INTERNATIONAL BANCSHARES CORPORATION ALL BANKS MEMBER FDIC MEMBER BANKS: INTERNATIONAL BANK OF COMMERCE 1200 San Bernando Avenue (956) 722-7611 LAREDO 7002 San Bernando Ave. (956) 728-0060 1002 Matamoros (956) 726-6622 1300 Guadalupe (956) 722-0179 5300 San Dario Ste. 440D (956) 728-0063 5300 San Dario Ste. 202 (956) 790-6500 9710 Mines Road (956) 728-0092 4501 San Bernardo (956) 722-0485 7909 McPherson (956) 728-0064 2442 San Isidro Pkwy (956) 726-6611 2415 S. Zapata Hwy. (956) 728-0061 In-Store Banking Center 5610 San Bernardo (956) 726-6688 2320 Bob Bullock Lp 20 @ Clark (956) 728-0062 SAN ANTONIO 130 E. Travis (210) 518-2500 5029 Broadway (210) 518-2500 6630 Callaghan (210) 341-7277 2201 Northwest Military Dr. (210) 366-0617 2101 NW Military Dr. (210) 344-1754 12400 Hwy 281 N (210) 369-2905 20450 Huebner Rd. (210) 499-4238 1500 NE Lp. 410 (210) 828-2407 10200 San Pedro Ave. (210) 366-5400 18750 Stone Oak Pkwy Ste. 100 (210) 496-6111 5300 Walzem Rd. (210) 656-6600 In-Store Banking Center 6301 NW Lp. 410 Ste. P3 (210) 369-2910 7400 San Pedro (210) 369-2940 6909 N Lp. 1604 E Ste. EO-1 (210) 369-2922 2310 SW Military Dr. Ste. 216 (210) 518-2558 999 E. Basse Rd. Ste. 150 (210) 369-2920 20760 US Hwy 281 N (210) 369-2914 14610 Huebner Rd. (210) 369-2918 24165 IH 10 W. Ste. 300 (210) 369-2912 12018 Perrin Beitel Rd. (210) 369-2916 LULING 200 S. Pecan (830) 875-2445 MARBLE FALLS 700 Highway 281 (830) 693-4301 SAN MARCOS 1081 Wonder World (512) 353-1011 NEW BRAUNFELS In-Store Banking Center 955 N. Walnut Ave. (830) 608-9665 MCALLEN One S. Broadway (956) 686-0263 1301 Ash (956) 632-3545 301 S. 10th St. (956) 631-9300 3600 N.10th. St. (956) 682-9622 2200 S. 10th St. (E. La Plaza) (956) 686-3772 2200 S. 10th St. (W. La Plaza) (956) 630-4839 2225 Nolana (956) 682-1237 In-Store Banking Center 1200 E. Jackson (956) 668-0998 4001 N. 23rd St (956) 661-1695 EDINBURG 400 South Closner (956) 383-3891 In-Store Banking Center 1724 W. University Dr. Ste. B (958) 380-3553 MISSION 900 N. Bryan Rd. (956) 581-2131 In-Store Banking Center 200 E. Griffin Pkwy (956) 632-3512 2410 E. Expressway 83 (956) 585-3485 PHARR 401 S. Cage (956) 787-5596 WESLACO 606 S. Texas Blvd. (956) 968-5551 CORPUS CHRISTI 221 S. Shoreline (361) 888-4000 6130 S. Staples (361) 991-4000 ROCKPORT 2701 N. Hwy. 35 (361) 729-0500 In-Store Banking Center ARANSAS PASS 2501 W. Wheeler (361) 758-6900 PORT LAVACA 311 N. Virginia St. (361) 552-9771 ANGLETON 200 E. Mulberry (979) 849-7711 BAY CITY 1916 7th Street (979) 245-5781 FREEPORT 1208 N. Brazosport Blvd. (979) 233-2677 LAKE JACKSON 212 That Way (979) 297-2466 VICTORIA 6411 N. Navarro (361) 575-8394 HOUSTON 5615 Kirby Dr. (713) 526-1211 Kelvin @ Nottingham (713) 526-1211 5706 Kirby (713) 526-1211 8203 S. Kirkwood (713) 285-2162 1001 McKinney Ste. 150 (713) 285-2138 1010 Richmond (713) 285-2189 1777 Sage Rd. (713) 285-2128 RICHMOND 5250 FM 1460 (832) 595-0920 In-Store Banking Center 5085 Westheimer Ste. 4640 (713) 285-2292 12400 FM 1960 W. (713) 285-2212 7747 Kirby Dr. (713) 285-2118 FRIENDSWOOD 3135 FM 528 (281) 316-0670 GALVESTON 2931 Central City Blvd. (409) 741-2573 SUGARLAND 1565 State Hwy 6 S. (713) 285-2203 EAGLE PASS 439 E. Main Street (830) 773-2313 2538 E. Main Street (830) 773-2313 New Mall Location (830) 773-4930 DEL RIO 2410 Dodson St. (830) 775-4265 International Bank of Commerce, Brownsville 630 E. Elizabeth St. Brownsville, TX 78522-1031 (956) 547-1000 1623 Central Blvd. (956) 547-1200 4520 E. 14th St. (956) 547-1300 1365 FM 802 (956) 547-1350 2370 N. Expressway (956) 547-1380 In-Store Banking Center 3600 W. Alton Gloor Blvd (956) 547-1390 Commerce Bank 2120 E. Saunders Laredo, Texas 78044 (956) 724-1616 HARLINGEN 501 S. Dixieland (956) 428-6902 902 N. 77th Sunshine Strip (956) 428-6454 In-Store Banking Center 1801 W. Lincoln (956) 428-4559 PORT ISABEL 1601 W. Hwy 100 (956) 943-2108 SOUTH PADRE ISLAND 911 Padre Blvd. (956) 761-6156 International Bank of Commerce, Zapata U.S Hwy. 83 at 10th Ave. Zapata, TX 78076 (956) 765-8361 IH 35 and Mann Rd. (956) 724-2424 Zapata Hwy at Blaine St. (956) 725-2525 1200 Welby Court (956) 728-1010 ROMA U.S Hwy. 83 at Portaleza (956) 849-1047 RIO GRANDE CITY E. Hwy. 83 # 4015 (956) 487-5531 In-Store Banking Center 4534 E. Hwy. 83 (956) 488-6367 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES (Consolidated) SELECTED FINANCIAL DATA AT OR FOR THE YEARS ENDED DECEMBER 31, 2002 2001 2000 1999 1998 (Dollars in Thousands, Except Per Share Data) BALANCE SHEET Assets . . . . . . . . . . . . . . . . . . . . . . Net loans . . . . . . . . . . . . . . . . . . . . Deposits . . . . . . . . . . . . . . . . . . . . Other borrowed funds . . . . . . . . . . Shareholders’ equity . . . . . . . . . . . . $6,495,635 2,725,349 4,239,899 1,185,857 547,264 $6,381,401 2,608,467 4,332,834 777,296 497,028 $5,860,714 2,212,467 3,744,598 1,432,500 416,892 $5,421,804 1,876,754 3,527,212 1,380,000 353,436 $4,987,877 1,589,788 3,369,637 1,074,000 370,283 INCOME STATEMENT Interest income . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . $ 353,928 116,415 $ 390,355 200,808 $ 415,332 251,756 $ 337,219 185,205 $ 323,632 181,909 Net interest income . . . . . . . . . . . . Provision for possible loan losses . . . Non-interest income . . . . . . . . . . . . Non-interest expense . . . . . . . . . . . Income before income taxes and cumulative change in accounting principle . . . . . . . . . . . . . . . . . . . Income taxes . . . . . . . . . . . . . . . . . Cumulative effect of a change in 237,513 8,541 85,645 154,843 189,547 8,631 79,588 135,441 163,576 6,824 63,796 111,957 152,014 6,379 64,483 106,983 159,774 125,063 108,591 103,135 54,013 41,721 33,417 36,887 141,723 8,571 44,240 99,047 78,345 24,620 accounting principle, net of taxes . 5,130 — — — — Net income . . . . . . . . . . . . . . . . . . $ 100,631 Adjusted net income . . . . . . . . . . . . $ 100,631 Per common share: Basic . . . . . . . . . . . . . . . . . . . . . Diluted . . . . . . . . . . . . . . . . . . . . Adjusted per common share: Basic . . . . . . . . . . . . . . . . . . . . . Diluted . . . . . . . . . . . . . . . . . . . . $ $ $ $ 3.15 3.08 3.15 3.08 $ $ $ $ $ $ 83,342 86,188 2.52 2.47 2.61 2.56 $ $ $ $ $ $ 75,174 77,266 2.25 2.22 2.31 2.28 $ $ $ $ $ $ 66,248 68,132 1.94 1.91 2.00 1.96 $ $ $ $ $ $ 53,725 55,633 1.56 1.52 1.61 1.58 Note 1: See note 2 of notes to the consolidated financial statements regarding the acquisitions made by International Bancshares Corporation and its subsidiaries in 2002 and 2001. Note 2: See note 8 of notes to the consolidated financial statements regarding the other borrowed funds of the Company and its subsidiaries. Note 3: See note 15 of notes to the consolidated financial statements regarding the discontinuation of goodwill amortization. On January 1, 2002, the Company adopted the remaining provisions of SFAS No. 142, which discontinued amortization of goodwill. Accordingly, there is no adjusted net income or per common share data for the year ended December 31, 2002. 1 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management’s discussion and analysis represents an explanation of significant changes in the financial position and results of operations of International Bancshares Corporation and subsidiaries (the ‘‘Com- pany’’) on a consolidated basis for the three-year period ended December 31, 2002. The Company is a financial holding company with four bank subsidiaries operating in over 95 main banking and branch facilities in South and Southeast Texas, and ten non-bank subsidiaries. The following discussion should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2002, and the Selected Financial Data and Consolidated Financial Statements included elsewhere herein. Special Cautionary Notice Regarding Forward Looking Information Certain matters discussed in this report, excluding historical information, include forward-looking statements. Although the Company believes such forward-looking statements are based on reasonable assumptions, no assurance can be given that every objective will be reached. The words ‘‘estimate,’’ ‘‘expect,’’ ‘‘intend,’’ and ‘‘project,’’ as well as other words or expressions of a similar meaning are intended to identify forward-looking statements. Readers are cautioned not to place undue reliance on forward- looking statements, which speak only as of the date of this report. Such statements are based on current expectations, are inherently uncertain, are subject to risks and should be viewed with caution. Actual results and experience may differ materially from the forward-looking statements as a result of many factors. Risk factors that could cause actual results to differ materially from any results that are projected, forecasted, estimated or budgeted by the Company in forward-looking statements include, among others the following possibilities: (I) changes in interest rates and market prices, which could reduce the Company’s net interest margins, asset valuations and expense expectations, (II) changes in the capital markets utilized by the Company and its subsidiaries, including changes in the interest rate environment that may reduce margins, (III) changes in state and/or federal laws and regulations to which the Company and its subsidiaries, as well as their customers, competitors and potential competitors, are subject, including, without limitation, banking, tax, securities, insurance and employment laws and regulations, (IV) the loss of senior management or operating personnel, (V) increased competition from both within and outside the banking industry, (VI) changes in local, national and international economic business conditions which adversely affect the Company’s customers and their ability to transact profitable business with the Company, including the ability of its borrowers to repay their loans according to their terms or a change in the value of the related collateral, (VII) the timing, impact and other uncertainties of the Company’s potential future acquisitions including the Company’s ability to identify suitable potential future acquisition candidates, the success or failure in the integration of their operations, and the Company’s ability to maintain its current branch network and to enter new markets successfully and capitalize on growth opportunities, (VIII) changes in the Company’s ability to pay dividends on its Common Stock, (IX) the effects of the litigation and proceedings pending with the Internal Revenue Service regarding the Company’s lease financing transactions, and (X) additions to the Company’s loan loss reserves as the result of changes in local, national, or international conditions which adversely affect the Company’s customers. It is not possible to foresee or identify all such factors. The Company makes no commitment to update any forward-looking statement, or to disclose any facts, events or circumstances after the date hereof that may affect the accuracy of any forward-looking statement, unless required by law. 2 Results of Operations Overview Net income for 2002 was $100,631,000, or $3.15 per share—basic ($3.08 per share—diluted), com- pared with $83,342,000, or $2.52 per share—basic ($2.47 per share—diluted), in 2002 and $75,174,000, or $2.25 per share—basic ($2.22 per share—diluted), in 2001. During the year-ended December 31, 1999, IBC Aircraft Services, Inc., a wholly owned subsidiary of the Company’s lead bank, International Bank of Commerce, Laredo, Texas, acquired for approximately $15 million, a 20% ownership interest in the Aircraft Finance Trust (‘‘AFT’’), a special purpose business trust formed to acquire, finance, refinance, own, lease, sublease, sell and maintain aircraft. During 1999, AFT issued approximately $1.209 billion in aggregate principal amount of notes in five debt classes. AFT used the proceeds from the debt offering to initially purchase 36 leased aircraft located in at least thirteen different countries from General Electric Capital Corporation and certain of its affiliates. The expected final payment date of the AFT notes is August 15, 2016 and the final maturity date of the AFT notes is May 15, 2024. GE Capital Aviation Services Limited acts as servicer of the AFT aircraft portfolio. The Company accounts for its investment in AFT under the equity method of accounting. AFT utilizes derivative instruments to manage the interest rate on bonds that it has issued. The derivatives qualify as cash flow hedges and are reported at fair value. The Company records its proportionate share of the fair value of the derivatives as an increase or decrease in the investment in AFT and accumulated other comprehensive income, net of tax. The Company’s proportionate share of earnings or losses of AFT were losses of $6,799,000 and $1,766,000 for the years ended December 31, 2002 and 2001, respectively, and earnings of $1,069,000 for the year ended December 31, 2000. Because of the losses from operations that AFT has reported as a result of the events of September 11 and the impact on the airline industry including continued declines in air travel and continued reduced demand for commercial aircraft, the Company evaluated its investment, which resulted in the Company recording an impairment charge of $6,081,000 in 2002. At December 31, 2002 and 2001, the Company’s investment in AFT, excluding its proportionate share of the fair value of the AFT derivatives, was $948,000 and $13,828,000, respectively. The Company’s investment including the proportionate share of the fair value of the AFT derivatives at December 31, 2002 and 2001, was $0 and $6,281,000, respectively. On March 13, 2002, Albertson’s, Inc. announced its intention to exit substantially all of the Company’s markets. The Company began its relationship with Albertson’s in 1995. 39 Albertson’s supermarkets and the related in-store branches of the Company located in Houston, San Antonio, Brownsville, Corpus Christi, Laredo, Endinburg, San Juan, Pharr, Mission, Weslaco and Harlingen have been closed. On June 7, 2002, H-E-B agreed to purchase certain former Albertson’s locations in San Antonio and the Rio Grande Valley. The Company subsequently agreed with H-E-B to open in 5 of the Company’s previous in-store locations and the Company also agreed to open an in-store branch in another former Albertson’s store that was not occupied by the Company. On May 10, 2002, Kroger Co. agreed to purchase certain former Albertson’s locations in Houston. The Company subsequently agreed with Kroger to open in 3 of the Company’s previous in-store locations. During the third quarter 2002, the Company concluded that the remaining in-store locations would not be re-opened and wrote off $1,159,000 of its investment in the related in-store branches. The Company will continue to maintain 1 Albertson’s in-store branch in the New Braunfels market that was not closed by Albertson’s. As a result of the new branch arrangements in Houston and San Antonio and the Company’s extensive branch network, the Company does not expect any further significant loss of its deposit base or a significant impact from the branch closings on its consolidated financial condition or results of operations. On August 1, 2002, the Company completed its sale of three non-strategic bank branches in Rockdale, Taylor and Giddings, Texas to Citizens National Bank located in Cameron, Texas. The branches were previously acquired by the Company as part of its acquisition of National Bancshares Corporation in the 3 fourth quarter of 2001 and represented approximately $36.3 million in loans and $93.1 million in deposits. As a result of the sale, the Company recorded a gain of $3.1 million. Total assets at December 31, 2002 grew 1.8% to $6,495,635,000 from $6,381,401,000 at December 31, 2001, and grew 8.9% in 2001 from $5,860,714,000 at December 31, 2000. Net loans increased 4.5% to $2,725,349,000 at December 31, 2002 from $2,608,467,000 at December 31, 2001 and grew 17.9% in 2001 from $2,212,467,000 at December 31, 2000. Deposits at December 31, 2002 were $4,239,899,000, a decrease of 2.1% from $4,332,834,000 at December 31, 2001, which represented an increase of 15.7% over $3,744,598,000 at December 31, 2000. The decrease in deposits and slight increase in assets from 2002 to 2001 is primarily attributed to the sale of the bank branches. The aggregate amount of certificates of indebtedness with the Federal Home Loan Bank of Dallas (‘‘FHLB’’) increased to $1,050,857,000 at December 31, 2002 from the $709,296,000 at December 31, 2001. Long term debt of $135,000,000 in the form of trust preferred securities was issued in 2002 and 2001. Trust preferred securities, certificates of indebtedness and the deposits are used to fund the earning asset base of the Company. Net Interest Income Net interest income in 2002 increased by $47,966,000, or 25.3%, over that in 2001, while net interest income in 2001 increased by $25,971,000, or 15.9%, over that in 2000. The net yield on average interest earning assets increased by 0.61% from 3.53% in 2001 to 4.14% in 2002. The net yield on average interest earning assets increased by 0.3% in 2001 to 3.53% from 3.23% in 2000. Average interest earning assets increased 6.8% from $5,376,790,000 in 2001, to $5,741,369,000 in 2002 and increased 4.5% from $5,147,489,000 in 2000 to $5,376,790,000 in 2001, which contributed to the growth in net interest income for 2002 and 2001, respectively. Due to decreasing market rates in 2002 and 2001, the Company consequently lowered interest rates on loans and deposits, which in turn affected the yield on interest earning assets and interest bearing liabilities. The yield on average interest earning assets decreased 1.1% from 7.26% in 2001 to 6.16% in 2002, and the rates paid on average interest bearing liabilities decreased 1.86% from 4.13% in 2001 to 2.27% in 2002. The yield on average interest earning assets decreased .93% from 8.19% in 2000 to 7.26% in 2001 and the rates paid on average interest bearing liabilities decreased 1.2% from 5.33% in 2000 to 4.13% in 2001. Net interest income is the spread between income on interest earning assets, such as loans and securities, and the interest expense on liabilities used to fund those assets, such as deposits, repurchase agreements and funds borrowed. Net interest income is affected by both changes in the level of interest rates and changes in the amount and composition of interest earning assets and interest bearing liabilities. As part of its strategy to manage interest rate risk, the Company strives to manage both assets and liabilities so that interest sensitivities match. One method of calculating interest rate sensitivity is through gap analysis. A gap is the difference between the amount of interest rate sensitive assets and interest rate sensitive liabilities that re-price or mature in a given time period. Positive gaps occur when interest rate sensitive assets exceed interest rate sensitive liabilities, and negative gaps occur when interest rate sensitive liabilities exceed interest rate sensitive assets. A positive gap position in a period of rising interest rates should have a positive effect on net interest income as assets will re-price faster than liabilities. Conversely, net interest income should contract somewhat in a period of falling interest rates. Management can quickly change the Company’s interest rate position at any given point in time as market conditions dictate. Additionally, interest rate changes do not affect all categories of assets and liabilities equally or at the same time. Analytical techniques employed by the Company to supplement gap analysis include simulation analysis to quantify interest rate risk exposure. The gap analysis prepared by management is reviewed by the Investment Committee of the Company twice a year. Management currently believes that the Company is properly positioned for interest rate changes; however if management determines at any time that the Company is not properly positioned, it will strive to adjust the interest rate sensitive assets and liabilities in order to manage the effect of interest rate changes. 4 Non-Interest Income Non-interest income increased 7.6% in 2002 to $85,645,000 from $79,588,000 in 2001, and increased 24.8% in 2001 from $63,796,000 in 2000. Service charges and fees on deposit accounts and other banking services provided increased $3,007,000 from 2001 to 2002 as a result of the acquisition of NBC Bank and new products offerred by the Company. Investment securities gains of $2,303,000 were recorded in 2002 compared to losses of $1,010,000 for 2001. These gains in 2002 and losses in 2001 occurred due to a bond program to reposition a portion of the Company’s bond portfolio and take advantage of higher bond yields. Non-interest income includes income on other investments. Income on other investments decreased by 124.4% in 2002 to $(2,598,000) from $10,536,000 in 2001, which represented a 23.7% decrease from $13,941,000 in 2000. The decrease in 2002 can be attributed to losses taken by the Company on its investment in AFT. Other non-interest income increased $3,383,000 primarily from the gain recorded on the sale of the branches. Non-Interest Expense Expense control is an essential element in the Company’s profitability. This is achieved through maintaining optimum staffing levels, an effective budgeting process, and internal consolidation of bank functions. Non-interest expense includes such items as wages and employee benefits, net occupancy expenses, equipment expenses and other operating expenses such as Federal Deposit Insurance Corpora- tion (‘‘FDIC’’) insurance. Non-interest expense increased 14.3% in 2002 to $154,843,000 from $135,441,000 in 2001, which increased 21.0% from $111,957,000 in 2000. The increases in non-interest expense for the three years ended 2002 were due to the expanded operations of the Company’s bank subsidiaries. The efficiency ratio, a measure of non-interest expense to net interest income plus non-interest income, was 47.92% for the year ended December 31, 2002, compared to 50.32% for the year ended December 31, 2001. The Company’s efficiency ratio has been under 53% for each of the last five years, which the Company believes is better than national peer group ratios. Effects of Inflation The principal component of earnings is net interest income, which is affected by changes in the level of interest rates. Changes in rates of inflation affect interest rates. It is difficult to precisely measure the impact of inflation on net interest income because it is not possible to accurately differentiate between increases in net interest income resulting from inflation and increases resulting from increased business activity. Inflation also raises costs of operation, primarily those of employment and services. Financial Condition Loans and Allowance for Possible Loan Loss Most of the Company’s lending activities involve commercial (domestic and foreign), consumer and real estate mortgage financing. In 2002, the Company’s efforts to increase its loan volume resulted in an increase of 14.5% in average domestic loans from $2,111,103,000 for 2001 to $2,416,259,000 in 2002 and an increase of 0.3% in average foreign loans from $247,784,000 for 2001 to $248,597,000 in 2002 for an increase of 13.0% in total average loans from $2,358,887,000 for 2001 to $2,664,856,000 in 2002. The average yield for these loans decreased 1.4% for domestic loans and decreased by 3.4% for foreign loans in 2002 as compared to 2001. The Company experienced an increase of 14% in average domestic loans from 2000 to 2001 and a .26% increase in average foreign loans from 2000 to 2001. The yield for these loans decreased 1.9% for domestic loans and decreased by 0.2% for foreign loans in 2001 as compared to 2000. 5 Loan commitments, consisting of unused commitments to lend, letters of credit, credit card lines and other approved loans, which have not been funded, were $722,453,000 at December 31, 2002. See Note 18 to the Consolidated Financial Statements. The allowance for possible loan losses increased 10.4% from $40,065,000 at December 31, 2001 to $44,213,000 at December 31, 2002 and increased 30.0% from $30,812,000 at December 31, 2000 to $40,065,000 at December 31, 2001. The provision for possible loan losses charged to expense decreased 1.0% from $8,631,000 in 2001 to $8,541,000 in 2002 and increased 26.5% from $6,824,000 in 2000 to $8,631,000 in 2001. The 2001 increase in the allowance for possible loan losses was largely due to the increase in the size of the loan portfolio and the addition of $3,995,000 in existing allowance for loan losses as part of the loan portfolio acquired in the NBC acquisition. The allowance for possible loan losses was 1.6% of total loans, net of unearned income, at December 31, 2002 compared to 1.5% at 2001 and 1.4% at 2000. Non-performing assets as a percentage of total loans and total assets were .34% and .14%, respectively, at December 31, 2002, and .43% and .18%, respectively, at December 31, 2001. Loans accounted for on a non-accrual basis decreased 52.3% from $8,252,000 at December 31, 2001 to $3,903,000 at December 31, 2002. As loans are placed on non-accrual status, interest previously accrued and recorded is reversed unless the loan is well secured and in the process of collection. Foreclosed assets increased 20.2% from $5,308,000 at December 31, 2001 to $6,381,000 at December 31, 2002. In 2001, non-accruals increased 31.5% from $6,273,000 at December 31, 2000 to $8,252,000 at December 31, 2001 and foreclosed assets increased 186.3% from $1,854,000 at December 31, 2000 to $5,308,000 at December 31, 2001. The allowance for possible loan losses consists of the aggregate loan loss allowances of the bank subsidiaries. The allowances are established through charges to operations in the form of provisions for possible loan losses. Loan losses or recoveries are charged or credited directly to the allowances. Management of each of the bank subsidiaries, along with management of the Company, continually reviews the allowances to determine whether additional provisions should be made after considering the preceding factors. The bank subsidiaries charge off that portion of any loan which management considers to represent a loss as well as that portion of any other loan which is classified as a ‘‘loss’’ by bank examiners. Commercial, financial and agricultural or real estate loans are generally considered by management to represent a loss, in whole or part, when an exposure beyond any collateral coverage is apparent and when no further collection of the portion of the loan so exposed is anticipated based on the borrower’s financial condition and general economic conditions in the borrower’s industry. Generally, unsecured consumer loans are charged off when 90 days past due. While management of the Company considers that it is generally able to identify borrowers with financial problems reasonably early and to monitor credit extended to such borrowers carefully, there is no precise method of predicting loan losses. The determination that a loan is likely to be un-collectible and that it should be wholly or partially charged off as a loss is an exercise of judgment. Similarly, the determination of the adequacy of the allowance for possible loan losses can be made only on a subjective basis. It is the judgment of the Company’s management that the allowance for possible loan losses at December 31, 2002 was adequate to absorb probable losses from loans in the portfolio at that date. See Critical Accounting Policies on page 13. Investment Securities The average balances of taxable investment securities increased 2.6% from $2,854,225,000 for 2001 to $2,927,420,000 for 2002 and decreased 2.7% for 2001 from $2,932,778,000 for 2000. Mexico On December 31, 2002, the Company had $6,495,635,000 of consolidated assets of which approxi- mately $233,277,000 or 3.6% were related to loans outstanding to borrowers domiciled in Mexico. The loan 6 policies of the Company’s bank subsidiaries generally require that loans to borrowers domiciled in Mexico be primarily secured by assets located in the United States or have credit enhancements, in the form of guarantees, from significant United States corporations. The composition of such loans and the related amounts of allocated allowance for possible loan losses as of December 31, 2002 is presented below. Amount of Loans Related Allowance for Possible Losses Secured by certificates of deposit in United States banks . . . . . . . . . . . . . . . Secured by United States real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Secured by other United States collateral (securities, gold, silver, etc.) . . . . . . Foreign real estate guaranteed under lease obligations primarily by U.S. (Dollars in Thousands) 63 383 15 $132,224 35,235 8,275 $ companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,755 Direct unsecured Mexican sovereign debt (principally former FICORCA debt) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other (principally Mexico real estate) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,293 48,495 51 — 667 $233,277 $1,179 The transactions for the year ended December 31, 2002 in that portion of the allowance for possible loan losses related to Mexican debt were as follows: Balance at December 31, 2001 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision charged to operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance at December 31, 2002 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,502 (115) 35 (80) (243) $1,179 (Dollars in Thousands) Deposits The Company offers a variety of deposit accounts having a wide range of interest rates and terms. The Company relies primarily on its high quality customer service and advertising to attract and retain these deposits. Deposits provide the primary source of funding for the Company’s lending and investment activities, and the interest paid for deposits must be managed carefully to control the level of interest expense. Deposits at December 31, 2002 were $4,239,899,000, a decrease of 2.1% over $4,332,834,000 at December 31, 2001, which represented an increase of 15.7% from $3,744,598,000 at December 31, 2000. The decrease in deposits from 2002 to 2001 is primarily attributable to the sale of the bank branches. Liquidity and Capital Resources Generally The maintenance of adequate liquidity provides the Company’s bank subsidiaries with the ability to meet potential depositor withdrawals, provide for customer credit needs, maintain adequate statutory reserve levels and take full advantage of high-yield investment opportunities as they arise. Liquidity is afforded by access to financial markets and by holding appropriate amounts of liquid assets. The bank subsidiaries of the Company derive their liquidity largely from deposits of individuals and business entities. Historically, the Mexico based deposits of the Company’s bank subsidiaries have been a stable source of funding. Deposits from persons and entities domiciled in Mexico comprise a significant and stable portion of the deposit base of the Company’s bank subsidiaries. Such deposits comprised approximately 41%, 40% 7 and 42% of the Company’s bank subsidiaries’ total deposits as of December 31, 2002, 2001 and 2000, respectively. Other important funding sources for the Company’s bank subsidiaries during 2002 and 2001 have been wholesale liabilities with the Federal Home Loan Bank (‘‘FHLB’’) and large certificates of deposit, requiring management to closely monitor its asset/liability mix in terms of both rate sensitivity and maturity distribution. Primary liquidity of the Company and its subsidiaries has been maintained by means of increased investment in shorter-term securities, certificates of deposit and loans. As in the past, the Company will continue to monitor the volatility and cost of funds in an attempt to match maturities of rate-sensitive assets and liabilities, and respond accordingly to anticipated fluctuations in interest rates over reasonable periods of time. The Company’s funds management policy has as its primary focus the measurement and management of the banks’ earnings at risk in the face of rising and falling interest rate forecasts. The earliest and most simplistic concept of earnings at risk measurement is the gap report, which is used to generate a rough estimate of the vulnerability of net interest income to changes in market rates as implied by the relative re-pricings of assets and liabilities. The gap report calculates the difference between the amounts of assets and liabilities re-pricing across a series of intervals in time, with emphasis typically placed on the one-year period. This difference, or gap, is usually expressed as a percentage of total assets. If an excess of liabilities over assets matures or re-prices within the one-year period, the balance sheet is said to be negatively gapped. This condition is sometimes interpreted to suggest that an institution is liability-sensitive, indicating that earnings would suffer from rising rates and benefit from falling rates. If a surplus of assets over liabilities occurs in the one-year time frame, the balance sheet is said to be positively gapped, suggesting a condition of asset sensitivity in which earnings would benefit from rising rates and suffer from falling rates. The gap report thus consists of an inventory of dollar amounts of assets and liabilities that have the potential to mature or re-price within a particular period. The flaw in drawing conclusions about interest rate risk from the gap report is that it takes no account of the probability that potential maturities or re-pricings of interest-rate-sensitive accounts will occur, or at what relative magnitudes. Because simplicity, rather than utility, is the only virtue of gap analysis, financial institutions increasingly have either abandoned gap analysis or accorded it a distinctly secondary role in managing their interest-rate risk exposure. See page 15 of the Company’s Form 10-K for a tabular summary of the Company’s interest rate sensitive assets and liabilities by their re-pricing dates at December 31, 2002. The detailed inventory of balance sheet items contained in gap reports is the starting point of income simulation analysis. Income simulation analysis also focuses on the variability of net interest income and net income, but without the limitations of gap analysis. In particular, the fundamental, but often unstated, assumption of the gap approach that every balance sheet item that can re-price will do so to the full extent of any movement in market interest rates is taken into consideration in income simulation analysis. Accordingly, income simulation analysis captures not only the potential of assets and liabilities to mature or re-price but also the probability that they will do so. Moreover, income simulation analysis focuses on the relative sensitivities of these balance sheet items and projects their behavior over an extended period of time in a motion picture rather than snapshot fashion. Finally, income simulation analysis permits management to assess the probable effects on balance sheet items not only of changes in market interest rates but also of proposed strategies for responding to such changes. The Company and many other institutions rely primarily upon income simulation analysis in measuring and managing exposure to interest rate risk. At December 31, 2002, based on these simulations, a rate shift of 200 basis points in interest rates either up or down will not vary earnings by more than 3 percent of projected 2003 net interest income. A 200 basis point shift in interest rates is a hypothetical rate scenario used to calibrate risk, and does not necessarily represent management’s current view of future market developments. 8 All the measurements of risk described above are made based upon the Company’s business mix and interest rate exposures at the particular point in time. The exposure changes continuously as a result of the Company’s ongoing business and its risk management initiatives. While management believes these measures provide a meaningful representation of the Company’s interest rate sensitivity, they do not necessarily take into account all business developments that have an effect on net income, such as changes in credit quality or the size and composition of the balance sheet. Principal sources of liquidity and funding for the Company are dividends from subsidiaries and borrowed funds, with such funds being used to finance the Company’s cash flow requirements. The Company closely monitors the dividend restrictions and availability from the bank subsidiaries as disclosed in Note 19 to the Consolidated Financial Statements. At December 31, 2002, the aggregate amount legally available to be distributed to the Company from bank subsidiaries as dividends was approximately $188,000,000, assuming that each bank subsidiary continues to be classified as ‘‘well capitalized’’ under the applicable regulations. The restricted capital (capital, surplus and certified surplus) of the bank subsidiar- ies was approximately $399,042,000 as of December 31, 2002. The undivided profits of the bank subsidiar- ies were approximately $251,625,000 as of December 31, 2002. As of December 31, 2002, the Company has outstanding $1,185,857,000 in other borrowed funds and long-term debt. In addition to borrowed funds and dividends, the Company has a number of other available alternatives to finance the growth of its existing banks as well as future growth and expansion. The Company maintains an adequate level of capital as a margin of safety for its depositors and shareholders. At December 31, 2002, shareholders’ equity was $547,264,000 compared to $497,028,000 at December 31, 2001, an increase of $50,236,000, or 10%. The increase in shareholders’ equity resulted from the retention of earnings and comprehensive income. Comprehensive income includes unrealized gains or losses on securities held available for sale and changes in the fair value of derivative instruments of an equity method investee, net of tax. The accumulated other comprehensive income is not included in the calculation of regulatory capital ratios. During 1990, the Federal Reserve Board (‘‘FRB’’) adopted a minimum leverage ratio of 3% for the most highly rated bank holding companies and at least 4% to 5% for all other bank holding companies. The Company’s leverage ratio (defined as shareholders’ equity plus eligible trust preferred securities issued and outstanding less goodwill and certain other intangibles divided by average quarterly assets) was 8.71% at December 31, 2002 and 6.67% at December 31, 2001. The core deposit intangibles and goodwill of $74,611,000 as of December 31, 2002, recorded in connection with financial institution acquisitions of the Company after February 1992, are deducted from the sum of core capital elements when determining the capital ratios of the Company. The FRB has adopted risk-based capital guidelines which assign risk weightings to assets and off-balance sheet items. The guidelines also define and set minimum capital requirements (risk-based capital ratios). Under the final 1992 rules, all banks are required to have Tier 1 capital of at least 4.0% of risk-weighted assets and total capital of 8.0% of risk-weighted assets. Tier 1 capital consists principally of shareholders’ equity plus trust preferred securities issued and outstanding less goodwill and certain other intangibles, while total capital consists of Tier 1 capital, certain debt instruments and a portion of the reserve for loan losses. In order to be deemed well capitalized pursuant to the regulations, an institution must have a total risk-weighted capital ratio of 10%, a Tier 1 risk-weighted ratio of 6% and a Tier 1 leverage ratio of 5%. The Company had risk-weighted Tier 1 capital ratios of 15.95% and 13.83% and risk weighted total capital ratios of 17.21% and 15.06% as of December 31, 2002 and 2001, respectively, which are well above the minimum regulatory requirements and exceed the well capitalized ratios (see note 19 to notes to Consolidated Financial Statements). During the past few years the Company has expanded its banking facilities. Among the activities and commitments the Company funded during 2002 and 2001 were certain capital expenditures relating to the 9 modernization and improvement of several existing bank facilities and the expansion of the bank branch network. Trust Preferred Securities The Company has formed six statutory business trusts under the laws of the State of Delaware, for the purpose of issuing trust preferred securities (the ‘‘Trusts’’). The Trusts have issued Capital and Common Securities and invested the proceeds in an equivalent amount thereof in Junior Subordinated Deferrable Interest Debentures (the ‘‘Debentures’’) issued by the Company. The Debentures will mature on various dates; however the Debentures may be redeemed at specified prepayment prices, in whole or in part after the specified dates, or in whole within 90 days upon the occurrence of any one of certain legal, regulatory or tax events specified in the Indenture. Through December 31, 2002, the amount of Capital Securities outstanding totaled $135,000,000. The Debentures are subordinated and junior in right of payment to all present and future senior indebtedness (as defined in the Indentures) of the Company, and are pari passu with one another. The interest rate payable on, and the payment terms of the Debentures is the same as the distribution rate and payment terms of the respective issues of Capital and Common Securities issued by the Trusts. The Company has fully and unconditionally guaranteed the obligations of each of the Trusts with respect to the Capital and Common Securities. The Company has the right, unless an Event of Default (as defined in the Indentures) has occurred and is continuing, to defer payment of interest on the Debentures for up to ten consecutive semi-annual periods. If interest payments on any of the Debentures are deferred, distributions on both the Capital and Common Securities related to that Debenture would also be deferred. The redemption prior to maturity of any of the Debentures may require the prior approval of the Federal Reserve and/or other regulatory bodies. For financial reporting purposes, the Trusts are treated as non-banking subsidiaries of the Company and consolidated in the consolidated financial statements. Although the Capital Securities issued by each of the Trusts are included as long-term debt and not as a component of shareholders’ equity on the statement of condition, the Capital Securities are treated as capital for regulatory purposes. Specifically, under applicable regulatory guidelines, the Capital Securities issued by the Trusts qualify as Tier 1 capital up to a maximum of 25% of Tier 1 capital on an aggregate basis. Any amount that exceeds the 25% threshold would qualify as Tier 2 capital. To date, all of the Capital Securities qualify as Tier 1 capital. Management of the Company believes that the treatment of the trust preferred securities as Tier 1 capital, in addition to the ability to deduct the expense of the related Debentures for federal income tax purposes, provided the Company with a cost-effective method of raising capital. The following table illustrates key information about each of the Capital Securities and their interest rate at December 31, 2002: Capital Securities Issued (in thousands) $ 10,000 $ 25,000 $ 33,000 $ 22,000 $ 20,000 $ 25,000 $135,000 Trust I . . . . Trust II . . . Trust III . . Trust IV . . Trust V . . . Trust VI . . Repricing Frequency Interest Rate Interest Rate Index Maturity Date Optional Redemption Date Fixed Semi-Annually Semi-Annually Semi-Annually Quarterly Quarterly 10.18% Fixed June 2031 5.61% LIBOR + 3.75 July 2031 5.17% LIBOR + 3.75 December 2031 December 2006 5.32% LIBOR + 3.70 April 2032 5.51% LIBOR + 3.65 July 2032 5.27% LIBOR + 3.45 November 2032 November 2007 April 2007 July 2007 June 2011 July 2006 10 Stock Repurchase Program The Company expanded its formal stock repurchase program on January 28, 2002, June 6, 2002, September 19, 2002 and November 6, 2002. Under the expanded stock repurchase program, the Company is authorized to repurchase up to $140,000,000 of its common stock through December 2003. Stock repurchases may be made from time to time, on the open market or through private transactions. Shares repurchased in this program will be held in treasury for reissue for various corporate purposes, including employee stock option plans. As of March 24, 2003, a total of 3,208,112 shares had been repurchased under this program at a cost of $127,674,000, which shares are now reflected as 4,145,394 shares of treasury stock as adjusted for stock dividends. Stock repurchases are reviewed quarterly at the Company’s Board of Directors meetings and the Board of Directors has stated that the aggregate investment in treasury stock should not exceed $160,973,000. In the past, the Board of Directors has increased previous caps on treasury stock once they were met, but there are no assurances that an increase of the $160,973,000 cap will occur in the future. As of March 24, 2003, the Company has approximately $148,737,000 invested in treasury shares, adjusted for stock dividends, which amount has been accumulated since the inception of the Company. Contractual Obligations and Commercial Commitments The following table presents contractual cash obligations of the Company (other than deposit liabilities) as of December 31, 2002 (dollars in thousands): Contractual Cash Obligations Securities sold under repurchase Payments due by Period Total Less than One Year One to Three Years Four to Five Years After Five Years Agreements . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank borrowings . . . . Trust Preferred Securities . . . . . . . . . . . . . $ 457,915 $1,050,857 $ 135,000 $ 157,915 1,050,080 125,000 $ — 690 — Total Contractual Cash Obligations . . . . $1,643,772 $1,332,995 $690 $— — — $ $300,000 87 10,000 $310,087 The following table presents contractual commercial commitments of the Company (other than deposit liabilities) as of December 31, 2002 (dollars in thousands): Commercial Commitments Financial & Performance Amount of Commitment Expiration Per Period Total Less than One Year One to Three Years Four to Five Years After Five Years Standby Letters of Credit . . . . . . . . . . . . . . Commercial Letters of Credit . . . . . . . . . . . . . Credit Card Lines . . . . . . . . . . . . . . . . . . . . . Other Commercial Commitments . . . . . . . . . . $ 59,657 $ 3,176 $ 33,290 $626,330 $ 55,871 3,176 33,290 382,692 $ 3,752 — — 243,489 $ 34 — — 3,359 $ — — — 790 Total Commercial Commitments . . . . . . . . . $722,453 $475,029 $243,241 $3,393 $790 Due to the nature of the Company’s commercial commitments, including unfunded loans commit- ments and lines of credit, the amounts presented above do not necessarily reflect the amounts the Company anticipates funding in the periods presented above. 11 Critical Accounting Policies The Company has established various accounting policies which govern the application of accounting principles in the preparation of the Company’s consolidated financial statements. The significant account- ing policies are described in the footnotes to the consolidated financial statements. Certain accounting policies involve significant judgments and assumptions by management which have a material impact on the carrying value of certain assets and liabilities; management considers such accounting policies to be critical accounting policies. The Company considers its Allowance for Possible Loan Losses policy as a policy critical to the sound operations of the Banks. See also discussion regarding the allowance for possible loan losses and provision for possible loan losses included in the results of operations and ‘‘Provision and Allowance for Possible Loan Losses’’ included in Notes 1 and 4 of the Notes to Consolidated Financial Statements for further information regarding the Company’s provision and allowance for possible loan losses policy. The allowance for possible loan losses consists of the aggregate loan loss allowances of the bank subsidiaries. The allowances are established through charges to operations in the form of provisions for possible loan losses. Loan losses or recoveries are charged or credited directly to the allowances. The allowance for possible loan losses of each bank subsidiary is maintained at a level considered appropriate by management, based on estimated probable losses in the loan portfolio. The allowance is derived from the following elements: (i) allowances established on specific loans, and (ii) allowances based on historical loss experience on the Company’s remaining loan portfolio. The specific loan loss provision is determined using the following methods. On a weekly basis, loan past due reports are reviewed by the servicing loan officer to determine if the loan has any potential problem and if the loan should be placed on the Company’s internal classified report. The Company’s credit department reviews the majority of the loans regardless of past due status and to determine if the loan should be placed on an internal classified report because of issues related to the analysis of the credit, credit documents, collateral and/or payment history. As part of its review process, the credit department will discuss the loans with the servicing loan officers to determine any relevant issues that were not discovered in the evaluation. Also, any analysis on loans that is provided through examinations by regulatory authorities is considered in the review process. The Company’s internal classified report is segregated into the following categories: (i) ‘‘Pass Credits,’’ (ii) ‘‘Special Review Credits,’’ or (iii) ‘‘Watch List Credits.’’ The loans placed in the ‘‘Pass Credits’’ category reflect the Company’s opinion that the loan conforms to the bank’s lending policies, which includes the borrower’s ability to repay, the value of the underlying collateral, if any, as it relates to the outstanding indebtedness of the loan, and the economic environment and industry in which the borrower operates. The loans placed in the ‘‘Special Review Credits’’ category reflect the Company’s opinion that the loans reflect potential weakness which required monitoring on a more frequent basis; however, the ‘‘Special Review Credits’’ are not considered to need a specific reserve at the time, but are reviewed and discussed on a regular basis with the credit department and the lending staff to determine if a change in category is warranted. The loans placed in the ‘‘Watchlist Credits’’ category reflect the Company’s opinion that the loans contain clearly pronounced credit weaknesses and/or inherent financial weaknesses of the borrower. Credits classified as ‘‘Watch List Credits’’ are evaluated under Statement of Financial Accounting Standards No. 114, ‘‘Accounting by Creditors for Impairment of a Loan,’’ criteria and, if deemed necessary a specific reserve is allocated to the credit. The specific reserve allocated under SFAS No. 114, is based on (1) the present value of expected future cash flows discounted at the loan’s effective interest rate; (2) the loan’s observable market price; or (3) the fair value of the collateral if the loan is collateral dependent. The allowances based on historical loss experience on the Company’s remaining loan portfolio is determined by segregating the remaining loan portfolio into similar categories such as commercial loans, installment loans, international loans and overdrafts. Installment loans are then further segregated by 12 number of days past due. A historical loss percentage, adjusted for management’s evaluation of changes in lending policies and procedures and current economic conditions in the market area served by the Company is applied to each category. The Company’s management continually reviews the loan loss allowance of the bank subsidiaries using the amounts determined from the allowances established on specific loans, the allowance established based on historical percentages and the loans charged off and recoveries to establish an appropriate amount to maintain in the Company’s loan loss allowance. If the basis of the Company’s assumptions change, the loan loss allowance would either decrease or increase and the Company would increase or decrease the provision for loan loss charged to operations accordingly. Recent Accounting Standards Issued In June 2001, the Financial Accounting Standards Board issued SFAS No. 141 ‘‘Business Combina- tions’’, and SFAS No. 142, ‘‘Goodwill and Other Intangible Assets.’’ SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 as well as all purchase method business combinations completed after June 30, 2001. SFAS No. 141 also specifies criteria that intangible assets acquired in a purchase method business combination must meet to be recognized and reported apart from goodwill. SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions in SFAS No. 142. SFAS No. 142 requires that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No 144, ‘‘Accounting for the Impairment or Disposal of Long-Lived Assets.’’ On July 1, 2001, the Company adopted the provisions of SFAS 141 and certain provisions of SFAS 142 as required for goodwill and intangible assets resulting from business combinations consummated after June 30, 2001. The Company acquired approximately 71% of outstanding common shares of National Bancshares Corporation of Texas on November 20, 2001 and the remaining 29% outstanding common shares on December 31, 2001. The Company recorded an identified intangible asset and goodwill of $35,126,000 related to the acquisition. Under the provisions of SFAS No. 142, the amount of goodwill acquired in the acquisition that was not amortized during 2001 was not significant. SFAS No. 141 requires upon adoption of SFAS No. 142, that the Company evaluate its existing intangible assets and goodwill that were acquired in prior purchase business combinations, and to make any necessary reclassifications in order to conform with the new classification criteria in SFAS No. 141 for recognition apart from goodwill. Upon adoption of SFAS No. 142, the Company is required to reassess the useful lives and residual values of all intangible assets acquired in purchase business combinations, and make any necessary amortization period adjustments by the end of the first interim period after adoption. In addition, to the extent an intangible asset is identified as having an indefinite useful life, the Company is required to test the intangible asset for impairment in accordance with the provisions of SFAS No. 142 within the first interim period. Any impairment loss will be measured as of the date of adoption and recognized as the cumulative effect of a change in accounting principle in the first interim period. The Company adopted the remaining provisions of SFAS No. 142 as of January 1, 2002 and no longer amortizes goodwill relating to business combinations consummated before July 1, 2001. As of the date of the adoption, the Company had unamortized goodwill in the amount of $69,639,000 and unamortized identifiable intangible assets in the amount of $21,978,000, all of which are subject to the transition provisions of SFAS No. 141 and No. 142. Amortization expense related to goodwill that will no longer be amortized was $2,846,000 and $2,092,000 for the years ended December 31, 2001 and 2000, respectively. In addition, the Company has evaluated its existing intangible assets and determined that no reclassifications were necessary to conform to the new criteria in SFAS No. 141 for recognition apart from goodwill. The Company performed a transitional assessment of whether there is an indication that goodwill is impaired. 13 The Company concluded that it is probable that its investment services reporting unit is impaired. The amount of the impairment is $5,130,000, net of tax, which is reported as a cumulative effect of a change in accounting principle, net of tax, in 2002. In August 2001, the Financial Accounting Standards Board issued SFAS No. 144, ‘‘Accounting for the Impairment or Disposal of Long-Lived Assets’’, which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. While SFAS No. 144 supercedes SFAS No. 121, ‘‘Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of,’’ it retains many of the fundamental provisions of SFAS No. 121, establishes a single accounting model for long-lived assets to be disposed of by sale, and resolves certain implementation issues not previously addressed by SFAS No. 121. SFAS No. 144 also supercedes the accounting and reporting provisions of Financial Accounting Standards Board Opinion No. 30, ‘‘Reporting the Results of Operations—Reporting the Effects of a Disposal of a Segment of a Business and Extraordinary, Unusual and Infrequently Occurring Events and Transactions’’, for the disposal of a segment of a business. However, it retains the requirement in Opinion No. 30 to report separately discontinued operations and extends the reporting to a component of an entity, rather than a segment of a business, that either has been disposed of or is classified as held for sale. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001. The Company adopted SFAS No. 144 on January 1, 2002. The adoption of SFAS No. 144 did not have an impact on the Company’s consolidated financial statements. In October 2002, the Financial Accounting Standards Board issued SFAS No. 147 ‘‘Acquisitions of Certain Financial Institutions, an amendment of FASB Statements No. 72 and 144 and FASB Interpreta- tion No. 9’’. SFAS No. 72 required that in acquisitions of financial institutions, any excess of the fair value of liabilities assumed over the fair value of tangible and intangible assets acquired be accounted for as an unidentifiable intangible asset and subsequently amortized. SFAS No. 72 unidentified intangible assets were excluded from the scope of SFAS No. 141 and SFAS No. 142. Except for transactions between two or more mutual companies, SFAS No. 147 removes acquisitions of financial institutions from the scope of SFAS No. 72 and FASB Interpretation No. 9 and requires that those transactions be accounted for in accordance with SFAS No. 141 and SFAS No. 142. SFAS No. 147 is effective October 1, 2002 and requires that if the transaction that gave rise to the unidentified intangible asset was a business combination, the carrying amount of that asset shall be reclassified to goodwill as of the later of the date of acquisition or the date of the full application of SFAS No. 142. SFAS No. 147 also requires that any interim or annual financial statements that reflect the amortization of the unidentified intangible asset subsequent to the full application of SFAS 142 shall be restated to remove that amortization expense. The Company adopted SFAS No. 147 on October 1, 2002. Upon the adoption of SFAS No. 147, the Company reclassified $10,487,000 from intangible assets to goodwill and reversed $792,000 of amortization expense recognized during 2002 related to the SFAS 72 unidentified intangible asset. In December 2002, the Financial Accounting Standards Board issue SFAS No. 148, ‘‘Accounting for Stock-Based Compensation—Transition Disclosure, an amendment of FASB Statement No. 123.’’ SFAS No. 148 amends SFAS No. 123, ‘‘Accounting for Stock-Based Compensation,’’ to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirement of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the fair value based method of accounting for stock-based employee compensation for those companies that have elected to continue to apply Accounting Principles Board Opinion No. 25 (‘‘APB 25’’), ‘‘Accounting for Stock Issued to Employees.’’ The adoption of SFAS No. 148 did not have an impact on the Company’s consolidated financial statements. In November 2002, the FASB issued FASB Interpretation No. 45 (‘‘FIN 45’’), ‘‘Guarantor’s Account- ing and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an interpretation of FASB Statements No. 5, 57 and 107 and rescission of FASB Interpretation No. 34.’’ FIN 45 elaborates on the disclosures to be made by a guarantor in its interim and annual financial 14 statements about its obligations under certain guarantees that it has issued. This Interpretation also incorporates, without change, the guidance in Financial Accounting Standards Board Interpretation No. 34 (‘‘FIN 34’’), ‘‘Disclosure of Indirect Guarantees of Indebtedness of Others,’’ which is being superceded. FIN 45 also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the obligations it has undertaken in issuing the guarantee, including its ongoing obligations to stand ready to perform over the term of the guarantee in the event that the specified triggering events or conditions occur. The initial recognition and initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year-end. The disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002 and are included in the notes to the Company’s consolidated financial statements. The adoption of FIN 45 did not have an impact on the Company’s consolidated financial statements. Common Stock and Dividends The Company had issued and outstanding 30,921,327 shares of $1.00 par value Common Stock held by approximately 2,120 holders of record at March 24, 2003. The book value of the stock, adjusted for stock dividends, at December 31, 2002 was $18.91 per share compared with $16.38 per share at December 31, 2001. The Common Stock is traded on the NASDAQ National Market under the symbol ‘‘IBOC.’’ The following table sets forth the approximate high and low bid prices in the Company’s Common Stock, adjusted for stock dividends during 2001 and 2002, as quoted on the NASDAQ National Market for each of the quarters in the two year period ended December 31, 2002. Some of the quotations reflect inter- dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions. The closing sales price of the Company’s Common Stock was $40.74 per share at March 24, 2003. 2002: First quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Second quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Third quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fourth quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $35.89 41.99 42.59 41.51 $32.93 38.00 30.25 34.35 High Low 2001: First quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Second quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Third quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fourth quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $31.80 38.78 32.80 35.84 $25.20 26.80 27.44 24.86 High Low The Company paid cash dividends to the shareholders in 2002 of $.32 per share on April 15, and $.37 per share on October 15, adjusted for stock dividends, or $22,015,000 in the aggregate. In 2001, the Company paid cash dividends of $.32 per share on April 16, and $.32 per share on October 15, adjusted for stock dividends, or $21,182,000 in the aggregate. The Company has no set schedule for paying cash or stock 15 dividends and does not guarantee that they will continue to be declared. In addition, the Company has issued stock dividends during the last five-year period as follows: Date Stock Dividend May 16, 1997 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . May 22, 1998 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . May 20, 1999 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . May 18, 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . May 17, 2001 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . May 20, 2002 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25% 25% 25% 25% 25% 25% The Company’s principal source of funds to pay cash dividends on its Common Stock is cash dividends from its bank subsidiaries. There are certain statutory limitations on the payment of dividends from the subsidiary banks. For a discussion of the limitations, please see Note 19 of notes to Consolidated Financial Statements. Recent Sales of Unregistered Securities No equity securities were sold by the Company during the fiscal year ended December 31, 2002 that were not registered under the Securities Act of 1933. Equity Compensation Plan Information The following table sets forth information as of December 31, 2002, with respect to the Company’s compensation plans: Plan Category (A) (B) (C) Number of securities to be issued upon exercise of outstanding options, warrants and rights Weighted average exercise price of outstanding options, warrants and rights Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column A) Equity Compensation plans approved by security holders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,353,295 Equity Compensation plans not approved by security holders(1) . . . . . . . . . . . . . . . . . . . . . . 187,500 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,540,795 $17.97 $20.80 $18.31 313,030 — 313,030 (1) The Company granted non-qualified stock options exercisable for a total of 187,500 shares, adjusted for stock dividends, of Common Stock to certain employees of the Gulfstar Group. The grants were not made under any of the approved Stock Option Plans. The options are exercisable for a period of seven years and vest in equal increments over a period of five years. All options granted to the Gulfstar Group employees had an option price of not less than the fair market value of the Common Stock on or about the date of grant. 16 INDEPENDENT AUDITORS’ REPORT The Board of Directors and Shareholders International Bancshares Corporation: We have audited the accompanying consolidated statements of condition of International Bancshares Corporation and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of income, comprehensive income, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2002. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by manage- ment, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of International Bancshares Corporation and subsidiaries as of Decem- ber 31, 2002 and 2001, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America. As discussed in Notes 1 and 15 to the consolidated financial statements, the Company changed its method of accounting for goodwill and other intangible assets. /s/ KPMG LLP San Antonio, Texas February 21, 2003, except as to the fifth paragraph of Note 16, which is as of March 7, 2003 17 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Consolidated Statements of Condition December 31, 2002 and 2001 (Dollars in Thousands, Except Per Share Amounts) 2002 2001 ASSETS Cash and due from banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal funds sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 141,204 13,000 $ 177,122 108,100 Total cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154,204 Time deposits with banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99 285,222 1,253 Investment securities: Held to maturity (Market value of $2,060 on December 31, 2002 and $2,085 on December 31, 2001) Available for sale (Amortized cost of $2,992,906 on December 31, 2002 and $2,889,542 on . 2,060 2,085 December 31, 2001) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,070,711 2,925,121 Total investment securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,072,771 2,927,206 Loans: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial, financial and agricultural Real estate—mortgage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate—construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less unearned discounts Loans, net of unearned discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less allowance for possible loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,595,140 507,837 276,595 160,546 233,276 2,773,394 (3,832) 2,769,562 (44,213) 1,488,196 441,296 271,026 180,652 273,038 2,654,208 (5,676) 2,648,532 (40,065) Net loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,725,349 2,608,467 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bank premises and equipment, net Accrued interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Identified intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets 185,477 35,193 203,733 7,169 67,442 44,198 190,051 33,850 197,275 21,978 69,639 46,460 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,495,635 $6,381,401 Liabilities: Deposits: LIABILITIES AND SHAREHOLDERS’ EQUITY Demand—non-interest bearing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Savings and interest bearing demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 683,966 1,262,907 2,293,026 $ 695,218 1,213,243 2,424,373 Total deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,239,899 4,332,834 Securities sold under repurchase agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other borrowed funds and long term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 457,915 1,185,857 64,700 714,675 777,296 59,568 Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,948,371 5,884,373 Shareholders’ equity: Common shares of $1.00 par value. Authorized 75,000,000 shares; issued 41,766,439 shares in 2002 and 33,214,263 shares in 2001 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated other comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less cost of shares in treasury, 10,506,298 shares in 2002 and 6,991,148 shares in 2001 . . . . . . . . . 41,766 30,821 560,613 49,957 683,157 (135,893) 33,214 27,564 490,328 18,221 569,327 (72,299) Total shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 547,264 497,028 Total liabilities and shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,495,635 $6,381,401 See accompanying notes to consolidated financial statements. 18 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Consolidated Statements of Income Years ended December 31, 2002, 2001 and 2000 (Dollars in Thousands, Except Per Share Amounts) Interest income: Loans, including fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Time deposits with banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal funds sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment securities: Taxable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tax-exempt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other Total interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense: Savings and interest bearing demand deposits . . . . . . . . . . . . . . . . . . . . . . . . . . Time deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal funds purchased and securities sold under repurchase agreements . . . . . . . . Other borrowings and Long term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for possible loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest income after provision for possible loan losses . . . . . . . . . . . . . . . Non-interest income: Service charges on deposit accounts Other service charges, commissions and fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment securities transactions, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other investments, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total non-interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-interest expense: Employee compensation and benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Occupancy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation of bank premises and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . Professional fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stationery and supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other Total non-interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before cumulative change in accounting principle . . . . . . . . . . . . . . . . . . . . Cumulative effect of a change in accounting principle, net of tax . . . . . . . . . . . . . . . 2002 2001 2000 $ 183,803 36 671 $ 199,028 162 1,142 $ 212,522 157 929 164,272 4,990 156 353,928 14,185 57,907 19,696 24,627 116,415 237,513 8,541 228,972 184,576 4,861 586 390,355 23,585 106,754 23,100 47,369 200,808 189,547 8,631 180,916 196,284 5,119 321 415,332 27,945 120,743 8,160 94,908 251,756 163,576 6,824 156,752 52,648 42,497 35,348 13,000 5,669 2,303 (2,598) 14,623 85,645 65,907 13,211 16,153 6,089 4,079 1,812 6,010 41,582 154,843 159,774 54,013 105,761 5,130 9,993 6,132 (1,010) 10,636 11,340 79,588 58,962 11,190 13,434 5,019 3,664 5,378 6,846 30,948 135,441 125,063 41,721 83,342 — 8,423 1,130 (4,248) 13,941 9,202 63,796 47,900 9,204 12,220 4,565 3,268 4,220 4,257 26,323 111,957 108,591 33,417 75,174 — Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,631 $ 83,342 $ 75,174 Basic earnings per common share: Weighted average number of shares outstanding . . . . . . . . . . . . . . . . . . . . . . . . . Income before cumulative effect of a change in accounting principle . . . . . . . . . . . . Cumulative effect of a change in accounting principle, net of tax . . . . . . . . . . . . . . 31,964,465 3.31 $ (.16) 33,076,056 2.52 $ — 33,482,444 2.25 $ — Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3.15 $ 2.52 $ 2.25 Diluted earnings per common share: Weighted average number of shares outstanding . . . . . . . . . . . . . . . . . . . . . . . . . Income before cumulative effect of a change in accounting principle . . . . . . . . . . . . Cumulative effect of a change in accounting principle, net of tax . . . . . . . . . . . . . . 32,695,278 3.23 $ (.15) 33,682,362 2.47 $ — 33,905,545 2.22 $ — Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3.08 $ 2.47 $ 2.22 See accompanying notes to consolidated financial statements. 19 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Consolidated Statements of Comprehensive Income Years ended December 31, 2002, 2001, and 2000 (Dollars in Thousands) 2002 2001 2000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,631 $ 83,342 $75,174 Other comprehensive income, net of tax: Net unrealized gains on securities available for sale arising during the year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31,809 16,648 11,902 Reclassification adjustment for gains on securities available for sale included in net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Change in fair value of equity method investee’s derivatives . . . . . . . 543 (616) 25,642 (4,906) 5,847 — Comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $132,367 $120,726 $92,923 See accompanying notes to consolidated financial statements. 20 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Consolidated Statements of Shareholders’ Equity Years ended December 31, 2002, 2001 and 2000 (in Thousands) Number Common of Shares Stock Accumulated Other Retained Comprehensive Treasury Income (Loss) Stock Surplus Earnings Total Balances at December 31, 1999 . . . . . . . Net income . . . . . . . . . . . . . . . . . . . Dividends: Shares issued . . . . . . . . . . . . . . . . Cash . . . . . . . . . . . . . . . . . . . . . . Purchase of treasury stock . . . . . . . . . Exercise of stock options . . . . . . . . . Other comprehensive income, net of tax: Net change in unrealized gains and losses on available for sale securities, net of reclassification adjustment . . . . . . . . . . . . . . . . Balances at December 31, 2000 . . . . . . . Net income . . . . . . . . . . . . . . . . . . . Dividends: Shares issued . . . . . . . . . . . . . . . . Cash . . . . . . . . . . . . . . . . . . . . . . Purchase of treasury stock . . . . . . . . . Exercise of stock options . . . . . . . . . Other comprehensive income, net of tax: Net change in unrealized gains and losses on available for sale securities, net of reclassification adjustment . . . . . . . . . . . . . . . . Change in fair value of equity method investee’s derivatives . . . . . . . . . . . . Balances at December 31, 2001 . . . . . . . Net income . . . . . . . . . . . . . . . . . . . Dividends: Shares issued . . . . . . . . . . . . . . . . Cash . . . . . . . . . . . . . . . . . . . . . . Purchase of treasury stock . . . . . . . . . Exercise of stock options . . . . . . . . . Other comprehensive income, net of tax: Net change in unrealized gains and losses on available for sale securities, net of reclassification adjustment . . . . . . . . . . . . . . . . Change in fair value of equity method investee’s derivatives . . . . . . . . . . . 21,092 $21,092 $24,050 $385,942 — 75,174 — — $(36,912) — $ (40,736) $353,436 — 75,174 5,280 — — 109 5,280 — — 109 — (5,280) — (21,040) — — — 1,883 — — — — — — — (21,040) (10,419) 1,992 (10,419) — — — — — 17,749 — 17,749 26,481 — 26,481 — 25,933 434,796 — 83,342 (19,163) — (51,155) 416,892 — 83,342 6,628 — — 105 6,628 — — 105 — (6,628) — (21,182) — — — 1,631 — — — — — — — (21,182) (21,144) 1,736 (21,144) — 33,214 — 33,214 — 27,564 490,328 — 100,631 8,331 — — 221 8,331 — — 221 — (8,331) — (22,015) — — — 3,257 42,290 (4,906) 18,221 — — — — — 32,352 (616) 42,290 (4,906) (72,299) 497,028 — 100,631 — — — (22,015) (63,594) 3,478 (63,594) — 32,352 (616) Balances at December 31, 2002 . . . . . . . 41,766 $41,766 $30,821 $560,613 $ 49,957 $(135,893) $547,264 See accompanying notes to consolidated financial statements. 21 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Consolidated Statements of Cash Flows Years ended December 31, 2002, 2001 and 2000 (Dollars in Thousands) 2002 2001 2000 $ 100,631 $ 83,342 $ 75,174 Operating activities: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to reconcile net income to net cash provided by operating activities: Impairment charges and write downs on investments . . . . . . . . . . . . . . . . . . . Provision for possible loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation of bank premises and equipment . . . . . . . . . . . . . . . . . . . . . . . Gain on sale of bank premises and equipment Depreciation and amortization of leasing assets . . . . . . . . . . . . . . . . . . . . . . . Gain on sale of branch banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accretion of investment securities discounts . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of investment securities premiums . . . . . . . . . . . . . . . . . . . . . . Gain/Loss on investment securities transactions . . . . . . . . . . . . . . . . . . . . . . . Amortization of intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity loss (earnings) from affiliates and other investments . . . . . . . . . . . . . . . Deferred tax expense (benefit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (Increase) decrease in accrued interest receivable . . . . . . . . . . . . . . . . . . . . . Net (increase) decrease in other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net (decrease) in other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,393 8,541 16,153 (2,129) 2,694 (3,087) (4,046) 16,909 (2,303) 1,812 4,531 (655) (1,537) (897) (11,254) — 8,631 13,434 (13) 3,069 — (9,213) 9,579 1,010 5,378 (7,666) 2,788 8,402 (12,098) (1,227) Net cash provided by operating activities . . . . . . . . . . . . . . . . . . . . . . . . . 134,756 105,416 Investing activities: Proceeds from maturities of securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from sales of available for sale securities . . . . . . . . . . . . . . . . . . . . . . Purchases of available for sale securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Principal collected on mortgage-backed securities . . . . . . . . . . . . . . . . . . . . . . . Proceeds from matured time deposits with banks . . . . . . . . . . . . . . . . . . . . . . . Purchases of time deposits with banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net increase in loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchases of other investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Distributions from other investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchases of bank premises and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from sales of bank premises and equipment . . . . . . . . . . . . . . . . . . . . Cash paid in excess of net assets acquired . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash acquired in purchase transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash disposed in sale transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,330 330,152 (1,749,496) 1,300,115 1,253 (99) (161,450) (11,166) 5,275 (15,056) 3,371 — — (44,010) 2,060 568,058 (1,284,871) 1,051,520 2,669 (594) (128,412) (3,544) 1,609 (29,661) 119 (41,415) 73,881 — Net cash provided by (used in) investing activities . . . . . . . . . . . . . . . . . . . . . (335,781) 211,419 — 6,824 12,222 (171) 1,747 — (18,397) 10,313 4,248 4,220 (7,647) 7,593 (5,332) 3,014 (788) 93,020 1,573 163,085 (578,602) 353,699 1,184 (1,778) (342,537) (12,797) 5,943 (22,676) 446 (16,202) — — (448,662) Financing activities: Net (decrease) increase in non-interest bearing demand deposits . . . . . . . . . . . . . Net increase (decrease) in savings and interest bearing demand deposits . . . . . . . . Net (decrease) increase in time deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net (decrease) increase in securities sold under repurchase agreements . . . . . . . . . Proceeds from issuance of other borrowed funds and long term debt . . . . . . . . . . . Principal payments on other borrowed funds . . . . . . . . . . . . . . . . . . . . . . . . . . Purchase of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from stock transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Payments of cash dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Payments of cash dividends in lieu of fractional shares . . . . . . . . . . . . . . . . . . . . (11,272) 107,068 (95,459) (256,760) 2,055,329 (1,646,768) (63,594) 3,478 (21,984) (31) 27,109 83,701 (57,324) 484,567 1,825,296 (2,480,500) (21,144) 1,736 (21,158) (24) Net cash provided by (used in) financing activities . . . . . . . . . . . . . . . . . . . . . 70,007 (157,741) (Decrease) increase in cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . Cash and cash equivalents at beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . (131,018) 285,222 Cash and cash equivalents at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 154,204 Supplemental cash flow information: Interest paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income taxes paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 123,963 51,759 159,094 126,128 285,222 209,384 35,993 $ $ 74,312 (14,561) 157,635 106,356 2,365,500 (2,313,000) (10,419) 1,992 (21,016) (24) 346,775 (8,867) 134,995 126,128 247,698 26,520 $ $ See accompanying notes to consolidated financial statements. 22 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (1) Summary of Significant Accounting Policies The accounting and reporting policies of International Bancshares Corporation (‘‘Corporation’’) and Subsidiaries (the Corporation and Subsidiaries collectively referred to herein as the ‘‘Company’’) conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry. The following is a description of the more significant of those policies. Consolidation and Basis of Presentation The consolidated financial statements include the accounts of the Corporation and its wholly-owned bank subsidiaries, International Bank of Commerce, Laredo (‘‘IBC’’), Commerce Bank, International Bank of Commerce, Zapata, International Bank of Commerce, Brownsville, and the Corporation’s wholly- owned non-bank subsidiaries, IBC Subsidiary Corporation, IBC Life Insurance Company, IBC Trading Company and IBC Capital Corporation, International Bancshares Capital Trust I, International Banc- shares Capital Trust II, International Bancshares Capital Trust III, International Bancshares Capital Trust IV, International Bancshares Capital Trust V, International Bancshares Capital Trust VI and NBC Acquisitions Corp. All significant inter-company balances and transactions have been eliminated in consolidation. The Company, through its subsidiaries, is primarily engaged in the business of banking, including the acceptance of checking and savings deposits and the making of commercial, real estate, personal, home improvement, automobile and other installment and term loans. The primary markets of the Company are South and Southeast Texas. Each bank subsidiary is very active in facilitating international trade along the United States border with Mexico and elsewhere. Although the Company’s loan portfolio is diversified, the ability of the Company’s debtors to honor their contracts is primarily dependent upon the economic conditions in the Company’s trade area. In addition, the investment portfolio is directly impacted by fluctuations in market interest rates. The Company and its bank subsidiaries are subject to the regulations of certain Federal agencies as well as the Texas Department of Banking and undergo periodic examinations by those regulatory authorities. Such agencies may require certain standards or impose certain limitations based on their judgments or changes in law and regulations. The preparation of the consolidated financial statements in conformity with accounting policies generally accepted in the United States of America requires management to make estimates and assump- tions that affect the reported amounts of assets and liabilities as of the dates of the statement of condition and income and expenses for the periods. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant changes in the near-term relate to the determination of the allowance for possible loan losses. Per Share Data All share and per share information has been restated giving retroactive effect to stock dividends distributed. Investment Securities The Company classifies debt and equity securities into one of these categories: held-to-maturity, available-for-sale, or trading. Such classifications are reassessed for appropriate classification at each reporting date. Securities classified as ‘‘held-to-maturity’’ are carried at amortized cost for financial statement reporting, while securities classified as ‘‘available-for-sale’’ and ‘‘trading’’ are carried at their fair value. Unrealized holding gains and losses are included in net income for those securities classified as 23 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (1) Summary of Significant Accounting Policies (Continued) ‘‘trading’’, while unrealized holding gains and losses related to those securities classified as ‘‘avail- able-for-sale’’ are excluded from net income and reported net of tax as other comprehensive income and in shareholders’ equity as accumulated other comprehensive income until realized. The Company did not maintain any trading securities during the three year period ended December 31, 2002. Mortgage-backed securities held at December 31, 2002 and 2001 represent participating interests in pools of long-term first mortgage loans originated and serviced by the issuers of the securities. Premiums and discounts are amortized using the straight-line method over the contractual maturity of the loans adjusted for anticipated prepayments. Income recognized under the straight-line method is not materially different from income that would be recognized under the level yield or ‘‘interest method’’. Mortgage- backed securities are either issued or guaranteed by the U.S. Government or its agencies. Market interest rate fluctuations can affect the prepayment speed of principal and the yield on the security. Unearned Discounts Consumer loans are frequently made on a discount basis. The amount of the discount is subsequently included in interest income ratably over the term of the related loans to approximate the effective interest method. Provision and Allowance for Possible Loan Losses The allowance for possible loan losses is maintained at a level considered adequate by management to provide for probable loan losses. The allowance is increased by provisions charged to operating expense and reduced by net charge-offs. The provision for possible loan losses is the amount, which, in the judgment of management, is necessary to establish the allowance for probable loan losses at a level that is adequate to absorb known and inherent risks in the loan portfolio. Management believes that the allowance for possible loan losses is adequate. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s bank subsidiaries allowances for possible loan losses. Such agencies may require the Company’s bank subsidiaries to recognize additions or reductions to their allowances based on their judgments of information available to them at the time of their examination. Non-Accrual Loans The non-accrual loan policy of the Company’s bank subsidiaries is to discontinue the accrual of interest on loans when management determines that it is probable that future interest accruals will be un-collectible. Interest income on non-accrual loans is recognized only to the extent payments are received or when, in management’s opinion, the creditor’s financial condition warrants reestablishment of interest accruals. Other Real Estate Owned Other real estate owned is comprised of real estate acquired by foreclosure and deeds in lieu of foreclosure. Other real estate is carried at the lower of the recorded investment in the property or its fair value less estimated costs to sell such property (as determined by independent appraisal). Prior to 24 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (1) Summary of Significant Accounting Policies (Continued) foreclosure, the value of the underlying loan is written down to the fair value of the real estate to be acquired by a charge to the allowance for loan possible losses, if necessary. Any subsequent write-downs are charged against other non-interest expense. Operating expenses of such properties and gains and losses on their disposition are included in other non-interest expense. Bank Premises and Equipment Bank premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed on straight-line and accelerated methods over the estimated useful lives of the assets. Repairs and maintenance are charged to operations as incurred and expenditures for renewals and betterments are capitalized. Income Taxes Deferred income tax assets and liabilities are determined using the asset and liability method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the differences between the book and tax basis of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws. The Company files a consolidated federal income tax return with its subsidiaries. Stock Options In December 2002, the Financial Accounting Standards Board (‘‘FASB’’) issued Statement of Finan- cial Accounting Standards No. 148 (‘‘SFAS No. 148’’), ‘‘Accounting for Stock-Based Compensation— Transition and Disclosure, an amendment of FASB Statement No. 123.’’ SFAS No. 148 amends SFAS No. 123, ‘‘Accounting for Stock-Based Compensation,’’ to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirement of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the fair value based method of accounting for stock-based employee compensation for those companies that have elected to continue to apply Accounting Principles Board Opinion No. 25 (‘‘APB 25’’), ‘‘Accounting for Stock Issued to Employ- ees.’’ The adoption of SFAS No. 148 did not have an impact on the Company’s consolidated financial statements. At December 31, 2002, the Company had one stock-based employee compensation plan, which is described more fully in Note 14. The Company accounts for the plan under the recognition and measurement principles of APB 25 and related interpretations. No stock-based employee cost is reflected in net income, as all options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and 25 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (1) Summary of Significant Accounting Policies (Continued) earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock based employee compensation. Years Ended December 31, 2002 2001 2000 Net income, as reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deduct: Total stock-based compensation expense determined under fair value based method for all awards, net of tax related tax effects . . . . . (Dollars in Thousands, except per share data) $83,342 $100,631 $75,174 (1,535) (1,814) (2,029) Pro forma net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 99,096 $81,528 $73,145 Earnings per share: Basic earnings As reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Pro forma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted earnings As reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Pro forma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ 3.15 3.10 3.08 3.03 $ $ 2.52 2.46 2.47 2.42 $ $ 2.25 2.18 2.22 2.16 Net Income Per Share Basic Earnings Per Share (‘‘EPS’’) is calculated by dividing net income by the weighted average number of common shares outstanding. The computation of diluted EPS assumes the issuance of common shares for all dilutive potential common shares outstanding during the reporting period. The dilutive effect of stock options is considered in earnings per share calculations if dilutive, using the treasury stock method. Goodwill and Intangible Assets Goodwill represents the excess of the purchase price over the estimated fair value of identifiable net assets associated with acquisition transactions. Through 2001, the Company amortized goodwill related to acquisitions prior to July 1, 2001 on a straight-line basis over 15 years and identifiable intangibles on a straight-line basis over their estimated periods of benefit. In addition, the Company reviewed its intangible assets periodically for other-than-temporary impairments. If such impairments were indicated, recover- ability of the asset was assessed based on expected undiscounted net cash flows. In June 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (‘‘SFAS’’) No. 141 (‘‘SFAS No. 141’’), ‘‘Business Combinations’’, and SFAS No. 142 (‘‘SFAS No. 142’’), ‘‘Goodwill and Other Intangible Assets.’’ SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 as well as all purchase method business combinations completed after June 30, 2001. SFAS No. 141 also specifies criteria that intangible assets acquired in a purchase method business combination must meet to be recognized and reported apart from goodwill. SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions in SFAS No. 142. SFAS No. 142 requires that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for 26 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (1) Summary of Significant Accounting Policies (Continued) impairment in accordance with SFAS No 144, ‘‘Accounting for the Impairment or Disposal of Long-Lived Assets’’. On July 1, 2001, the Company adopted the provisions of SFAS 141 and certain provisions of SFAS 142 as required for goodwill and intangible assets resulting from business combinations consummated after June 30, 2001. The Company adopted the remaining provisions of SFAS No. 142 as of January 1, 2002. See Note 15 for the effects of the adoption of SFAS No. 142. In October 2002, the Financial Accounting Standards Board issued SFAS No. 147 (‘‘SFAS No. 147’’) ‘‘Acquisitions of Certain Financial Institutions, an amendment of FASB Statements No 72 and 144 and FASB Interpretation No. 9’’. SFAS No. 72 required that in acquisitions of financial institutions, any excess of the fair value of liabilities assumed over the fair value of tangible and intangible assets acquired be accounted for as an unidentifiable intangible asset and subsequently amortized. SFAS No. 72 unidentified intangible assets were excluded from the scope of SFAS No. 141 and SFAS No. 142. Except for transactions between two or more mutual companies, SFAS No. 147 removes acquisitions of financial institutions from the scope of SFAS No. 72 and FASB Interpretation No. 9 and requires that those transactions be accounted for in accordance with SFAS No. 141 and SFAS No. 142. SFAS No. 147 is effective October 1, 2002 and requires that if the transaction that gave rise to the unidentified intangible asset was a business combination, the carrying amount of that asset shall be reclassified to goodwill as of the later of the date of acquisition or the date of the full application of SFAS No. 142. SFAS No. 147 also requires that any interim or annual financial statements that reflect the amortization of the unidentified intangible asset subsequent to the full application of SFAS 142 shall be restated to remove that amortization expense. The Company adopted SFAS No. 147 as of October 1, 2002. Upon the adoption of SFAS No. 147, the Company reclassified $10,487,000 from intangible assets to goodwill and reversed $792,000 of amortization expense recognized during 2002 related to the SFAS 72 unidentified intangible asset. Impairment of Long-Lived Assets In August 2001, the FASB issued SFAS No. 144, ‘‘Accounting for the Impairment or Disposal of Long-Lived Assets,’’ which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. While SFAS No. 144 supercedes SFAS No. 121, ‘‘Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of,’’ it retains many of the fundamental provisions of SFAS No 121, establishes a single accounting model for long-lived assets to be disposed of by sale, and resolves certain implementation issues not previously addressed by SFAS No. 121. SFAS No. 144 also supercedes the accounting and reporting provisions of Financial Accounting Standards Board Opinion No. 30, (‘‘Opinion No. 30’’) ‘‘Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions,’’ for the disposal of a segment of a business; however, it retains the requirement in Opinion No. 30 to report separately discontinued operations and extends the reporting to a component of an entity, rather than a segment of a business, that either has been disposed of or is classified as held for sale. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001. The Company adopted SFAS No. 144 on January 1, 2002. The adoption of SFAS No. 144 did not have an impact on the Company’s consolidated financial statements. 27 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (1) Summary of Significant Accounting Policies (Continued) Consolidated Statements of Cash Flows For purposes of the consolidated statements of cash flows, the Company considers all short-term investments with a maturity at date of purchase of three months or less to be cash equivalents. Also, the Company reports transactions related to deposits with other financial institutions, customer time deposits and loans to customers on a net basis. Accounting for Transfers and Servicing of Financial Assets The Company accounts for transfers and servicing of financial assets and extinguishments of liabilities based on the application of a financial-components approach that focuses on control. After a transfer of financial assets, the Company recognizes the financial and servicing assets it controls and liabilities it has incurred, derecognizes financial assets when control has been surrendered and derecognizes liabilities when extinguished. Segments of an Enterprise and Related Information The Company applies the provisions of SFAS No. 131, ‘‘Disclosures about Segments of an Enterprise and Related Information,’’ in determining its reportable segments and related disclosures. Management of the Company believes that it does not have separate reportable operating segments under the provisions of SFAS No. 131. The Company’s non-banking operations do not meet the threshold for reporting as separate segments. Derivative Instruments The Company currently does not directly engage in hedging activities and does not directly hold any derivative instruments or embedded derivatives. However, the Company’s equity method investee, Aircraft Finance Trust (‘‘AFT’’), uses derivative instruments to manage the interest rate on the bonds that AFT has issued. The derivative instruments qualify as cash flow hedges under the provisions of SFAS 133, ‘‘Accounting for Derivative Instruments and Hedging Activities’’ and as such, the Company’s proportionate share of changes in fair value of the derivative instruments are included in comprehensive income and accumulated other comprehensive income, net of tax. The Company adopted SFAS No. 133 on January 1, 2001 and the adoption did not have a significant impact on its consolidated financial statements. Guarantor’s Accounting and Disclosure Requirements for Guarantees In November 2002, the FASB issued FASB Interpretation No. 45 (‘‘FIN 45’’), ‘‘Guarantor’s Account- ing and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an interpretation of FASB Statements No. 5, 57 and 107 and rescission of FASB Interpretation No. 34.’’ FIN 45 elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. This Interpretation also incorporates, without change, the guidance in Financial Accounting Standards Board Interpretation No. 34 (‘‘FIN 34’’), ‘‘Disclosure of Indirect Guarantees of Indebtedness of Others,’’ which is being superceded. FIN 45 also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the obligations it has undertaken in issuing the guarantee, including its ongoing obligations to stand ready to perform over the term of the guarantee in the event that the specified triggering events or conditions occur. The initial recognition and initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal 28 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (1) Summary of Significant Accounting Policies (Continued) year-end. The disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002, and are included in the notes to the Company’s consolidated financial statements. The adoption of FIN 45 did not have an impact on the Company’s consolidated financial statements. Reclassifications Certain amounts in the prior year’s presentations have been reclassified to conform to the current presentation. These reclassifications have no effect on previously reported net income. (2) Acquisitions Effective December 31, 2001, the Company completed its acquisition of National Bancshares Corpo- ration of Texas. The acquisition was effected through a tender offer by the Company’s subsidiary, NBC Acquisitions Corp. (‘‘NBC Acquisition’’), for all the outstanding shares of National Bancshares Corpora- tion of Texas, (‘‘NBC’’), followed by the merger of NBC Acquisitions with and into NBC. Additionally, on December 31, 2001, NBC’s subsidiary commercial bank, NBC Bank, N.A. (‘‘NBC Bank’’), was merged with and into the Company’s lead bank, IBC, and the three former NBC Bank branches located in Laredo, Texas were transferred to another subsidiary bank, Commerce Bank, Laredo, Texas. The acquisition of NBC was accounted for as a purchase under the provisions of SFAS No. 141. The purchase price for the outstanding common shares of NBC in the tender offer and the merger was $24.75 per common share, and the total consideration paid to NBC shareholders was $93,681,000 (exclusive of amounts paid to option holders). The following table summarizes the estimated fair value of the assets acquired and liabilities assumed at the date of the acquisition, in thousands. Cash and due from banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other intangible asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 73,881 222,445 278,200 24,192 10,934 26,079 Total assets acquired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 635,731 Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total liabilities assumed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (531,461) (10,589) (542,050) Net assets acquired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 93,681 The intangible asset is core deposit premium and has a useful life of approximately 10 years. Goodwill and the other intangible asset in the amount of approximately $35,126,000 are deductible for tax purposes. The amount of goodwill that was not amortized under the provisions of SFAS No. 142 for the year ended December 31, 2001 was not significant. 29 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (2) Acquisitions (Continued) The following unaudited pro forma financial information is presented to show the impact on the Company’s results of operations assuming that the NBC acquisition was consummated on January 1, 2001. Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for possible loan losses . . . . . . . . . . . . . . . . . . . . . . . Non-interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . For the year ended December 31, 2001 (Dollars in Thousands, except Per Share Data) (Unaudited) $430,161 216,396 213,765 9,546 81,967 161,380 124,806 41,942 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 82,864 Per common share: Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ 2.50 2.45 Effective April 1, 2001, IBC through its insurance agency subsidiary, acquired the assets of Grove Agency Insurance, Inc., of Corpus Christi, Texas. The acquisition was accounted for as a purchase transaction. In connection with the acquisition, IBC recorded goodwill totaling $1,575,000. Effective February 16, 2001, IBC acquired the assets of First Equity Corporation, an Austin-based mortgage banker. The acquisition was accounted for as a purchase transaction. In connection with the acquisition, IBC recorded goodwill totaling $4,864,000. Effective October 2, 2000, the Company purchased a controlling interest in the GulfStar Group, a Houston-based investment banking firm serving middle-market corporations primarily in Texas. The acquisition was accounted for as a purchase transaction. In connection with the acquisition, the Company recorded goodwill totaling $13,199,000. During 2000, IBC established an insurance agency subsidiary and acquired the assets of two insurance agencies in Texas. The acquisitions were accounted for as purchase transactions. In connection with the acquisitions, IBC recorded goodwill totaling $3,003,000. 30 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (3) Investment Securities The amortized cost and estimated fair value by type of investment security at December 31, 2002 are as follows: Held to Maturity Amortized cost Gross Gross unrealized unrealized gains losses Estimated fair value Carrying value (Dollars in Thousands) Other securities . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,060 $ — $ — $ 2,060 $ Total investment securities . . . . . . . . . . . . . . . . . $ 2,060 $ — $ — $ 2,060 $ 2,060 2,060 Available for Sale Amortized cost Gross Gross unrealized unrealized gains losses Estimated fair value Carrying value U.S. Treasury securities . . . . . . . . . . . . . . . . . . . $ Mortgage-backed securities . . . . . . . . . . . . . . . . Obligations of states and political subdivisions . . . Other securities . . . . . . . . . . . . . . . . . . . . . . . . . Equity securities . . . . . . . . . . . . . . . . . . . . . . . . 12,344 $ 2,820,538 105,489 47,125 7,410 12,589 $ (Dollars in Thousands) $ — $ 245 74,908 827 2,250 647 (108) 2,895,338 105,952 (364) 48,775 (600) 8,057 — 12,589 2,895,338 105,952 48,775 8,057 Total investment securities . . . . . . . . . . . . . . . . . $2,992,906 $78,877 $(1,072) $3,070,711 $3,070,711 The amortized cost and estimated fair value of investment securities at December 31, 2002, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to prepay obligations with or without prepayment penalties. Held to Maturity Available for Sale Amortized cost Estimated fair value Amortized cost Estimated fair value Due in one year or less . . . . . . . . . . . . . . . . . . . . . . . . Due after one year through five years . . . . . . . . . . . . . Due after five years through ten years . . . . . . . . . . . . . Due after ten years . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage-backed securities . . . . . . . . . . . . . . . . . . . . . Equity securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 225 1,735 100 — — — (Dollars in Thousands) 1,509 $ 973 — 162,476 2,820,538 7,410 $ 225 1,735 100 — — — $ 1,509 984 — 164,823 2,895,338 8,057 Total investment securities . . . . . . . . . . . . . . . . . . . . . . $2,060 $2,060 $2,992,906 $3,070,711 31 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (3) Investment Securities (Continued) The amortized cost and estimated fair value by type of investment security at December 31, 2001 are as follows: Held to Maturity Amortized cost Gross Gross unrealized unrealized gains losses Estimated fair value Carrying value (Dollars in Thousands) Other securities . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,085 $ — $ — $ 2,085 $ Total investment securities . . . . . . . . . . . . . . . . . $ 2,085 $ — $ — $ 2,085 $ 2,085 2,085 Available for Sale Amortized cost Gross Gross unrealized unrealized gains losses Estimated fair value Carrying value U.S. Treasury securities . . . . . . . . . . . . . . . . . . . $ 151,645 $ Mortgage-backed securities . . . . . . . . . . . . . . . . Obligations of states and political subdivisions . . . Other securities . . . . . . . . . . . . . . . . . . . . . . . . . Equity securities . . . . . . . . . . . . . . . . . . . . . . . . 2,613,236 92,219 27,859 4,583 (Dollars in Thousands) 48 43,381 42 1,121 95 $(3,552) $ 148,141 $ 148,141 2,655,417 89,486 27,467 4,610 (1,200) 2,655,417 89,486 (2,775) 27,467 (1,513) 4,610 (68) Total investment securities . . . . . . . . . . . . . . . . . $2,889,542 $44,687 $(9,108) $2,925,121 $2,925,121 Mortgage-backed securities are primarily securities issued by the Federal Home Loan Mortgage Corporation (‘‘Freddie Mac’’), the Federal National Mortgage Association (‘‘Fannie Mae’’), and the Government National Mortgage Association (‘‘Gennie Mae’’). The amortized cost and fair value of available for sale investment securities pledged to qualify for fiduciary powers, to secure public monies as required by law, repurchase agreements and short-term fixed borrowings was $1,439,122,000 and $1,486,472,000, respectively, at December 31, 2002. Proceeds from the sale of securities available-for-sale were $330,152,000, $568,058,000 and $163,085,000 during 2002, 2001 and 2000, respectively. Gross gains of $2,396,000, $5,693,000 and $434,000 and gross losses of $93,000, $6,703,000 and $4,682,000 were realized on the sales in 2002, 2001 and 2000, respectively. 32 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (4) Allowance for Possible Loan Losses A summary of the transactions in the allowance for possible loan losses for the years ended December 31, 2002, 2001 and 2000 is as follows: 2002 2001 2000 Balance at December 31, 2001 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (Dollars in Thousands) $30,812 $40,065 $26,770 Losses charged to allowance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Recoveries credited to allowance . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net losses charged to allowance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision charged to operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Acquired (disposed)in purchase or sale transactions . . . . . . . . . . . . . . (5,257) 1,329 (3,928) 8,541 (465) (4,269) 936 (3,333) 8,631 3,955 (3,682) 900 (2,782) 6,824 — Balance at December 31, 2002 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $44,213 $40,065 $30,812 Loans accounted for on a non-accrual basis at December 31, 2002, 2001 and 2000 amounted to $3,903,000, $8,252,000 and $6,273,000, respectively. The effect of such non-accrual loans reduced interest income by $567,000, $695,000 and $842,000 for the years ended December 31, 2002, 2001 and 2000, respectively. Amounts received on non-accruals are applied, for financial accounting purposes, first to principal and then to interest after all principal has been collected. Impaired loans are those loans where it is probable that all amounts due according to contractual terms of the loan agreement will not be collected. The Company has identified these loans through its normal loan review procedures. Impaired loans are measured based on (1) the present value of expected future cash flows discounted at the loan’s effective interest rate; (2) the loan’s observable market price; or (3) the fair value of the collateral if the loan is collateral dependent. Substantially all of the Company’s impaired loans are measured at the fair value of the collateral. In limited cases the Company may use other methods to determine the level of impairment of a loan if such loan is not collateral dependent. Impaired loans were $3,428,000 at December 31, 2002, $4,958,000 at December 31, 2001 and $5,226,000 at December 31, 2000. The average recorded investment in impaired loans during 2002, 2001, and 2000 was $4,289,000, $5,997,000 and $6,064,000, respectively. The total allowance for possible loan losses related to these loans was $266,000, $515,000 and $1,772,000 at December 31, 2002, 2001 and 2000, respectively. Interest income on impaired loans of $112,000, $412,000 and $279,000 was recognized for cash payments received in 2002, 2001 and 2000, respectively. Management of the Company recognizes the risks associated with these impaired loans. However, management’s decision to place loans in this category does not necessarily mean that losses will occur. The bank subsidiaries charge off that portion of any loan which management considers to represent a loss as well as that portion of any other loan which is classified as a ‘‘loss’’ by bank examiners. Commercial and industrial or real estate loans are generally considered by management to represent a loss, in whole or part, when an exposure beyond any collateral coverage is apparent and when no further collection of the loss portion is anticipated based on the borrower’s financial condition and general economic conditions in the borrower’s industry. Generally, unsecured consumer loans are charged-off when 90 days past due. While management of the Company considers that it is generally able to identify borrowers with financial problems reasonably early and to monitor credit extended to such borrowers carefully, there is no precise method of predicting loan losses. The determination that a loan is likely to be un-collectible and 33 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (4) Allowance for Possible Loan Losses (Continued) that it should be wholly or partially charged-off as a loss is an exercise of judgment. Similarly, the determination of the adequacy of the allowance for possible loan losses can be made only on a subjective basis. It is the judgment of the Company’s management that the allowance for possible loan losses at December 31, 2002 was adequate to absorb probable losses from loans in the portfolio at that date. (5) Bank Premises and Equipment A summary of bank premises and equipment, by asset classification, at December 31, 2002 and 2001 were as follows: Bank buildings and improvements . . . . . . . . . . . . . . . . . . . . . . . . Furniture, equipment and vehicles . . . . . . . . . . . . . . . . . . . . . . . . Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate held for future expansion: Land, building, furniture, fixture and equipment . . . . . . . . . . . . Less: accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . Bank premises and equipment, net . . . . . . . . . . . . . . . . . . . . Estimated useful lives 5 - 40 years 1 - 20 years 7 - 27 years 2002 2001 (Dollars in Thousands) $141,661 $146,670 103,752 109,679 36,042 34,750 1,072 (106,694) 1,123 (92,527) $185,477 $190,051 34 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (6) Deposits Deposits as of December 31, 2002 and 2001 and related interest expense for the years ended December 31, 2002, 2001 and 2000 were as follows: 2002 2001 (Dollars in Thousands) Deposits: Demand—non-interest bearing Domestic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 613,215 70,751 $ 627,135 68,083 Total demand non-interest bearing . . . . . . . . . . . . . . . . . 683,966 695,218 Savings and interest bearing demand Domestic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 962,019 300,888 930,861 282,382 Total savings and interest bearing demand . . . . . . . . . . . 1,262,907 1,213,243 Time, certificates of deposit $100,000 or more Domestic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,622 1,010,610 519,819 1,024,136 Less than $100,000 Domestic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 437,514 344,280 519,480 360,938 Total time, certificates of deposit . . . . . . . . . . . . . . . . . . 2,293,026 2,424,373 Total deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,239,899 $4,332,834 2002 2001 2000 (Dollars in Thousands) Interest Expense: Savings and interest bearing demand Domestic . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,320 2,865 $ 18,636 4,949 $ 21,756 6,189 Total savings and interest bearing demand . . . . . . 14,185 23,585 27,945 Time, certificates of deposit $100,000 or more . . . Domestic . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less than $100,000 Domestic . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total time, certificates of deposit . . . . . . . . . . . . . 13,442 24,743 12,652 7,070 57,907 25,609 46,447 21,402 13,296 28,359 51,675 24,756 15,953 106,754 120,743 Total interest expense on deposits . . . . . . . . . . . . $72,092 $130,339 $148,688 35 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (7) Securities Sold Under Repurchase Agreements The Company’s bank subsidiaries have entered into repurchase agreements with Salomon Brothers and individual customers of the bank subsidiaries. The purchasers have agreed to resell to the bank subsidiaries identical securities upon the maturities of the agreements. Securities sold under repurchase agreements were mortgage-backed book entry securities and averaged $498,869,000, $478,875,000 and $145,096,000 during 2002, 2001 and 2000, respectively, and the maximum amount outstanding at any month end during 2002, 2001 and 2000 was $684,839,000, $769,262,000 and $231,663,000, respectively. Further information related to repurchase agreements at December 31, 2002 and 2001 is set forth in the following table: Collateral Securities Repurchase Borrowing Book Value of Securities Sold Fair Value of Securities Sold Balance of Weighted Average Liability Interest Rate (Dollars in Thousands) December 31, 2002 Term: Overnight agreements . . . . . . . . . . . . . . . . 1 to 29 days . . . . . . . . . . . . . . . . . . . . . . . 30 to 90 days . . . . . . . . . . . . . . . . . . . . . . . Over 90 days . . . . . . . . . . . . . . . . . . . . . . . $ 70,384 23,154 60,637 430,715 $ 72,362 23,602 62,121 449,013 $ 28,990 18,223 46,327 364,375 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $584,890 $607,098 $457,915 December 31, 2001 Term: Overnight agreements . . . . . . . . . . . . . . . . 1 to 29 days . . . . . . . . . . . . . . . . . . . . . . . 30 to 90 days . . . . . . . . . . . . . . . . . . . . . . . Over 90 days . . . . . . . . . . . . . . . . . . . . . . . $272,657 45,282 84,606 354,064 $272,401 45,810 86,133 358,740 $274,946 31,594 59,874 348,261 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $756,609 $763,084 $714,675 1.18% 2.03% 2.05% 4.66% 3.99% 1.76% 3.74% 3.22% 4.90% 2.83% The book value and fair value of securities sold includes the entire book value and fair value of securities partially or fully pledged under repurchase agreements. (8) Other Borrowed Funds and Long Term Debt Other borrowed funds and long-term debt as of December 31, 2002 and 2001 were as follows: Federal Home Loan Bank borrowings . . . . . . . . . . . . . . . . . Capital Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,050,857 135,000 $709,296 68,000 Total other borrowings and long term debt . . . . . . . . . . . . . . $1,185,857 $777,296 2002 2001 (Dollars in Thousands) Federal Home Loan Bank borrowings are short term fixed borrowings issued by the Federal Home Loan Bank of Dallas at the market price offered at the time of funding. These borrowings are secured by mortgage-backed investment securities. The weighted average interest rate on the short-term fixed borrowings outstanding at December 31, 2002 and 2001 was 1.80% and 1.96%, respectively, and the 36 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (8) Other Borrowed Funds and Long Term Debt (Continued) weighted average interest rate for the year 2002 and 2001 was 1.96% and 2.06%, respectively. The average daily balance on short-term fixed borrowings was $747,772,000 and $1,337,947,000 during 2002 and 2001, respectively, and the maximum amount outstanding at any month end during 2002 and 2001 was $1,020,000,000 and $1,605,000,000, respectively. Beginning in March 2001, the Company began issuing debt in the form of Capital Securities. The Capital Securities are subordinated and junior in right of payment to all present and future senior indebtedness of the Company, and are pari passu with one another. The Company has fully and unconditionally guaranteed the obligations of each of the Trusts issuing the Capital Securities. The Company has the right, unless an Event of Default has occurred and is continuing, to defer payment of interest on the Capital Securities for up to ten consecutive semi-annual periods. The redemption prior to maturity of any of the Capital Securities may require the prior approval of the Federal Reserve and/or other regulatory bodies The following table illustrates key information about each of the Capital Securities and their interest rate at December 31, 2002: Capital Securities Issued Repricing Frequency Interest Rate Interest Rate Index Maturity Date Optional Redemption Date Trust I . . . . . . . Trust II . . . . . . Trust III . . . . . Trust IV . . . . . Trust V . . . . . . Trust VI . . . . . (in thousands) $ 10,000 $ 25,000 $ 33,000 $ 22,000 $ 20,000 Quarterly $ 25,000 Quarterly Fixed Semi-Annually Semi-Annually Semi-Annually $135,000 (9) Earnings per Share 10.18% Fixed June 2031 5.61% LIBOR + 3.75 July 2031 5.17% LIBOR + 3.75 December 2031 December 2006 5.32% LIBOR + 3.70 April 2032 5.51% LIBOR + 3.65 July 2032 5.27% LIBOR + 3.45 November 2032 November 2007 April 2007 July 2007 June 2011 July 2006 Basic EPS is calculated by dividing net income by the weighted average number of common shares outstanding. The computation of diluted EPS assumes the issuance of common shares for all dilutive 37 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (9) Earnings per Share (Continued) potential common shares outstanding during the reporting period. The calculation of the basic EPS and the diluted EPS for the years ended December 31, 2002, 2001, and 2000 is set forth in the following table: Income (Numerator) Shares (Denominator) Per-Share Amount (Dollars in Thousands, Except Per Share Amounts) December 31, 2002: Basic EPS Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,631 31,964,465 $3.15 Potential dilutive common shares . . . . . . . . . . . . . . . . . . . . . . 730,813 Diluted EPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,631 32,695,278 $3.08 December 31, 2001: Basic EPS Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 83,342 33,076,056 $2.52 Potential dilutive common shares . . . . . . . . . . . . . . . . . . . . . . 606,306 Diluted EPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 83,342 33,682,362 $2.47 December 31, 2000: Basic EPS Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 75,174 33,482,444 $2.25 Potential dilutive common shares . . . . . . . . . . . . . . . . . . . . . . 423,101 Diluted EPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 75,174 33,905,545 $2.22 (10) Employees’ Profit Sharing Plan The Company has a deferred profit sharing plan for full-time employees with a minimum of one year of continuous employment. The Company’s annual contribution to the plan is based on a percentage, as determined by the Board of Directors, of income before income taxes, as defined, for the year. Allocation of the contribution among officers and employees’ accounts is based on length of service and amount of salary earned. Profit sharing costs of $2,662,000, $2,084,000 and $1,845,000 were charged to income for the years ended December 31, 2002, 2001, and 2000, respectively. (11) International Operations The Company provides international banking services for its customers through its bank subsidiaries. Neither the Company nor its bank subsidiaries have facilities located outside the United States. Interna- tional operations are distinguished from domestic operations based upon the domicile of the customer. Because the resources employed by the Company are common to both international and domestic operations, it is not practical to determine net income generated exclusively from international activities. 38 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (11) International Operations (Continued) A summary of assets attributable to international operations at December 31, 2002 and 2001 are as follows: Loans: 2002 2001 (Dollars in Thousands) Commercial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Others . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $180,209 53,068 $228,610 44,428 Less allowance for possible loan losses . . . . . . . . . . . . . . . . 233,277 (1,179) 273,038 (1,502) Net loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $232,098 $271,536 Accrued interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,357 $ 1,282 At December 31, 2002, the Company had $62,833,000 in outstanding international commercial letters of credit to facilitate trade activities. The letters of credit are issued primarily in conjunction with credit facilities, which are available to various Mexican banks doing business with the Company. Income directly attributable to international operations was $14,128,000, $22,389,000 and $22,826,000 for the years ended December 31, 2002, 2001 and 2000, respectively. (12) Income Taxes The Company files a consolidated U.S. Federal income tax return. The current and deferred portions of net income tax expense included in the consolidated statements of income are presented below for the years ended December 31: 2002 2001 2000 (Dollars in Thousands) Current U.S. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $54,550 118 $38,849 84 $25,702 122 Total current taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54,668 38,933 25,824 Deferred . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (655) 2,788 7,593 Total income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $54,013 $41,721 $33,417 39 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (12) Income Taxes (Continued) Total income tax expense differs from the amount computed by applying the U.S. Federal income tax rate of 35% for 2002, 2001 and 2000 to income before income taxes. The reasons for the differences for the years ended December 31 are as follows: 2002 2001 2000 Computed expected tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $55,921 $43,772 $38,007 Change in taxes resulting from: Tax-exempt interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leasing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Employee benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,692) 3,031 (2,707) (540) (1,590) 1,239 (2,110) 410 (1,596) (1,386) (1,994) 386 Actual tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $54,013 $41,721 $33,417 The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2002 and 2001 are reflected below: 2002 2001 (Dollars in Thousands) Deferred tax assets: Loans receivable, principally due to the allowance for possible loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 13,422 $ 11,863 Net unrealized loss on derivative instruments of equity method investee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other real estate owned . . . . . . . . . . . . . . . . . . . . . . . . . . . Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332 553 2,763 259 2,641 267 — 348 Total deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,329 15,119 Deferred tax liabilities: Net unrealized gains on available for sale investment securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Lease financing receivable . . . . . . . . . . . . . . . . . . . . . . . . . . Bank premises and equipment, principally due to differences in depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FHLB stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (27,231) (16,549) (12,439) (16,871) (3,592) (5,139) (1,181) (2,822) (4,433) (1,234) Total deferred tax liabilities . . . . . . . . . . . . . . . . . . . . . . . . . (53,692) (37,799) Net deferred tax liability . . . . . . . . . . . . . . . . . . . . . . . . . $(36,363) $(22,680) 40 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (12) Income Taxes (Continued) The net deferred tax liability of $36,363,000 and $22,680,000 at December 31, 2002 and 2001, respectively, is included in other liabilities in the consolidated statements of condition. The Company did not record a valuation allowance against deferred tax assets at December 31, 2002, 2001 and 2000 because management has concluded it is more likely than not the Company will have future taxable earnings in excess of future tax deductions. (13) Other Investments Included in other investments is the Company’s investment in Aircraft Finance Trust (‘‘AFT’’), a special purpose business trust formed to acquire and lease aircraft. The Company accounts for its investment in AFT under the equity method of accounting. AFT utilizes derivative instruments to manage the interest rate on bonds that it has issued. The derivatives qualify as cash flow hedges and are reported at fair value. The Company records its proportionate share of the fair value of the derivatives as an increase or decrease in the investment in AFT and accumulated other comprehensive income, net of tax. The Company’s proportionate share of earnings or losses of AFT were losses of $6,799,000 and $1,766,000 for the years ended December 31, 2002 and 2001, respectively, and earnings of $1,069,000 for the year ended December 31, 2000. Because of the losses from operations that AFT has reported as a result of the events of September 11 and the impact on the airline industry including continued declines in air travel and continued reduced demand for commercial aircraft, the Company evaluated its investment, which resulted in the Company recording an impairment charge of $6,081,000 in 2002. At December 31, 2002 and 2001, the Company’s investment in AFT, excluding its proportionate share of the fair value of the AFT derivatives was $948,000 and $13,828,000, respectively. The Company’s investment including the proportionate share of the fair value of the AFT derivatives at December 31, 2002 and 2001, was $0 and $6,281,000, respectively. (14) Stock Options On April 3, 1996, the Board of Directors adopted the 1996 International Bancshares Corporation Stock Option Plan (the ‘‘1996 Plan’’). The 1996 Plan replaced the 1987 International Bancshares Corpora- tion Key Contributor Stock Option Plan (the ‘‘1987 Plan’’). On April 5, 2001, the Board of Directors amended the 1996 plan and added 300,000 shares to the plan. Under the 1987 Plan and the 1996 Plan both qualified incentive stock options (‘‘ISOs’’) and nonqualified stock options (‘‘NQSOs’’) may be granted. Options granted may be exercisable for a period of up to 10 years from the date of grant, excluding ISOs granted to 10% shareholders, which may be exercisable for a period of up to only five years. The Company granted nonqualified stock options exercisable for a total of 187,500 shares, adjusted for stock dividends, of Common Stock to certain employees of the GulfStar Group. The grants were not made under either the 1987 Plan or the 1996 Plan. The options are exercisable for a period of seven years and vest in equal increments over a period of five years. All options granted to the GulfStar Group employees had an option price of not less than the fair market value of the Common Stock on or about the date of grant. 41 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (14) Stock Options (Continued) The following table summarizes the pertinent information (adjusted for stock distributions) with regard to the Company’s stock options. Option Price per share Options outstanding Balance at December 31, 1999 . . . . . . . . . . . . . . . . . . . Terminated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance at December 31, 2000 . . . . . . . . . . . . . . . . . . . Terminated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12.00 - 34.40 23.55 - 27.52 12.59 - 24.18 $10.06 24.32 - 27.20 10.48 - 27.52 Balance at December 31, 2001 . . . . . . . . . . . . . . . . . . . Terminated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10.06 - 27.24 — 8.05 - 27.24 Balance at December 31, 2002 . . . . . . . . . . . . . . . . . . . 1,355,760 (750) 395,312 (108,954) 1,641,368 (54.263) 307,187 (105,513) 1,788,779 (26,932) — (221,052) 1,540,795 At December 31, 2002, 2001, and 2000, 1,057,089, 732,012, and 531,004 options were exercisable, respectively, and as of December 31, 2002, 313,030 shares were available for future grants under the 1996 Plan, as amended. All options granted under the 1987 Plan and the 1996 Plan had an option price of not less than the fair market value of the Company’s common stock at the date of grant and a vesting period of five years. The following table summarizes information about stock options outstanding at December 31, 2002: Options Outstanding Options Exercisable Range of Exercise prices $ 8.04 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15.47 - 21.30 . . . . . . . . . . . . . . . . . . . . . . 19.66 - 20.37 . . . . . . . . . . . . . . . . . . . . . . 18.84 - 22.02 . . . . . . . . . . . . . . . . . . . . . . 20.48 - 20.80 . . . . . . . . . . . . . . . . . . . . . . 27.20 - 29.20 . . . . . . . . . . . . . . . . . . . . . . Number Outstanding at 12/31/02 179,119 529,913 30,643 305,488 205,627 290,005 Weighted- Average Remaining Contractual Life .5 years 2.4 years 3.10 years 5.3 years 5.10 years 6.9 years Weighted- Average Exercise Price $ 8.04 15.70 19.77 18.58 20.43 27.27 $ 8.04 - 29.20 . . . . . . . . . . . . . . . . . . . . . . 1,540,795 Weighted- Average Exercise Price $ 8.04 15.70 19.77 18.58 20.43 27.27 Number Exercisable At 12/31/02 179,119 529,913 24,514 183,992 82,250 58,001 1,057,089 42 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (14) Stock Options (Continued) The fair values of options at date of grant were estimated using the Black-Scholes option pricing model with the following weighted-average assumptions: Expected life (years) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 5 4.42% 5.81% 31.14% 35.54% 2001 2000 The Company has a formal stock repurchase program and as part of the program, the Company occasionally repurchases shares of Common Stock related to the exercise of stock options through the surrender of other shares of Common Stock of the Company owned by the option holders. (15) Adoption of SFAS 142 The Company fully adopted the remaining provisions of SFAS No. 142 as of January 1, 2002 and discontinued amortizing goodwill relating to business combinations consummated before July 1, 2001. As of the date of the adoption, the Company had unamortized goodwill in the amount of $69,639,000 and unamortized identifiable intangible assets in the amount of $21,978,000. The Company evaluated its existing intangible assets and goodwill that were acquired in prior purchase business combinations and determined that no reclassifications were necessary in order to conform with the new classification criteria in SFAS No. 141 for recognition apart from goodwill. The Company has reassessed the useful lives and residual values of all intangible assets acquired in purchase business combinations and determined that no amortization adjustments were necessary and no intangible assets had indefinite lives. The Company performed a transitional assessment of whether there is an indication that goodwill is impaired. The Company concluded that it is probable that the goodwill related to its investment services reporting unit is impaired. The amount of the impairment is $7,893,000, or $5,130,000, net of tax, which is reported as a cumulative effect of a change in accounting principle, net of tax. The fair value of the investment services reporting unit was estimated using a combination of capitalized cash flows, discounted cash flows and multiples based on publicly traded company’s market capitalization to sales. 43 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (15) Adoption of SFAS 142 (Continued) The following table reconciles the Company’s reported net income and earnings per share amounts to the adjusted amounts adding back previous amounts of goodwill amortization: Years Ended December 31, 2002 2001 2000 Reported net income . . . . . . . . . . . . . . . . . . . . . . . . Add back: (Amounts in thousands, except for per share data) $83,342 $100,631 $75,174 Goodwill amortization, net of tax . . . . . . . . . . . . — 2,846 2,092 Adjusted net income . . . . . . . . . . . . . . . . . . . . . . . . $100,631 $86,188 $77,266 Basic earnings per share: Reported net income . . . . . . . . . . . . . . . . . . . . . . Goodwill amortization . . . . . . . . . . . . . . . . . . . . . Adjusted net income . . . . . . . . . . . . . . . . . . . . . . . Diluted earnings per share: Reported net income . . . . . . . . . . . . . . . . . . . . . . Goodwill amortization . . . . . . . . . . . . . . . . . . . . . Adjusted net income . . . . . . . . . . . . . . . . . . . . . . . $ $ $ $ 3.15 — 3.15 3.08 — 3.08 $ $ $ $ 2.52 .09 2.61 2.47 .08 2.56 $ $ $ $ 2.25 .06 2.31 2.22 .06 2.28 Changes in the carrying amount of goodwill are as follows for the year ended December 31, 2002: Balance as of December 31, 2001 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $69,639 Adjustments to deferred tax asset and goodwill relating to a 2001 acquisition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (488) Record disposition of goodwill related to the sale of branches acquired in 2001 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Impairment charge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reclassification of intangible assets to goodwill upon adoption of SFAS (4,303) (7,893) No. 147 (Note 1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,487 Balance as of December 31, 2002 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $67,442 44 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (15) Adoption of SFAS 142 (Continued) Information on the Company’s identified intangible assets follows: Carrying Amount Accumulated Amortization Net December 31, 2002 Core deposit premium . . . . . . . . . . . . . . . . . . . . $14,150 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14,150 $6,981 $6,981 $ 7,169 $ 7,169 December 31, 2001 Core deposit premium . . . . . . . . . . . . . . . . . . . . SFAS 72 unidentified intangible . . . . . . . . . . . . . $16,660 15,279 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $31,939 $5,169 4,792 $9,961 $11,492 10,487 $21,978 Amortization expense of intangible assets for the years ended December 31, 2002, 2001 and 2000 was $1,812,000, $5,378,000, and $4,220,000, respectively. Estimated amortization expense for each of the five succeeding fiscal years, and thereafter, is as follows: Fiscal year ended: 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2006 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Thereafter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total (in thousands) $1,276 984 798 690 690 2,731 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7,169 (16) Commitments and Contingent Liabilities The Company is involved in various legal proceedings that are in various stages of litigation. Some of these actions allege ‘‘lender liability’’ claims on a variety of theories and claim substantial actual and punitive damages. The Company has determined, based on discussions with its counsel that any material loss in such actions, individually or in the aggregate, is remote or the damages sought, even if fully recovered, would not be considered material to the consolidated financial position or results of operations of the Company. However, many of these matters are in various stages of proceedings and further developments could cause management to revise its assessment of these matters. The Company leases portions of its banking premises and equipment under operating leases. Total rental expense for the years ended December 31, 2002, 2001 and 2000 and non-cancellable lease commitments at December 31, 2002 were not significant. Cash of approximately $62,628,000 and $43,671,000 at December 31, 2002 and 2001, respectively, was maintained to satisfy regulatory reserve requirements. 45 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (16) Commitments and Contingent Liabilities (Continued) The Company’s lead bank subsidiary has invested in partnerships, which have entered into several lease-financing transactions. The lease-financing transactions in two of the partnerships have been examined by the Internal Revenue Service (‘‘IRS’’). In both partnerships, the lead bank subsidiary is the owner of a ninety-nine percent (99%) limited partnership interest. The IRS has issued separate Notice of Final Partnership Administrative Adjustments (‘‘FPAAs’’) to the partnerships and on September 25, 2001, and January 10, 2003, the Company filed lawsuits contesting the adjustments asserted in the FPAAs. Prior to filing the lawsuits, the Company was required to deposit the estimated tax due of approximately $4,083,000 with respect to the first FPAA, and $7,710,606 with respect to the second FPAA, with the IRS pursuant to the Internal Revenue Code. No reliable prediction can be made at this time as to the likely outcome of the lawsuits; however, if the lawsuits are decided adversely to the partnerships, all or a portion of the $12 million in tax benefits previously recognized by the Company in connection with the partner- ships’ lease-financing transactions would be in question and penalties and interest could be assessed by the IRS. In order to curtail the accrual of additional interest related to the disputed tax benefits and because interest rates are unfavorable, the Company decided to submit to the IRS the interest which would have accrued based on the adjustments proposed in the FPAAs related to both of the lease-financing transac- tions. On March 7, 2003, the Company submitted to the IRS a total of $13,640,797 of interest on the proposed adjustments. If the lawsuits are decided in favor of the Company the prepaid interest and deposits will be returned to the Company plus interest thereon. Management has estimated the Company’s exposure in connection with these transactions and has reserved an appropriate amount based on the estimated exposure at December 31, 2002. Management intends to continue to evaluate the merits of each matter and make appropriate revisions to the reserve amount as deemed necessary. (17) Transactions with Related Parties In the ordinary course of business, the Corporation and its subsidiaries make loans to directors and executive officers of the Corporation, including their affiliates, families and companies in which they are principal owners. In the opinion of management, these loans are made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons and do not involve more than normal risk of collectibility or present other unfavorable features. The aggregate amounts receivable from such related parties amounted to approximately $50,780,000 and $31,014,000 at December 31, 2002 and 2001, respectively. (18) Financial Instruments with Off-Statement of Condition Risk and Concentrations of Credit Risk In the normal course of business, the bank subsidiaries are party to financial instruments with off- statement of condition risk to meet the financing needs of their customers. These financial instruments include commitments to their customers. These financial instruments involve, to varying degrees, elements of credit risk in excess of the amounts recognized in the statement of condition. The contract amounts of these instruments reflect the extent of involvement the bank subsidiaries have in particular classes of 46 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (18) Financial Instruments with Off-Statement of Condition Risk and Concentrations of Credit Risk (Continued) financial instruments. At December 31, 2002, the following amounts of financial instruments, whose contract amounts represent credit risks, were outstanding: Commitments to extend credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Credit card lines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Standby letters of credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial letters of credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $626,330,000 33,290,000 59,657,000 3,176,000 The Company enters into a standby letter of credit to guarantee performance of a customer to a third party. These guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved is represented by the contractual amounts of those instruments. Under the standby letters of credit, the Company is required to make payments to the beneficiary of the letters of credit upon request by the beneficiary so long as all performance criteria have been met. At December 31, 2002, the maximum potential amount of future payments is $59,657,000. The Company enters into commercial letters of credit on behalf of its customers which authorize a third party to draw drafts on the Company up to a stipulated amount and with specific terms and conditions. A commercial letter of credit is a conditional commitment on the part of the Company to provide payment on drafts drawn in accordance with the terms of the commercial letter of credit. The bank subsidiaries’ exposure to credit loss in the event of nonperformance by the other party to the above financial instruments is represented by the contractual amounts of the instruments. The bank subsidiaries use the same credit policies in making commitments and conditional obligations as they do for on-statement of condition instruments. The bank subsidiaries control the credit risk of these transactions through credit approvals, limits and monitoring procedures. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates normally less than one year or other termination clauses and may require the payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The bank subsidiaries evaluate each customer’s credit-worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the subsidiary banks upon extension of credit, is based on management’s credit evaluation of the customer. Collateral held varies, but may include residential and commercial real estate, bank certificates of deposit, accounts receivable and inventory. The bank subsidiaries make commercial, real estate and consumer loans to customers principally located in Webb, Bexar, Hidalgo, Cameron, Starr and Zapata counties in South Texas as well as Matagorda, Brazoria, Galveston, Fort Bend, Calhoun, and Harris counties in Southeast Texas. Although the loan portfolio is diversified, a substantial portion of its debtors’ ability to honor their contracts is dependent upon the economic conditions in these areas, especially in the real estate and commercial business sectors. 47 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (19) Dividend Restrictions and Capital Requirements Bank regulatory agencies limit the amount of dividends, which the bank subsidiaries can pay the Corporation, through IBC Subsidiary Corporation, without obtaining prior approval from such agencies. At December 31, 2002, the aggregate amount legally available to be distributed to the Company from bank subsidiaries as dividends was approximately $188,000,000, assuming that each subsidiary bank continues to be classified as ‘‘well capitalized’’ pursuant to the applicable regulations. The restricted capital of the bank subsidiaries was approximately $399,042,000. The undivided profits of the bank subsidiaries were $251,625,000. In addition to legal requirements, regulatory authorities also consider the adequacy of the bank subsidiaries’ total capital in relation to their deposits and other factors. These capital adequacy considerations also limit amounts available for payment of dividends. The Company historically has not allowed any subsidiary bank to pay dividends in such a manner as to impair its capital adequacy. The Company and the bank subsidiaries are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines that involve quantitative measures of the Company’s assets, liabilities, and certain off- statement of condition items as calculated under regulatory accounting practices. The Company’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company to maintain minimum amounts and ratios (set forth in the table on the following page) of Total and Tier 1 capital to risk-weighted assets and of Tier 1 capital to average assets. Management believes, as of December 31, 2002, that the Company and each of the bank subsidiaries met all capital adequacy requirements to which it is subject. As of December 31, 2002, the most recent notification from the Federal Deposit Insurance Corpora- tion categorized all the bank subsidiaries as well capitalized under the regulatory framework for prompt corrective action. To be categorized as ‘‘well capitalized’’ the Company and the bank subsidiaries must maintain minimum Total risk-based, Tier 1 risk based, and Tier 1 leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the categorization of the Company or any of the bank subsidiaries as well capitalized. 48 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (19) Dividend Restrictions and Capital Requirements (Continued) The Company’s and the bank subsidiaries’ actual capital amounts and ratios for 2002 also presented in the following table: Actual For Capital Adequacy Purposes To Be Well Capitalized Under Prompt Corrective Action Provisions Amount Ratio Amount Ratio Amount Ratio (greater (greater than or than or equal to) equal to) equal to) equal to) (greater than or (greater than or As of December 31, 2002: Total Capital (to Risk Weighted Assets): (Dollars in thousands) Consolidated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $603,001 17.21% $280,365 231,582 International Bank of Commerce, Laredo . . . . . . . . . . 23,986 International Bank of Commerce, Brownsville . . . . . . . 9,737 International Bank of Commerce, Zapata . . . . . . . . . . 13,882 Commerce Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . 445,668 15.40 55,314 18.45 25,988 21.35 29,650 17.09 8.00% $350,456 289,478 8.00 29,983 8.00 12,171 8.00 17,343 8.00 10.00% 10.00 10.00 10.00 10.00 Tier 1 Capital (to Risk Weighted Assets): Consolidated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $559,025 15.95% $140,182 115,791 International Bank of Commerce, Laredo . . . . . . . . . . 11,993 International Bank of Commerce, Brownsville . . . . . . . 4,868 International Bank of Commerce, Zapata . . . . . . . . . . 6,941 Commerce Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . 409,373 14.14 52,095 17.38 25,203 20.71 27,451 15.82 4.00% $210,273 173,687 4.00 17,990 4.00 7,303 4.00 10,412 4.00 Tier 1 Capital (to Average Assets): Consolidated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $559,025 409,373 International Bank of Commerce, Laredo . . . . . . . . . . 52,095 International Bank of Commerce, Brownsville . . . . . . . 25,203 International Bank of Commerce, Zapata . . . . . . . . . . 27,451 Commerce Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.71% $256,640 205,229 7.98 23,729 8.78 12,260 8.22 16,440 6.68 4.00% $320,800 256,537 4.00 29,661 4.00 15,325 4.00 20,550 4.00 6.00% 6.00 6.00 6.00 6.00 5.00% 5.00 5.00 5.00 5.00 49 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (19) Dividend Restrictions and Capital Requirements (Continued) The Company’s and the bank subsidiaries’ actual capital amounts and ratios for 2001 are also presented in the following table: Actual For Capital Adequacy Purposes To Be Well Capitalized Under Prompt Corrective Action Provisions Amount Ratio Amount Ratio Amount Ratio (greater (greater than or than or equal to) equal to) equal to) equal to) (greater than or (greater than or As of December 31, 2001: Total Capital (to Risk Weighted Assets): (Dollars in thousands) Consolidated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $490,124 15.06% $260,339 220,595 International Bank of Commerce, Laredo . . . . . . . . . . 19,022 International Bank of Commerce, Brownsville . . . . . . . 5,665 International Bank of Commerce, Zapata . . . . . . . . . . 13,694 Commerce Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . 370,123 13.42 43,797 18.42 20,291 28.66 22,180 12.96 8.00% $325,424 275,743 8.00 23,777 8.00 7,081 8.00 17,117 8.00 10.00% 10.00 10.00 10.00 10.00 Tier 1 Capital (to Risk Weighted Assets): Consolidated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $450,059 13.83% $130,170 110,297 International Bank of Commerce, Laredo . . . . . . . . . . 9,511 International Bank of Commerce, Brownsville . . . . . . . 2,832 International Bank of Commerce, Zapata . . . . . . . . . . 6,847 Commerce Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . 336,486 12.20 40,822 17.17 19,737 27.88 20,034 11.70 4.00% $195,524 165,446 4.00 14,266 4.00 4,249 4.00 10,270 4.00 Tier 1 Capital (to Average Assets): Consolidated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $450,059 336,486 International Bank of Commerce, Laredo . . . . . . . . . . 40,822 International Bank of Commerce, Brownsville . . . . . . . 19,737 International Bank of Commerce, Zapata . . . . . . . . . . 20,034 Commerce Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.67% $270,032 192,178 7.00 20,037 8.15 8,126 9.72 9,624 8.33 4.00% $337,540 240,223 4.00 25,046 4.00 10,158 4.00 12,030 4.00 6.00% 6.00 6.00 6.00 6.00 5.00% 5.00 5.00 5.00 5.00 (20) Fair Value of Financial Instruments The fair value estimates, methods, and assumptions for the Company’s financial instruments at December 31, 2002 and 2001 are outlined below. Cash and Due From Banks and Federal Funds Sold For these short-term instruments, the carrying amount is a reasonable estimate of fair value. Time Deposits with Banks As the contract interest rates are comparable to current market rates, the carrying amount approxi- mates fair market value. 50 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (20) Fair Value of Financial Instruments (Continued) Investment Securities For investment securities, which include U. S. Treasury securities, obligations of other U. S. govern- ment agencies, obligations of states and political subdivisions and mortgage pass through and related securities, fair values are based on quoted market prices or dealer quotes. Fair values are based on the value of one unit without regard to any premium or discount that may result from concentrations of ownership of a financial instrument, possible tax ramifications, or estimated transaction costs. See disclosures of fair value of investment securities in Note 3. Loans Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, real estate and consumer loans as outlined by regulatory reporting guidelines. Each category is segmented into fixed and variable interest rate terms and by performing and non-performing categories. For variable rate performing loans, the carrying amount approximates the fair value. For fixed rate performing loans, except residential mortgage loans, the fair value is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. For performing residential mortgage loans, fair value is estimated by discounting contractual cash flows adjusted for prepayment estimates using discount rates based on secondary market sources or the primary origination market. At December 31, 2002 and 2001, the carrying amount of fixed rate performing loans was $970,967,000 and $1,407,367,000 respectively, and the estimated fair value was $977,985,000 and $1,406,633,000, respectively. Fair value for significant non-performing loans is based on recent external appraisals. If appraisals are not available, estimated cash flows are discounted using a rate commensurate with the risk associated with the estimated cash flows. Assumptions regarding credit risk, cash flows and discount rates are judgmentally determined using available market and specific borrower information. As of December 31, 2002 and 2001, the net carrying amount of non-performing loans was a reasonable estimate of the fair value. Deposits The fair value of deposits with no stated maturity, such as non-interest bearing demand deposit accounts, savings accounts and interest bearing demand deposit accounts, was equal to the amount payable on demand as of December 31, 2002 and 2001. The fair value of time deposits is based on the discounted value of contractual cash flows. The discount rate is based on currently offered rates. At December 31, 2002 and 2001, the carrying amount of time deposits was $2,293,026,000 and $2,424,373,000, respectively, and the estimated fair value was $2,273,994,000 and $2,395,652,000, respectively. Securities Sold Under Repurchase Agreements, Other Borrowed Funds and Long-term Debt Due to the contractual terms of these financial instruments, the carrying amounts approximated fair value at December 31, 2002 and 2001. Commitments to Extend Credit and Letters of Credit Commitments to extend credit and fund letters of credit are principally at current interest rates and therefore the carrying amount approximates fair value. 51 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (20) Fair Value of Financial Instruments (Continued) Limitations Fair value estimates are made at a point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Fair value estimates are based on existing on-and off-statement of condition financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Other significant assets and liabilities that are not considered financial assets or liabilities include the bank premises and equipment and core deposit value. In addition, the tax ramifications related to the effect of fair value estimates have not been considered in the above estimates. 52 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (21) International Bancshares Corporation (Parent Company Only) Financial Information Statements of Condition (Parent Company Only) December 31, 2002 and 2001 (Dollars in Thousands) ASSETS 2002 2001 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Repurchase Agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment in subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,783 12,750 5,464 20,374 634,665 6,921 $ 551 2,600 6,654 30,683 518,263 8,417 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 684,957 $567,168 LIABILITIES AND SHAREHOLDERS’ EQUITY Liabilities: Due to IBC Trusts (Subordinated Debentures) . . . . . . . . . . . . . . . . . . . . . . . Due to IBC Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Due to IBC Capital Trusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135,000 21 1,068 1,604 68,000 21 28 2,091 Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137,693 70,140 Shareholders’ equity: Common shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated other comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . 41,766 30,821 560,613 49,957 33,214 27,564 490,328 18,221 Less cost of shares in treasury . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (135,893) (72,299) Total shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 547,264 497,028 Total liabilities and shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . $ 684,957 $567,168 683,157 569,327 53 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (22) International Bancshares Corporation (Parent Company Only) Financial Information Statements of Income (Parent Company Only) Years ended December 31, 2002, 2001 and 2000 (Dollars in Thousands) 2002 2001 2000 Income: Dividends from subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest income on notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . Interest income on other investments . . . . . . . . . . . . . . . . . . . . . . . . Other interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sale of other securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 27,500 2,297 778 — — 2,334 $88,245 2,985 899 310 — 3,097 $22,000 3,771 399 321 386 904 Total income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,909 95,536 37,781 Expenses: Interest Expense (Debentures) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,040 1,126 2,014 967 Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,166 2,981 — 476 476 Income before federal income taxes and equity in undistributed net income of subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,743 92,555 27,305 Income tax (benefit) expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,578) 578 663 Income before equity in undistributed net income of subsidiaries . . 26,321 91,977 26,642 Equity in undistributed (dividends in excess of) net income of subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74,310 (8,635) 48,532 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,631 $83,342 $75,174 54 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (23) International Bancshares Corporation (Parent Company Only) Financial Information Statements of Cash Flows (Parent Company Only) Years ended December 31, 2002, 2001 and 2000 (Dollars in Thousands) Operating activities: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to reconcile net income to net cash provided by operating activities: Gain on sale of other investments . . . . . . . . . . . . . . . . . . . . . . . Increase in other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . (Equity in undistributed) dividends in excess of net income of 2002 2001 2000 $100,631 $ 83,342 $ 75,174 — 553 — 1,643 (386) 462 subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (74,310) 8,635 (48,532) Net cash provided by operating activities . . . . . . . . . . . . . . . . . . 26,874 93,620 26,718 Investing activities: Contributions to subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchase of repurchase agreement with banks . . . . . . . . . . . . . . . Proceeds from sales of available for sale securities . . . . . . . . . . . . Purchase of available for sale other securities . . . . . . . . . . . . . . . . Principal collected on mortgage-backed securities . . . . . . . . . . . . . Net decrease in notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . Decrease in other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (8,937) (10,150) — — 1,556 10,309 (289) (119,157) (2,600) — (5,000) 3,223 4,698 (2,377) (10,494) — 1,404 — 1,426 6,993 3,926 Net cash (used in) provided by investing activities . . . . . . . . . . . . . (7,511) (121,213) 3,255 Financing activities: Proceeds from issuance of subordinated debentures . . . . . . . . . . . Proceeds from stock transactions . . . . . . . . . . . . . . . . . . . . . . . . . Payments of cash dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Payments of cash dividends in lieu of fractional shares . . . . . . . . . Purchase of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67,000 3,478 (21,984) (31) (63,594) 68,000 1,736 (21,158) (24) (21,143) — 1,992 (21,016) (24) (10,419) Net cash (used in) provided by financing Activities . . . . . . . . . . . . (15,131) 27,411 (29,467) Increase (decrease) in cash and cash equivalents . . . . . . . . . . . . . . Cash at beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,232 551 (182) 733 506 227 Cash at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,783 $ 551 $ 733 55 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Condensed Quarterly Income Statements (Dollars in Thousands, Except Per Share Amounts) (Unaudited) Fourth Quarter Third Quarter Second Quarter First Quarter 2002 Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $87,007 27,652 $91,486 29,695 $88,444 28,773 $ 86,993 30,297 Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for possible loan losses . . . . . . . . . . . . . . . . . . . . Non-interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . 59,355 2,178 25,347 42,170 40,354 61,791 2,232 26,629 38,921 47,267 59,671 2,057 18,456 38,531 37,539 Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,890 16,394 12,674 56,696 2,074 15,213 35,222 34,613 12,054 Income before cumulative effect of a change in accounting principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,464 30,873 24,865 22,559 Cumulative effect of a change in accounting principle, net of tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — — — (5,130) Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $27,464 $30,873 $24,865 $ 17,429 Per common share: Basic Income before cumulative effect of a change in accounting principle . . . . . . . . . . . . . . . . . . . . . . . . . . $ .87 $ .97 $ .77 $ .69 Cumulative effect of a change in accounting principle, net of tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — — — (.16) Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ .87 $ .97 $ .77 $ .53 Diluted Income before cumulative effect of a change in accounting principle . . . . . . . . . . . . . . . . . . . . . . . . . . $ .85 $ .95 $ .75 $ .68 Cumulative effect of a change in accounting principle, net of tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — — — (.15) Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ .85 $ .95 $ .75 $ .53 Net income and per common share amounts for the first three quarters have been re-stated to reflect the reversal of $792,000 amortization expense in accordance with SFAS No. 147 (see note 1 to the Consolidated Financial Statements) 56 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Condensed Quarterly Income Statements (Continued) (Dollars in Thousands, Except Per Share Amounts) (Unaudited) Fourth Quarter Third Quarter Second Quarter First Quarter 2001 Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $85,099 37,075 $91,159 45,817 $99,681 54,882 $108,174 63,034 Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for possible loan losses . . . . . . . . . . . . . . . . . . . . Non-interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . 48,024 2,114 21,828 37,199 30,539 45,342 1,962 22,785 33,928 32,237 44,799 2,428 21,065 33,488 29,948 Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,146 10,793 10,048 45,140 2,127 20,152 30,826 32,339 10,734 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,393 $21,444 $19,900 $ 21,605 Adjusted net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $21,105 $22,156 $20,611 $ 22,316 Per common share: Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjusted per common share: Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ $ $ .62 .61 .64 .63 $ $ $ $ .65 .64 .67 .66 $ $ $ $ .60 .58 .62 .61 $ $ $ $ .81 .80 .84 .83 Adjusted net income and adjusted net income per common share are adjusted for the exclusion of goodwill amortization, net of tax. Beginning 2002, new accounting standards eliminated the amortization of goodwill. 57 INTERNATIONAL BANCSHARES CORPORATION OFFICERS AND DIRECTORS OFFICERS DIRECTORS DENNIS E. NIXON Chairman of the Board and President R. DAVID GUERRA Vice President EDUARDO J. FARIAS Vice President RICHARD CAPPS Vice President IMELDA NAVARRO Treasurer WILLIAM CUELLAR Auditor LUISA D. BENAVIDES Secretary MARISA V. SANTOS Assistant Secretary DENNIS E. NIXON President International Bank of Commerce R. DAVID GUERRA President International Bank of Commerce Branch in McAllen, Texas LEONARDO SALINAS Investments IMELDA NAVARRO Senior Executive Vice President International Bank of Commerce LESTER AVIGAEL Retail Merchant Chairman of the Board International Bank of Commerce IRVING GREENBLUM Retail Merchant RICHARD E. HAYNES Attorney at Law Real Estate Investments SIOMA NEIMAN International Entrepreneur PEGGY J. NEWMAN Investments DANIEL B. HASTINGS, JR. Licensed U.S. Custom Broker President Daniel B. Hastings, Inc. ANTONIO R. SANCHEZ, JR. Chairman of the Board Sanchez Oil & Gas Corporation; Investments 58