approval of the Federal  Reserve  Board prior to acquiring
control  of 1st State  Bancorp  or 1st State  Bank.  For  purposes  of the BHCA,
"control"  is  defined  as  ownership  of more  than 25% of any  class of voting
securities  of 1st State  Bancorp or 1st State Bank,  the ability to control the
election  of a majority  of the  directors,  or the  exercise  of a  controlling
influence over management or policies of 1st State Bancorp or 1st State Bank. In
addition,  the Change in Bank  Control  Act and the related  regulations  of the
Federal  Reserve Board require any person or persons acting in concert to file a
written notice with the Federal  Reserve Board before such person or persons may
acquire  control  of 1st State  Bancorp  or 1st State  Bank.  The Change in Bank
Control Act defines "control" as the power, directly or indirectly,  to vote 25%
or more of any voting  securities  or to direct the  management or policies of a
bank holding company or an insured bank.

     The Federal  Reserve  Board has adopted  guidelines  regarding  the capital
adequacy of bank holding  companies,  which  require  bank holding  companies to
maintain  specified  minimum  ratios of capital to total  assets and  capital to
risk-weighted assets.

     Interstate  Banking.  The  Riegle-Neal  Interstate  Banking  and  Branching
Efficiency Act of 1994 (the "Riegle-Neal  Act") was enacted to ease restrictions
on interstate banking.  Effective September 29, 1995, the Act allows the Federal
Reserve  Board to  approve  an  application  of an  adequately  capitalized  and
adequately managed bank holding company to acquire control of, or acquire all or
substantially  all of the  assets of, a bank  located in a state  other than the
holding  company's  home state,  without  regard to whether the  transaction  is
prohibited by the laws of any state.  The Federal  Reserve Board may not approve
the  acquisition  of a bank that has not been in existence for a minimum of five
years,  regardless of a longer minimum  period  specified by the law of the host
state.  The  Riegle-Neal  Act also  prohibits  the  Federal  Reserve  Board from
approving  an  application  if the  applicant  and  its  depository  institution
affiliates control or would control more than 10% of the insured deposits in the
United States or 30%, or more of the deposits in the target bank's home state or
in any state in which the target bank maintains a branch.  The  Riegle-Neal  Act
does not affect a state's  authority to limit the  percentage  of total  insured
deposits in the state which may be held or  controlled by a bank or bank holding
company to the extent such limitation does not discriminate against out-of-state
banks or bank  holding  companies.  Individual  states  may also  waive  the 30%
statewide concentration limit contained in the Riegle-Neal Act.

     Additionally,  the  federal  banking  agencies  are  authorized  to approve
interstate  merger  transactions  without regard to whether such  transaction is
prohibited  by the law of any  state,  unless the home state of one of the banks
has opted out of the Riegle-Neal Act by adopting a law, which applies equally to
all out-of-state  banks and expressly  prohibits merger  transactions  involving
out-of-state banks.  Interstate  acquisitions of branches will be permitted only
if  the  law  of  the  state  in  which  the  branch  is  located  permits  such
acquisitions.  Interstate  mergers  and branch  acquisitions  are subject to the
nationwide and statewide insured deposit  concentration amounts described above.
North   Carolina  has  enacted   legislation   permitting   interstate   banking
transactions.


                                       30


     The Riegle-Neal Act authorizes the FDIC to approve interstate  branching de
novo by state banks only in states which  specifically allow for such branching.
Pursuant to the Riegle-Neal  Act, the appropriate  federal banking agencies have
adopted  regulations  which  prohibit  any  out-of-state  bank  from  using  the
interstate  branching authority primarily for the purpose of deposit production.
These regulations include guidelines to ensure that interstate branches operated
by an  out-of-state  bank in a host  state are  reasonably  helping  to meet the
credit needs of the communities which they serve.

     Dividends.  The Federal Reserve Board has issued a policy  statement on the
payment of cash dividends by bank holding companies, which expresses the Federal
Reserve  Board's view that a bank holding company should pay cash dividends only
to the extent that the  company's  net income for the past year is sufficient to
cover both the cash dividends and a rate of earning retention that is consistent
with the company's capital needs, asset quality and overall financial condition.
The Federal  Reserve Board also indicated that it would be  inappropriate  for a
company   experiencing  serious  financial  problems  to  borrow  funds  to  pay
dividends.  Furthermore,  under the prompt corrective action regulations adopted
by the Federal  Reserve  Board,  the Federal  Reserve  Board may prohibit a bank
holding  company  from  paying  any  dividends  if the  holding  company's  bank
subsidiary   is   classified   as   "undercapitalized".   For  a  definition  of
"undercapitalized"  institution,  see "-- Depository  Institution  Regulation --
Prompt Corrective Regulatory Action."

     Bank holding companies are required to give the Federal Reserve Board prior
written  notice  of  any  purchase  or  redemption  of  its  outstanding  equity
securities  if the gross  consideration  for the  purchase or  redemption,  when
combined with the net  consideration  paid for all such purchases or redemptions
during  the  preceding  12  months,  is  equal  to 10%  or  more  of  the  their
consolidated net worth. The Federal Reserve Board may disapprove such a purchase
or redemption if it determines  that the proposal would  constitute an unsafe or
unsound  practice or would violate any law,  regulation,  Federal  Reserve Board
order,  directive,  or any condition  imposed by, or written agreement with, the
Federal  Reserve Board.  Bank holding  companies whose capital ratios exceed the
thresholds for well  capitalized  banks on a consolidated  basis are exempt from
the  foregoing  requirement  if they were rated  composite  1 or 2 in their most
recent inspection and are not the subject of any unresolved supervisory issues.

     Sarbanes-Oxley  Act of 2002. On July 30, 2002,  the  Sarbanes-Oxley  Act of
2002 ("SOX") was signed into law which mandated a variety of reforms intended to
address corporate and accounting fraud. SOX contained provisions which amend the
Securities  Exchange Act of 1934,  as amended (the "Act") and  provisions  which
directed the SEC to promulgate  rules.  The resultant law and regulations  under
the Act as of the time of this  annual  report  is set  forth  in the  following
paragraphs.  SOX  provides  for  the  establishment  of  a  new  Public  Company
Accounting  Oversight  Board  ("PCAOB"),  which will enforce  auditing,  quality
control and independence  standards for firms that audit Securities and Exchange
Commission  ("SEC")-reporting  companies  and will be  funded  by fees  from all
SEC-reporting  companies.  SOX imposed higher standards for auditor independence
and restricts  provision of consulting  services by auditing  firms to companies
they audit.  Any  non-audit  services  being  provided  to an audit  client will
require  preapproval  by the Company's  audit  committee  members.  In addition,
certain  audit  partners  must  be  rotated  periodically.  SOX  requires  chief
executive officers and chief financial officers, or their equivalent, to certify
to the  accuracy of periodic  reports  filed with the SEC,  subject to civil and
criminal  penalties if they  knowingly or willfully  violate this  certification
requirement. In addition, under SOX, counsel will be required to report evidence
of a material  violation of the securities laws or a breach of fiduciary duty by
a company to its chief  executive  officer or its chief legal  officer,  and, if
such  officer does not  appropriately  respond,  to report such  evidence to the
audit  committee  or other  similar  committee  of the board of directors or the
board itself.

     Longer  prison  terms  will also be  applied to  corporate  executives  who
violate federal  securities laws, the period during which certain types of suits
can be brought against a company or its officers has been extended,  and bonuses
issued  to  top  executives  prior  to  restatement  of  a  company's  financial
statements  are now  subject  to  disgorgement  if such  restatement  was due to
corporate  misconduct.  Executives  are  also  prohibited  from  trading  during
retirement  plan  "blackout"  periods,  and  loans  to  company  executives  are
restricted.  In addition, a provision directs that civil penalties levied by the
SEC as a result  of any  judicial  or  administrative  action  under  the Act be
deposited in a fund for the benefit of harmed investors. Directors and executive
officers  must also  report  most  changes  in their  ownership  of a  company's
securities  within two  business  days of the change,  and as of the end of June
2003, all ownership reports must be electronically filed.


                                       31


     SOX also  increases  the  oversight  and  authority of audit  committees of
publicly traded  companies.  Audit committee members must be independent and are
barred from accepting  consulting,  advisory or other compensatory fees from the
issuer. In addition, all SEC-reporting  companies must disclose whether at least
one member of the committee is an audit  committee  "financial  expert" (as such
term is  defined  by the SEC rules) and if not,  why not.  Audit  committees  of
publicly  traded  companies  will have authority to retain their own counsel and
other advisors funded by the company. Audit committees must establish procedures
for the receipt,  retention and treatment of complaints regarding accounting and
auditing  matters and  procedures  for  confidential,  anonymous  submission  of
employee concerns regarding  questionable  accounting or auditing matters. It is
the  responsibility  of the  audit  committee  to  hire,  oversee  and  work  on
disagreements with the Company's independent auditor.

     Beginning  six months  after the SEC  determines  that the PCAOB is able to
carry  out its  functions,  it will be  unlawful  for any  person  that is not a
registered  public  accounting firm ("RPAF") to audit an SEC-reporting  company.
Under SOX, a RPAF is  prohibited  from  performing  statutorily  mandated  audit
services  for a  company  if  such  company's  chief  executive  officer,  chief
financial officer,  comptroller,  chief accounting officer or any person serving
in equivalent  positions has been employed by such firm and  participated in the
audit of such company during the one-year period  preceding the audit initiation
date.  SOX also  prohibits  any  officer or  director  of a company or any other
person  acting  under their  direction  from  taking any action to  fraudulently
influence,  coerce,  manipulate or mislead any  independent  public or certified
accountant  engaged in the audit of the Company's  financial  statements for the
purpose of rendering the financial statement's  materially  misleading.  The SEC
has  prescribed  rules  requiring  inclusion of an internal  control  report and
assessment by management of the Company's internal controls in the annual report
to shareholders. SOX requires the RPAF that issues the audit report to attest to
and report on management's  assessment of the Company's  internal  controls.  In
addition,  SOX requires that each  financial  report  required to be prepared in
accordance with (or reconciled to) generally accepted accounting  principles and
filed  with  the SEC  reflect  all  material  correcting  adjustments  that  are
identified by a RPAF in accordance with generally accepted accounting principles
and the rules and regulations of the SEC.

     Although  the  Company  anticipates  it will  incur  additional  expense in
complying with the provisions of the Act and the related rules,  management does
not expect that such  compliance  will have a material  impact on the  Company's
financial condition or results of operations.

                                    TAXATION

GENERAL

     1st State Bancorp and 1st State Bank file a consolidated federal income tax
return  based on a fiscal year ending  September  30. They file  separate  state
returns.

FEDERAL INCOME TAXATION

     Financial institutions such as 1st State Bank are subject to the provisions
of the Internal  Revenue Code in the same general manner as other  corporations.
Through tax years beginning before December 31, 1995,  institutions  such as 1st
State Bank which met certain definitional tests and other conditions  prescribed
by the  Internal  Revenue Code  benefitted  from  certain  favorable  provisions
regarding their deductions from taxable income for annual additions to their bad
debt  reserve.  For  purposes  of the bad  debt  reserve  deduction,  loans  are
separated  into  "qualifying  real property  loans,"  which  generally are loans
secured by interests in certain real property,  and "nonqualifying loans", which
are  all  other  loans.   The  bad  debt  reserve   deduction  with  respect  to
nonqualifying  loans must be based on actual loss experience.  The amount of the
bad debt reserve deduction with respect to qualifying real property loans may be
based upon actual loss experience (the  "experience  method") or a percentage of
taxable income  determined  without regard to such deduction (the "percentage of
taxable income method"). Under the experience method, the bad debt deduction for
an  addition to the reserve for  qualifying  real  property  loans was an amount
determined  under a formula based generally on the bad debts actually  sustained
by a savings institution over a period of years. Under the percentage of taxable
income method, the bad debt reserve deduction for qualifying real property loans
was  computed as 8% of a savings  institution's  taxable  income,  with  certain
adjustments.  We  generally  elected to use the method which has resulted in the
greatest deductions for federal income tax purposes in any given year.


                                       32


     Legislation  that is effective for tax years  beginning  after December 31,
1995 requires  institutions  to recapture into taxable income over a six taxable
year period the portion of the tax loan  reserve  that  exceeds the pre-1988 tax
loan loss reserve. As a result of changes in the law, institutions were required
to change to either the reserve  method or the specific  charge-off  method that
applied to banks.

     We are not required to provide a deferred tax  liability for the tax effect
of additions to the tax bad debt reserve  through 1987, the base year.  Retained
income at September  30, 1998 includes  approximately  $4.2 million for which no
provision  for  federal  income  tax has  been  made.  These  amounts  represent
allocations of income to bad debt deductions for tax purposes only. Reduction of
such amounts for purposes other than tax bad debt losses could create income for
tax  purposes in certain  remote  instances,  which would be subject to the then
current corporate income tax rate.

     Our federal income tax returns have not been audited since 1993.

     For  additional  information  on our policies  regarding tax and accounting
matters,  see our  consolidated  financial  statements  and related notes in the
Annual Report filed as Exhibit 13 in this document.

STATE INCOME TAXATION

     Under North Carolina law, the corporate  income tax rate currently is 6.90%
of federal taxable income as computed under the Internal  Revenue Code,  subject
to certain  prescribed  adjustments.  An annual state franchise tax, recorded in
other  expense,  is imposed at a rate of .15%  applied  to the  greatest  of the
institution's (i) capital stock, surplus and undivided profits,  (ii) investment
in tangible property in North Carolina, or (iii) fifty-five percent of appraised
valuation of property in North Carolina.

     For additional  information  regarding taxation,  see Notes 1 and 11 of the
Notes to the Consolidated Financial Statements, which you can find in the Annual
Report.

ITEM 2.  PROPERTIES
-------------------

     The  following  table  sets  forth  the  location  and  certain  additional
information regarding our offices at September 30, 2003.



                                                           Book Value at                           Deposits at
                           Year           Owned or         September 30,         Approximate      September 30,
                          Opened           Leased            2003 (1)          Square Footage          2003
                          ------           ------           ----------         --------------        -------
                                                       (Dollars in thousands)
                                                                                         
Main Office:
445 S. Main Street          1988          Owned              $     3,471            33,700         $99,441
Burlington, NC  27215

BRANCH OFFICES:
2294 N. Church Street       1984          Leased (2)                 233             2,600          24,330
Burlington, NC  27215

503 Huffman Mill Road       1982          Owned                      335             2,600          36,232
Burlington, NC  27215

102 E. Washington Street    1973          Owned                      342             2,300          34,928
Mebane, NC  27302

211 N. Main Street          1974          Owned                       98             2,700          35,521
Graham, NC  27253
                                                                                     (table continued on next page)


                                       33

3466 S. Church Street       1996          Owned                    1,342             4,000         22,560
Burlington, NC  27215

1203 S. Main Street         2000          Owned                   1,384              4,000          9,700
Graham, NC 27253



----------
(1)  Land and building only.
(2)  Land is leased.  Lease expires on July 5, 2009,  with options to extend for
     three five-year periods.

     The net book value of our  investment  in premises and  equipment  was $8.4
million at September  30, 2003.  See Note 7 of Notes to  Consolidated  Financial
Statements, located in the annual report.

ITEM 3. LEGAL PROCEEDINGS
-------------------------

     From time to time, we are a party to various legal proceedings  incident to
our business.  There currently are no legal proceedings to which we are a party,
or to  which  any of our  property  was  subject,  except  as  described  in the
following  paragraph,  and none which are expected to result in a material loss.
There are no pending regulatory  proceedings to which we are a party or to which
any of our  properties  is subject  which are  expected  to result in a material
loss.

     A civil action was filed  against 1st State Bank and Brokers,  Incorporated
by Michael  Locklar in Davidson  County  Superior  Court,  in the State of North
Carolina on May 16, 2003.  Mr.  Locklar has alleged in the action that 1st State
Bank granted him an option to purchase certain real property located in Davidson
County,  North  Carolina,  which  1st State  Bank  wrongfully  sold to  Brokers,
Incorporated  for $150,000 in breach of the option granted to Mr.  Locklar.  Mr.
Locklar  is  seeking  to set  aside  the  conveyance  of  property  to  Brokers,
Incorporated  and to purchase  the  property  from 1st State Bank for the option
price.  Brokers,  Incorporated  has filed a  cross-claim  against 1st State Bank
seeking  indemnification  in the form of return of the purchase  price they paid
for the  property,  damages and attorneys  fees should  Locklar be successful in
setting aside the real estate  conveyance.  1st State Bank intends to vigorously
contest Mr. Locklar's allegations.

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

         Not applicable.

                                     PART II


ITEM 5.  MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDERS'
         MATTERS
--------------------------------------------------------------------------------

     The information contained under the sections captioned "Market Information"
in the  Company's  Annual  Report to  Stockholders  for the  Fiscal  Year  Ended
September  30,  2003  (the  "Annual  Report")  filed as  Exhibit  13  hereto  is
incorporated herein by reference.

ITEM 6.  SELECTED FINANCIAL DATA
--------------------------------

     The  information  contained in the table captioned  "Selected  Consolidated
Financial and Other Data" on page 2 in the Annual Report is incorporated  herein
by reference.

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

     The information contained in the section captioned "Management's Discussion
and  Analysis  of  Financial  Condition  and Results of  Operations"  on pages 4
through 21 in the Annual Report is incorporated herein by reference.


                                       34


ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
--------------------------------------------------------------------

     The  information  contained under the sections  captioned  "Market Risk" on
pages 7 and 8 in the Annual Report is incorporated herein be reference.

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
----------------------------------------------------

     The  Consolidated  Financial  Statements,  Notes to Consolidated  Financial
Statements,  Independent  Auditors' Report and Selected Financial Data contained
on pages 22  through  57 in the Annual  Report,  which are listed  under Item 14
herein, are incorporated herein by reference.

ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
         FINANCIAL DISCLOSURE
--------------------------------------------------------------------------------

         Not applicable.

Item 9A.  CONTROLS & PROCEDURES
-------------------------------

     As of the end of the  period  covered  by this  report,  management  of the
Company  carried  out  an  evaluation,   under  the  supervision  and  with  the
participation  of  the  Company's  principal  executive  officer  and  principal
financial officer, of the effectiveness of the Company's disclosure controls and
procedures.  Based on this evaluation, the Company's principal executive officer
and principal financial officer concluded that the Company's disclosure controls
and  procedures  are  effective  in  ensuring  that  information  required to be
disclosed  by the  Company  in  reports  that it  files  or  submits  under  the
Securities Exchange Act of 1934, as amended, is recorded, processed,  summarized
and reported,  within the time periods  specified in the Securities and Exchange
Commission's  rules  and  forms.  It  should  be noted  that the  design  of the
Company's  disclosure  controls  and  procedures  is based in part upon  certain
reasonable  assumptions about the likelihood of future events,  and there can be
no reasonable  assurance  that any design of disclosure  controls and procedures
will  succeed  in  achieving  its  stated  goals  under  all  potential   future
conditions,  regardless of how remote, but the Company's principal executive and
financial  officers have  concluded that the Company's  disclosure  controls and
procedures are, in fact, effective at a reasonable assurance level.

     In addition,  there have been no changes in the Company's  internal control
over financial reporting  identified in connection with the evaluation described
in the above  paragraph that occurred  during the Company's last fiscal quarter,
that has materially affected,  or is reasonably likely to materially affect, the
Company's internal control over financial reporting.

                                    PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
------------------------------------------------------------

     The  information  contained  under the  sections  captioned  "Proposal I --
Election  of  Directors"  and  "Section  16(a)  Beneficial  Ownership  Reporting
Compliance" in the Company's  definitive  proxy statement for the Company's 2004
Annual Meeting of Stockholders (the "Proxy Statement") is incorporated herein by
reference.

     The  Company has  adopted a Code of Ethics  that  applies to the  Company's
chief executive officer, chief financial officer, and all senior management.

ITEM 11.  EXECUTIVE COMPENSATION
--------------------------------

     The  information  contained  under the  sections  captioned  "Proposal I --
Election of  Directors  -- Executive  Compensation,"  in the Proxy  Statement is
incorporated herein by reference.

                                       35


ITEM 12.  SECURITY  OWNERSHIP OF CERTAIN  BENEFICIAL  OWNERS AND  MANAGEMENT AND
          RELATED STOCKHOLDER MATTERS
--------------------------------------------------------------------------------


     (a)  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS.  Information required
          by this  item is  incorporated  herein  by  reference  to the  section
          captioned  "Voting  Securities  and Security  Ownership"  in the Proxy
          Statement.

     (b)  SECURITY OWNERSHIP OF MANAGEMENT. Information required by this item is
          incorporated  herein by reference to the  sections  captioned  "Voting
          Securities  and  Security  Ownership"  and  "Proposal I -- Election of
          Directors" in the Proxy Statement.

     (c)  CHANGES  IN  CONTROL.   Management   of  the   Company   knows  of  no
          arrangements,  including any pledge by any person of securities of the
          Company,  the operation of which may at a subsequent  date result in a
          change in control of the registrant.

     (d)  EQUITY  COMPENSATION  PLANS.  The  following  table sets forth certain
          information with respect to the Company's equity compensation plans as
          of September 30, 2003.



                                                (a)                            (b)                        (c)
                                                                                                    Number of securities
                                                                                                     remaining available
                                     Number of securities to be         Weighted-average             for future issuance
                                      issued upon exercise of           exercise price of         under equity compensation
                                        outstanding options,          outstanding options,       plans (excluding securities
                                         warrants & rights             warrants and rights         reflected in column (a))
                                         -----------------             -------------------         ------------------------
                                                                                                 
Equity compensation plans                      316,312                       $  14.71                           --
  approved by security holders

Equity compensation plans not
  approved by security holders                      --                             --                           --
                                               -------                       --------                        -----
Total                                          316,312                       $  14.71                           --
                                               =======                       ========                        =====




ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
--------------------------------------------------------

     The information  required by this item is incorporated  herein by reference
to the section  captioned  "Proposal I -- Election of Directors --  Transactions
with Management" in the Proxy Statement.

                                     PART IV

ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
--------------------------------------------------------------------------

     (a)  LIST OF DOCUMENTS FILED AS PART OF THIS REPORT
          ----------------------------------------------

     (1) Financial Statements.  The following  consolidated financial statements
are incorporated by reference from Item 8 hereof (see Exhibit 13):

         Independent Auditors' Report
         Consolidated Balance Sheets as of  September 30, 2003 and 2002
         Consolidated Statements of Income for the Years Ended September 30,
          2003, 2002 and 2001
         Consolidated Statements of Stockholders' Equity and Comprehensive
          Income for the Years Ended
         September 30, 2003, 2002 and 2001
         Consolidated Statements of Cash Flows for the Years Ended September 30,
          2003, 2002 and 2001
         Notes to Consolidated Financial Statements

                                       36


     (2) Financial  Statement  Schedules.  All schedules for which  provision is
made in the  applicable  accounting  regulations  of the Securities and Exchange
Commission are omitted because of the absence of conditions under which they are
required or because the  required  information  is included in the  consolidated
financial statements and related notes thereto.


                                       37




     (3)  Exhibits.  The  following is a list of exhibits  filed as part of this
Annual Report on Form 10-K and is also the Exhibit Index.

      No.         Description
      ---         -----------


                     
       3.1        Articles of  Incorporation  of 1st State  Bancorp,  Inc.  (Incorporated  herein by reference from
                  Exhibit 3.1 to the Company's Registration Statement on Form S-1 (File No. 333-68091))
       3.2        Bylaws of 1st State  Bancorp,  Inc.  (Incorporated  herein by reference to the  Company's  Annual
                  Report on Form 10-K for the Fiscal Year Ended September 30, 2000)
       4          Form of Common Stock  Certificate of 1st State Bancorp,  Inc.  (Incorporated  herein by reference
                  from Exhibit 4 to the Company's Registration Statement on Form 8-A)
      10.1        1st State Bancorp,  Inc. 2000 Stock Option and Incentive Plan  (Incorporated  herein by reference
                  to the Company's Annual Report on Form 10-K for the Fiscal Year Ended September 30, 2000) +
      10.2        1st State Bancorp,  Inc.  Management  Recognition Plan  (Incorporated  herein by reference to the
                  Company's Annual Report on Form 10-K for the Fiscal Year Ended September 30, 2000) +
      10.3        Employment  Agreements by and between 1st State Bank and James C. McGill,  A. Christine Baker and
                  Fairfax  C.  Reynolds  (Incorporated  herein by  reference  from  Exhibit  10.3 to the  Company's
                  Registration Statement on Form S-1 (File No. 333-68091)) +
      10.4        Form of Guaranty  Agreement  by and between  1st State  Bancorp,  Inc.  and James C.  McGill,  A.
                  Christine  Baker and Fairfax C. Reynolds  (Incorporated  herein by reference from Exhibit 10.4 to
                  the Company's Registration Statement on Form S-1 (File No. 333-68091)) +
      10.5        1st State Bank Deferred Compensation Plan (Incorporated herein
                  by reference from Exhibit 10.5 to the Company's Registration
                  Statement on Form S-1 (File No. 333-68091)) +
      13          Annual Report to Stockholders
      14          Code of Ethics
      21          Subsidiaries of the Registrant
      23          Consent of KPMG LLP
      31.1        Rule 13a-14(a) Certification of Chief Executive Officer
      31.2        Rule 13a-14(a) Certification of Chief Financial Officer
      32          Certification pursuant to 18 U.S.C. Section 1350


      ----------
      + Management contract or compensation plan or arrangement.

     (b) REPORTS ON FORM 8-K. The Registrant filed the following  Current Report
         --------------------
on Form 8-K during the last quarter covered by this Report:



                                                                           Financial Statements
                  Date of Report               Items Reported                    Filed
                  --------------               --------------              --------------------
                                                                          
                  July 23, 2003                    7, 12                           N/A


     (c)  EXHIBITS.  The  exhibits  required by Item 601 of  Regulation  S-K are
          ---------
either  filed as part of this  Annual  Report  on Form 10-K or  incorporated  by
reference herein.

     (d) FINANCIAL. STATEMENTS AND SCHEDULES EXCLUDED FROM ANNUAL REPORT.  There
         ----------------------------------------------------------------
are no other financial  statements and financial  statement schedules which were
excluded from the Annual Report to Stockholders  pursuant to Rule 14a-3(b) which
are required to be included herein.

                                       38

                                   SIGNATURES

     Pursuant  to the  requirements  of  Section  13 or 15(d) of the  Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

                                       1st STATE BANCORP, INC.


December 26, 2003                  By: /s/ James C. McGill
                                       ----------------------------------------
                                       James C. McGill
                                       President

     Pursuant to the  requirements of the Securities  Exchange Act of 1934, this
report  has  been  signed  below  by the  following  persons  on  behalf  of the
registrant and in the capacities and on the dates indicated.


/s/ James C. McGill                                            December 26, 2003
-----------------------------------------------------
James C. McGill
President, Chief Executive Officer and Director
(Principal Executive Officer)

/s/ A. Christine Baker                                         December 26, 2003
-----------------------------------------------------
A. Christine Baker
Executive Vice President, Chief Financial
Officer, Secretary and Treasurer
(Principal Financial and Accounting Officer)

/s/ Richard C. Keziah                                          December 26, 2003
-----------------------------------------------------
Richard C. Keziah
Chairman of the Board

/s/ James A. Barnwell, Jr.                                     December 26, 2003
-----------------------------------------------------
James A. Barnwell, Jr.
Director

/s/ Bernie C. Bean                                             December 26, 2003
-----------------------------------------------------
Bernie C. Bean
Director

/s/ Ernest A. Koury, Jr.                                       December 26, 2003
-----------------------------------------------------
Ernest A. Koury, Jr.
Director

/s/ James G. McClure                                           December 26, 2003
-----------------------------------------------------
James G. McClure
Director

/s/ T. Scott Quakenbush                                        December 26, 2003
-----------------------------------------------------
T. Scott Quakenbush
Director

/s/ Richard H. Shirley                                         December 26, 2003
-----------------------------------------------------
Richard H. Shirley
Director

/s/ Virgil L. Stadler                                          December 26, 2003
-----------------------------------------------------
Virgil L. Stadler
Director