International Bancshares Corp.
Annual Report 2004

Plain-text annual report

INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES (Consolidated) The following consolidated selected financial data is derived from the Corporation’s audited financial statements as of and for the five years ended December 31, 2004. The following consolidated financial data should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and related notes in this report. SELECTED FINANCIAL DATA STATEMENT OF CONDITION Assets . . . . . . . . . . . . . . . . . . . . . . Net loans . . . . . . . . . . . . . . . . . . . . Deposits . . . . . . . . . . . . . . . . . . . . Other borrowed funds . . . . . . . . . . Junior subordinated deferrable interest debentures . . . . . . . . . . . Shareholders’ equity . . . . . . . . . . . . INCOME STATEMENT AS OF OR FOR THE YEARS ENDED DECEMBER 31, 2004 2003 2002 2001 2000 (Dollars in Thousands, Except Per Share Data) $9,917,951 4,804,069 6,571,104 1,670,199 $6,578,310 2,700,354 4,435,699 845,276 $6,495,635 2,725,349 4,239,899 1,185,857 $6,381,401 2,608,467 4,332,834 777,296 $5,860,714 2,212,467 3,744,598 1,432,500 235,395 753,090 172,254 577,383 — 547,264 — 497,028 — 416,892 Interest income . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . $ 352,378 108,602 $ 318,051 94,725 $ 353,928 116,415 $ 390,355 200,808 $ 415,332 251,756 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 accounting principle, net of taxes . 243,776 6,500 134,816 195,180 223,326 8,291 127,273 159,754 237,513 8,541 85,645 154,843 189,547 8,631 79,588 135,441 163,576 6,824 63,796 111,957 176,912 182,554 159,774 125,063 108,591 57,880 60,426 54,013 41,721 33,417 — — (5,130) Net income . . . . . . . . . . . . . . . . . . $ 119,032 $ 122,128 $ 100,631 Adjusted net income . . . . . . . . . . . . $ 119,032 $ 122,128 $ 100,631 Per common share: Basic . . . . . . . . . . . . . . . . . . . . . . . Diluted . . . . . . . . . . . . . . . . . . . . . Adjusted per common share: Basic . . . . . . . . . . . . . . . . . . . . . . . Diluted . . . . . . . . . . . . . . . . . . . . . $ $ $ $ 2.39 2.35 2.39 2.35 $ $ $ $ 2.53 2.48 2.53 2.48 $ $ $ $ 2.01 1.97 2.01 1.97 — 83,342 86,188 1.62 1.58 1.66 1.64 $ $ $ $ $ $ — 75,174 77,266 1.44 1.42 1.48 1.46 $ $ $ $ $ $ Note 1: See note 1 of notes to the consolidated financial statements regarding the adoption of SFAS No. 142. On January 1, 2002, the Company adopted the remaining provisions of SFAS No. 142, which discontinued amortization of goodwill. Accordingly, adjusted net income and per common share data for the years ended December 31, 2004, 2003 and 2002 is the same as actual numbers. Note 2: See note 11 of notes to the consolidated financial statements regarding the adoption of FIN 46, as revised. The Company early-adopted the provisions of FIN 46, as revised, as of December 31, 2003 and thus deconsolidated its investment in eight special purpose business trusts established for the issuance of trust preferred securities. 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 ‘‘Company’’ or the ‘‘Corporation’’) on a consolidated basis for the three-year period ended December 31, 2004. The following discussion should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2004, 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, within the meaning of Section 27A of the Securities Exchange Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are subject to the safe harbor created by these sections. 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,’’ ‘‘believe’’ 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. 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: (cid:127) Changes in interest rates and market prices, which could reduce the Company’s net interest margins, asset valuations and expense expectations. (cid:127) Changes in the capital markets utilized by the Company and its subsidiaries, including changes in the interest rate environment that may reduce margins. (cid:127) 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, changes in the accounting, tax and regulatory treatment of trust preferred securities, as well as changes in banking, tax, securities, insurance and employment laws and regulations. (cid:127) Changes in U.S.—Mexico trade, including, without limitation, reductions in border crossings and commerce resulting from the Homeland Security Programs called ‘‘US-VISIT,’’ which is derived from Section 110 of the Illegal Immigration Reform and Immigrant Responsibility Act of 1996. (cid:127) The loss of senior management or operating personnel. (cid:127) Increased competition from both within and outside the banking industry. (cid:127) Changes in local, national and international economic business conditions that 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. (cid:127) 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. 2 (cid:127) Changes in the Company’s ability to pay dividends on its Common Stock. (cid:127) The effects of the litigation and proceedings pending with the Internal Revenue Service regarding the Company’s lease financing transactions. (cid:127) Additions to the Company’s loan loss allowance as a result of changes in local, national or international conditions which adversely affect the Company’s customers. (cid:127) Political instability. (cid:127) Technological changes. (cid:127) Acts of war or terrorism. (cid:127) The effect of changes in accounting policies and practices as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board and other accounting standards setters. 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. Overview The Company, which is headquartered in Laredo, Texas, with more than 160 facilities and more than 250 ATMs, provides banking services for commercial, consumer and international customers of South, Central and Southeast Texas and the State of Oklahoma. The Company is the second largest independent commercial bank holding company headquartered in Texas. The Company, through its bank subsidiaries, is in the business of gathering funds from various sources and investing those funds in order to earn a return. The Company either directly or through a bank subsidiary owns two insurance agencies, a broker/dealer and a majority interest in an investment banking unit that owns a broker/dealer. The Company’s primary earnings come from the spread between the interest earned on interest-bearing assets and the interest paid on interest-bearing liabilities. In addition, the Company generates income from fees on products offered to commercial, consumer and international customers. A primary goal of the Company is to grow net interest income and non-interest income while adequately managing credit risk, interest rate risk and expenses. Effective management of capital is a critical objective of the Company. A key measure of the performance of a banking institution is the return on average common equity (‘‘ROE’’). The Company’s ROE for the year ended December 31, 2004 was 18.17% as compared to 22.68% for the year ended December 31, 2003. The Company is very active in facilitating trade along the United States border with Mexico. The Company does a significant amount of business with customers domiciled in Mexico. Deposits from persons and entities domiciled in Mexico comprise a significant and stable portion of the deposit base of the Company’s bank subsidiaries. The Company also serves the growing Hispanic population through the Company’s facilities located throughout South, Central and Southeast Texas. Expense control is another essential element in the Company’s long-term profitability. As a result, one of the key ratios the Company monitors is the efficiency ratio, which is a measure of non-interest expense to net-interest income plus non-interest income. The Company’s efficiency ratio has been under 53% for each of the last five years, which the Company believes is better than average compared to its national peer group. One of the benefits derived from such operating efficiencies is that the Company is not subject to undue pressure to generate interest income from high-risk loans. During the fourth quarter of 2003, the Company reduced its assets by approximately $1 billion dollars in anticipation of the Local Financial Corporation (‘‘LFIN’’) acquisition. The Company also increased its overnight liquidity in the form of fed funds sold to prepare for the cash payment required as part of the 3 transaction. On June 18, 2004, the Company completed its acquisition of LFIN. The Company paid consideration totaling approximately $276.6 million in cash and 2.11 million shares of Company stock. As a result of the strategic management of earning assets in anticipation of the LFIN acquisition, net interest income for the first, second and third quarters of 2004 was negatively affected. Results of Operations Summary Consolidated Statements of Condition Information December 31, 2004 December 31, 2003 (Dollars in Thousands) Percent Increase (Decrease) Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other borrowed funds . . . . . . . . . . . . . . . . . . . . . . Shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . $9,917,951 4,804,069 6,571,104 1,670,199 753,090 $6,578,310 2,700,354 4,435,699 845,272 577,383 50.8% 77.9 48.1 97.6 30.4 Consolidated Statements of Income Information Year Ended December 31, 2004 Year Ended December 31, 2003 Percent Increase (Decrease) 2004 vs. 2003 Year ended December 31, 2002 Percent Increase (Decrease) 2003 vs. 2002 (Dollars in Thousands) Interest income . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . Net interest income . . . . . . . . . . . . Provision for possible loan losses . . . Non-interest income . . . . . . . . . . . . Non-interest expense . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . $352,378 108,602 243,776 6,500 134,816 195,180 119,032 $318,051 94,725 223,326 8,291 127,273 159,754 122,128 10.8% 14.6 9.2 (21.6) 5.9 22.6 (2.5) $353,928 116,415 237,513 8,541 85,645 154,843 100,631 (10.1)% (18.6) (6.0) (2.9) 48.6 3.2 21.4 Per common share: Basic . . . . . . . . . . . . . . . . . . . . . Diluted . . . . . . . . . . . . . . . . . . . $ 2.39 2.35 $ 2.53 2.48 (5.5)% $ (5.2) 2.01 1.97 25.9% 25.9 Efficiency Ratio . . . . . . . . . . . . . . . 51.6% 45.6% 13.2% 47.9% (4.8)% Net Income Net income decreased for the year ended December 31, 2004 as compared to the year ended December 31, 2003 primarily because of differences created by the Company’s recognition of securities gains in 2003 as compared to 2004 and the Company’s strategic management of earning assets in anticipation of the Local Financial Corporation (‘‘LFIN’’) acquisition. During the fourth quarter of 2003, the Company reduced its assets by approximately $1 billion in anticipation of the LFIN acquisition. The Company also increased its overnight liquidity in the form of fed funds sold to prepare for the cash payment required as part of the transaction. On June 18, 2004, the Company completed its acquisition of LFIN. As a result of the strategic management of earning assets, net interest income for the first, second and third quarters of 2004 was negatively affected. Net income for 2004 was positively affected by certain gains on sales of Company-owned property in the amount of $2,080,000, net of tax. Additionally, net income for 2003 was positively affected by gains recognized on bond sales, which were made to reposition a portion of the Company’s bond portfolio to realize the equity that was eroding in the portfolio due to rapid 4 principal repayments. The Company recorded gains on the bond portfolio of $15,203,000 in 2003 compared to $5,775,000, net of tax in 2004. Net income for 2002 was negatively affected by an impairment charge of $3,953,000 relating to the Company’s investment in the Aircraft Finance Trust (‘‘AFT’’), net of tax. 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 $0, $616,000 and $4,419,000 for the years ended December 31, 2004, 2003 and 2002, respectively, net of tax. Because of the losses from operations that AFT had reported as a result of the events of September 11 and the resulting impact on the airline industry, the Company evaluated its investment, and recorded the impairment charge in 2002. At December 31, 2004 and 2003, the Company’s investment in AFT, with and without the proportionate share of the fair value of the AFT derivatives, was $0. Net income for 2002 was also negatively affected by a write-off of $753,000, net of tax, relating to the closure of several in-store branches previously located in Albertson’s supermarkets. 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. Thirty nine Albertson’s supermarkets and the related in-store branches of the Company located in Houston, San Antonio, Brownsville, Corpus Christi, Laredo, Edinburg, San Juan, Pharr, Mission, Weslaco and Harlingen were 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 four 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 three 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 $753,000, net of tax of its investment in the related in-store branches. The Company continues to maintain one Albertson’s in-store branch in the New Braunfels market that was not closed by Albertson’s. The Company does not believe that the Albertson’s closures had any negative effects on its deposit base, consolidated financial condition or results of operations. Additionally, net income was negatively affected in 2002 by the adoption of Statement of Financial Accounting Standards Number 142, ‘‘Goodwill and Other Intangible Assets’’ (‘‘SFAS No. 142’’). As part of the adoption, the Company concluded that it was probable that its investment services reporting unit was impaired. The amount of the impairment was $5,130,000, net of tax, and was reported as a cumulative effect of a change in accounting principle. On August 1, 2002, the Company completed its sale of three 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 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 $2.0 million, net of tax in 2002. The Company sold these branches because they did not fit into the long-term strategic plans of the Company. Net Interest Income 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 the Company’s largest source of revenue. Net 5 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. For the years ended December 31, 2004 Average Rate/Cost 2003 Average Rate/Cost 2002 Average Rate/Cost Assets Interest earning assets: Loan, net of unearned discounts: Domestic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.99% 4.91 6.53% 7.02% 5.15 5.68 Investment securities: Taxable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tax-exempt Time deposits with banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal funds sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.64 4.54 1.69 1.22 7.59 4.18 4.81 5.59 .92 10.01 5.61 4.91 2.18 1.53 4.55 Total interest-earning assets . . . . . . . . . . . . . . . . . . . . . . . . . . 4.87% 5.16% 6.16% Liabilities Interest bearing liabilities: Savings and interest bearing demand deposits . . . . . . . . . . . . . . . . . . Time deposits: Domestic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities sold under repurchase agreements . . . . . . . . . . . . . . . . . . . Other borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Junior subordinated deferrable interest debentures . . . . . . . . . . . . . . Senior notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .75% .77% 1.16% 1.44 1.85 3.64 1.55 6.38 11.47 1.18 3.05 3.97 1.22 5.97 — 2.73 2.31 3.95 1.83 6.93 — Total interest bearing liabilities . . . . . . . . . . . . . . . . . . . . . . . . 1.69% 1.73% 2.27% Due to decreasing market interest rates in 2003 and 2002, the Company accordingly lowered interest rates on loans and deposits, which in turn affected the yield on interest earning assets and interest bearing liabilities. In 2004, as short term interest rates began to increase, the Company accordingly increased interest rates on loans and deposits. The yield on average interest earning assets decreased 5.6% from 5.16% in 2003 to 4.87% in 2004, and the rates paid on average interest bearing liabilities decreased 2.3% from 1.73% in 2003 to 1.69% in 2004. The yield on average interest earning assets decreased 16.2% from 6.16% in 2002 to 5.16% in 2003 and the rates paid on average interest bearing liabilities decreased 23.8% from 2.27% in 2002 to 1.73% in 2003. 6 The following table analyzes the changes in net interest income during 2004 and 2003 and the relative effect of changes in interest rates and volumes for each major classification of interest-earning assets and interest-bearing liabilities. Nonaccrual loans have been included in assets for the purpose of this analysis, which reduces the resulting yields: 2004 compared to 2003 Net increase (decrease) due to 2003 compared to 2002 Net increase (decrease) due to Volume(1) Rate(1) Total Volume(1) Rate(1) Total (Dollars in Thousands) (Dollars in Thousands) Interest earned on: Loans, net of unearned discounts: Domestic . . . . . . . . . . . . . . . . . . . . . . . . $74,455 $(14,627) $59,828 $ 7,737 $(12,238) $ (4,501) (2,502) (6) Foreign . . . . . . . . . . . . . . . . . . . . . . . . . (1,259) (1,243) (543) (549) Investment securities: Taxable . . . . . . . . . . . . . . . . . . . . . . . . . . Tax-exempt . . . . . . . . . . . . . . . . . . . . . . . Time deposits with banks . . . . . . . . . . . . . . Federal funds sold . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . (9,438) 223 94 741 202 (16,602) (26,040) 15,877 258 (12) 250 13 (298) (11) 242 (105) (75) 83 983 97 (45,017) (29,140) 156 (27) (77) 214 (102) (15) (327) 201 Total interest income . . . . . . . . . . . . . . . . . $66,271 $(31,944) $34,327 $22,880 $(58,757) $(35,877) Interest incurred on: Savings and interest bearing demand deposits . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,897 $ (268) $ 3,629 $ 1,041 $ (5,058) $ (4,017) Time deposits: Domestic . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . Securities sold under repurchase agreements . Other borrowings . . . . . . . . . . . . . . . . . . . . Junior subordinated deferrable interest 1,658 9,433 2,731 (2,928) 4,017 (11,462) (1,636) 3,835 9,967 5,675 (2,029) (16,343) (1,024) 1,095 4,963 907 (18,856) 8,338 98 (6,941) (8,889) (8,005) (926) (1,978) debentures . . . . . . . . . . . . . . . . . . . . . . . Senior notes . . . . . . . . . . . . . . . . . . . . . . . . 3,570 383 647 — 4,217 383 3,171 — (1,046) — 2,125 — Total interest expense . . . . . . . . . . . . . . . . . $18,744 $ (4,867) $13,877 $ 1,775 $(23,465) $(21,690) Net interest income . . . . . . . . . . . . . . . . . . . . $47,527 $(27,077) $20,450 $21,105 $(35,292) $(14,187) (Note 1) The change in interest due to both rate and volume has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each. 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 7 the Investment Committee of the Company twice a year. The Investment Committee is comprised of certain senior managers of the various Company bank subsidiaries along with consultants when needed. 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. At December 31, 2004, based on these simulations, a rate shift of 200 basis points in interest rates up or a rate shift of 100 basis points down will not vary earnings by more than 3 percent of projected 2005 net interest income. The 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. The Company believes that it is properly positioned for a potential interest rate increase or decrease. Allowance for Possible Loan Loss The following table presents information concerning the aggregate amount of non-accrual, past due and restructured domestic loans; certain loans may be classified in one or more category: December 31, 2004 2003 2002 2001 2000 Loans accounted for on a non-accrual basis . . . . . . . . . Loans contractually past due ninety days or more as to $30,773 (Dollars in Thousands) $3,649 $20,960 $8,170 $6,191 interest or principal payments . . . . . . . . . . . . . . . . . . . . Loans accounted for as ‘‘troubled debt restructuring’’ 7,833 — 7,666 213 5,241 165 2,937 103 7,064 491 The allowance for possible loan losses increased 74.5% to $84,905,000 at December 31, 2004 from $48,646,000 at December 31, 2003. The increase in the allowance for possible loan losses can be primarily attributed to the additional allowance for possible loan losses related to the LFIN acquisition, totaling $33,865,000. On October 29, 2004, an approximately $9.6 million original loan relationship was refinanced by the borrower with a non-affiliated third party lender and as a result the Company recovered approximately $3.05 million of interest and principal. This recovery positively affected the Company’s 2004 provision for possible loan losses. The increase in non-accrual loans from 2003 to 2004 can be attributed to certain non-accrual loans acquired as a result of the LFIN acquisition. The following table presents information concerning the aggregate amount of non-accrual and past due foreign loans extended to persons or entities in foreign countries. Certain loans may be classified in one or more category: December 31, 2004 2003 2002 2001 2000 Loans accounted for on a non-accrual basis . . . . . . . . . . . . . . . . Loans contractually past due ninety days or more as to interest $13,741 (Dollars in Thousands) $82 $ 85 $254 $ 82 or principal payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104 597 21 66 258 The gross income that would have been recorded during 2004 and 2003 on non-accrual and restructured loans in accordance with their original contract terms was $962,000 and $1,814,000 on domestic loans and $241,000 and $56,000 on foreign loans, respectively. The amount of interest income on such loans that was recognized in 2004 and 2003 was $195,000 and $1,086,000 on domestic loans and $41,000 and $5,000 for foreign loans, respectively. The non-accrual loan policy of the bank subsidiaries is to discontinue the accrual of interest on loans when management determines that it is probable that future interest accruals will be uncollectible. Interest 8 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. Under special circumstances, a loan may be more than 90 days delinquent as to interest or principal and not be placed on non-accrual status. This situation generally results when a bank subsidiary has a borrower who is experiencing financial difficulties, but not to the extent that requires a restructuring of indebtedness. The majority of this category is composed of loans that are considered to be adequately secured and/or for which there has been a recent history of payments. When a loan is placed on non-accrual status, any interest accrued, not paid is reversed and charged to operations against interest income. Loan commitments, consisting of unused commitments to lend, letters of credit, credit card lines and other approved loans, that have not been funded, were $1,406,598,000 and $770,896,000 at December 31, 2004 and 2003, respectively. The increase in loan commitments can be attributed to the LFIN acquisition. See Note 20 to the Consolidated Financial Statements. The following table summarizes loan balances at the end of each year and average loans outstanding during the year; changes in the allowance for possible loan losses arising from loans charged-off and 9 recoveries on loans previously charged-off by loan category; and additions to the allowance which have been charged to expense: 2004 2003 2002 2001 2000 (Dollars in Thousands) Loans, net of unearned discounts, outstanding at December 31 . . . . . . $4,888,974 $2,749,000 $2,769,562 $2,648,532 $2,243,279 Average loans outstanding during the year (Note 1) . . . . . . . . . . . . . . . . . $3,982,580 $2,756,003 $2,664,856 $2,358,886 $2,103,593 Balance of allowance at December 31 . Provision charged to expense . . . . . . . $ 48,646 6,500 $ 44,213 8,291 $ 40,065 8,541 $ 30,812 8,631 $ 26,770 6,824 Loans charged off: Domestic: Commercial, financial and agricultural . . . . . . . . . . . . . . . Real estate—mortgage . . . . . . . . Real estate—construction . . . . . . Consumer . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . Total loans charged off: . . . . . . . . . . . Recoveries credited to allowance: Domestic: Commercial, financial and agricultural . . . . . . . . . . . . . . . Real estate—mortgage . . . . . . . . Real estate—construction . . . . . . Consumer . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . Total recoveries . . . . . . . . . . . . . . . . . (5,732) (1,179) (295) (2,034) (273) (9,513) 4,841 93 17 451 5 5,407 Net loans charged off . . . . . . . . . . . . . (4,106) Allowance acquired (disposed) in (2,174) (489) — (2,173) (107) (4,943) (2,490) (240) — (2,412) (115) (5,257) (2,023) (335) — (1,895) (16) (4,269) (1,161) (176) — (2,323) (22) (3,682) 313 41 — 287 444 495 247 — 553 34 1,085 (3,858) 1,329 (3,928) 435 21 — 471 9 936 502 69 — 327 2 900 (3,333) (2,782) purchase or sale transactions . . . . . . 33,865 — (465) 3,955 — Balance of allowance at December 31 . $ 84,905 $ 48,646 $ 44,213 $ 40,065 $ 30,812 Ratio of net loans charged-off during the year to average loans outstanding during the year (Note 1) . . . . . . . . . . . . . . . . . . . . Ratio of allowance to loans, net of unearned discounts, outstanding at December 31 . . . . . . . . . . . . . . . . . .10% .14% .15% .14% .13% 1.74% 1.77% 1.60% 1.51% 1.37% (Note 1) The average balances for purposes of the above table are calculated on the basis of month-end balances. 10 The allowance for possible loan losses has been allocated based on the amount management has deemed to be reasonably necessary to provide for the probable losses incurred within the following categories of loans at the dates indicated and the percentage of loans to total loans in each category: At December 31, 2004 2003 2002 2001 2000 Allowance Percent of total Allowance Percent of total Allowance Percent of total Allowance Percent of total Allowance Percent of total (Dollars in Thousands) $48,132 55.5% $26,359 50.9% $27,024 57.5% $24,101 56.1% $18,904 57.2% Commercial, Financial and Agricultural . . . Real estate— Mortgage . . . . 17,060 Real estate— Construction . . Consumer . . . . . Foreign . . . . . . . 13,314 4,072 2,327 19.6 15.3 4.7 4.9 9,328 9,266 2,635 1,058 18.0 17.9 5.1 8.1 8,604 4,686 2,720 1,179 18.3 10.0 5.8 8.4 7,147 4,389 2,926 1,502 16.6 10.2 6.8 10.3 4,222 3,418 2,437 1,831 12.8 10.3 7.4 12.3 $84,905 100.0% $48,646 100.0% $44,213 100.0% $40,065 100.0% $30,812 100.0% 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 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, (i) when an exposure beyond any collateral coverage is apparent, (ii) when no further collection of the portion of the loan so exposed is anticipated based on actual results, (iii) when the credit enhancements, if any, are not adequate, and (iv) when the borrower’s financial condition would so indicate. 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 uncollectible 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, 2004 was adequate to absorb probable losses from loans in the portfolio at that date. See Critical Accounting Policies on page 23. 11 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 . . . . . . . . . . . . . . . . . Year Ended December 31, 2004 Year Ended December 31, 2003 Percent Increase (Decrease) 2004 vs. 2003 Year Ended December 31, 2002 Percent Increase (Decrease) 2003 vs. 2002 $ 73,877 $ 60,022 23.1% $52,648 14.0% (Dollars in Thousands) 19,320 7,083 8,884 13,012 12,640 14,104 11,801 23,390 8,606 9,350 37.0 (40.0) (62.0) 51.2 35.2 13,000 5,669 2,303 (2,598) 14,623 8.5 108.2 915.6 (431.3) (36.1) Total non-interest income . . . . . . $134,816 $127,273 5.9% $85,645 48.6% Non-interest income for 2004 was positively affected by the Company’s expansion into the state of Oklahoma through its acquisition of LFIN. The Company recorded investment securities gains of $8,884,000 in 2004 compared to gains of $23,390,000 for 2003 and gains of $2,303,000 in 2002. These gains in 2003 occurred due to a program to reposition a portion of the Company’s bond portfolio to realize the equity that was eroding in the portfolio due to rapid principal repayments, the result of which, in effect, accelerated future earnings. The decreases in non-banking service charges for 2004 can be attributed to a decrease in fees earned by the Company’s investment services unit. Non-interest income also includes income on other investments. Income on other investments increased to $13,012,000 in 2004 compared to $8,606,000 in 2003, and $(2,598,000) in 2002. The increase in 2004 can be attributed to the LFIN acquisition. The decrease in 2002 can be attributed to losses taken by the Company on its investment in AFT. Other income for 2002 was positively affected by the sale of three bank branches in Rockdale, Taylor and Giddings, Texas to Citizen’s National Bank located in Cameron, Texas. The branches were previously acquired by the Company in 2001 as part of its acquisition of National Bancshares Corporation. The gain recognized on the sale totaled $3,100,000. Non-Interest Expense Employee compensation and benefits . . . . . . . . . . . . . . . . . . . Occupancy . . . . . . . . . . . . . . . . . . . Depreciation of bank premises and equipment . . . . . . . . . . . . . . . . . Professional fees . . . . . . . . . . . . . . Stationery and supplies . . . . . . . . . . Amortization of identified intangible assets . . . . . . . . . . . . . . . . . . . . . Advertising . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . Year Ended December 31, 2004 Year Ended December 31, 2003 Percent Increase (Decrease) 2004 vs. 2003 Year Ended December 31, 2002 Percent Increase (Decrease) 2003 vs. 2002 (Dollars in Thousands) $ 83,631 18,403 $ 72,860 12,050 14.8% 52.7 $ 65,907 13,211 10.5% (8.8) 18,975 6,513 5,075 3,681 10,082 48,820 18,105 7,545 3,855 1,276 7,011 37,052 4.8 (13.7) 31.6 188.5 43.8 31.8 16,153 6,089 4,079 1,812 6,010 41,582 12.1 23.9 (5.5) (29.6) 16.7 (10.9) Total non-interest expense . . . . . . $195,180 $159,754 22.2% $154,843 3.2% 12 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. The increases in non-interest expense for the three years ended 2004 were due to the expanded operations of the Company’s bank subsidiaries (including the acquisition of LFIN in June 2004, which added approximately 700 employees, 52 branches and $42,188,000 in identified intangible assets) and increased fees paid by the Company’s investment banking unit, the GulfStar Group in 2003. 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 operations, primarily those of employment and services. Financial Condition Investment Securities The following table sets forth the carrying value of investment securities as of December 31, 2004, 2003 and 2002: December 31, 2004 2003 2002 (Dollars in Thousands) U.S. Treasury and Government Securities Available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,276 $ 22,011 $ 12,589 Mortgage-backed securities Available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,743,225 2,868,293 2,895,338 Obligations of states and political subdivisions Available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104,317 110,382 105,952 Equity securities Available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,235 10,455 8,057 Other securities Held to maturity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,385 4,780 2,160 28,200 2,060 48,775 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,877,218 $3,041,501 $3,072,771 The following tables set forth the contractual maturities of investment securities, based on amortized cost, at December 31, 2004 and the average yields of such securities, except for the totals, which reflect the 13 weighted average yields. Actual maturities will differ from contractual maturities because borrowers may have the right to prepay obligations with or without prepayment penalties. Within one year Adjusted Cost Yield Available for Sale Maturing After one but within five years Adjusted Cost Yield After five but within ten years Adjusted Cost Yield (Dollars in Thousands) After ten years Adjusted Cost Yield U.S. Treasury and obligations of U.S. Government agencies . . . . . . . . . . . . . . . . $9,285 1.79% $ — —% $ Mortgage-backed securities . . . . . . . . . . . . . . Obligations of states and political subdivisions . Other securities . . . . . . . . . . . . . . . . . . . . . Equity securities . . . . . . . . . . . . . . . . . . . . . 353 8.13 — — — — 325 — 57,204 5.36 — — — — — — — 215,879 2,300 — — —% $ — —% 4.40 4.52 — — 3,452,315 96,940 12,000 4.54 4.69 3.61 5,140 20.02 Total . . . . . . . . . . . . . . . . . . . . . . . . . . $9,963 1.96% $57,204 5.36% $218,179 4.36% $3,566,395 4.57% Within one year Adjusted Cost Yield Held to Maturity Maturing After one but within five years Adjusted Cost Yield After five but within ten years Adjusted Cost Yield (Dollars in Thousands) After ten years Adjusted Cost Yield Other securities . . . . . . . . . . . . . . . . . . . . . . $ 235 7.09% $ 2,150 5.22% $ — — $ — — Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 235 7.09% $ 2,150 5.22% $ — — $ — — Mortgage-backed securities are securities primarily issued by the Federal Home Loan Mortgage Corporation (‘‘Freddie Mac’’), Federal National Mortgage Association (‘‘Fannie Mae’’), and the Government National Mortgage Association (‘‘Ginnie Mae’’). Loans The amounts of loans outstanding, by classification, at December 31, 2004, 2003, 2002, 2001 and 2000 are shown in the following table: 2004 2003 2002 2001 2000 December 31, Commercial, financial and agricultural . . Real estate—mortgage . . . . . . . . . . . . . Real estate—construction . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . $2,710,270 960,599 749,689 229,302 239,622 $1,400,173 495,481 492,208 139,987 222,797 (Dollars in Thousands) $1,595,140 507,837 276,595 160,546 233,276 $1,488,196 441,296 271,026 180,652 273,038 $1,286,576 287,319 232,589 165,875 278,119 Total loans . . . . . . . . . . . . . . . . . . . . 4,889,482 2,750,646 2,773,394 2,654,208 2,250,478 Unearned discount . . . . . . . . . . . . . . . . (508) (1,646) (3,832) (5,676) (7,199) Loans, net of unearned discount . . . . $4,888,974 $2,749,000 $2,769,562 $2,648,532 $2,243,279 The following table shows the amounts of loans (excluding real estate mortgages and consumer loans) outstanding as of December 31, 2004, which based on remaining scheduled repayments of principal are 14 due in the years indicated. Also, the amounts due after one year are classified according to the sensitivity to changes in interest rates: Maturing Within one year After one but within five years After five years Total (Dollars in Thousands) Commercial, financial and agricultural . . . . . . . . . . . Real estate—construction . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 718,987 382,840 163,192 $1,580,583 332,932 73,166 $410,700 33,917 3,264 $2,710,270 749,689 239,622 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,265,019 $1,986,681 $447,881 $3,699,581 Due after one but within five years . . . . . . . . . . . . . . . . . . . Due after five years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $401,705 95,862 $1,584,976 352,019 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $497,567 $1,936,995 Interest sensitivity Fixed Rate Variable Rate (Dollars in Thousands) International Operations On December 31, 2004, the Company had $239,622,000 (2.4% of total assets) in loans outstanding to borrowers domiciled in foreign countries. The loan policies of the Company’s bank subsidiaries generally require that loans to borrowers domiciled in foreign countries 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, 2004 is presented below. Amount of Loans Related Allowance for Possible Losses (Dollars in Thousands) Secured by certificates of deposits 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. $131,140 33,440 26,692 companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,213 $ 68 339 138 12 Direct unsecured Mexican sovereign debt (principally former FICORCA debt) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other (principally Mexico real estate) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,071 44,066 31 1,739 $239,622 $2,327 15 The transactions for the year ended December 31, 2004, in that portion of the allowance for possible loan losses related to foreign debt were as follows: (Dollars in Thousands) Balance at December 31, 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Chargeoffs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net chargeoffs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision charged to operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance at December 31, 2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,058 (299) 5 (294) 1,563 $2,327 Deposits Deposits: Demand—non-interest bearing 2004 2003 Average Balance Average Balance (Dollars in Thousands) Domestic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 883,567 105,092 $ 671,771 80,206 Total demand non-interest bearing . . . . . . . . . . . . . . . . . . . . . . . . . . 988,659 751,977 Savings and interest bearing demand Domestic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,545,905 286,809 Total savings and interest bearing demand . . . . . . . . . . . . . . . . . . . . 1,832,714 Time certificates of deposit $100,000 or more: Domestic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less than $100,000: Domestic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 793,940 873,721 796,289 305,054 1,008,259 309,487 1,317,746 506,628 951,368 416,217 363,019 Total time, certificates of deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,769,004 2,237,232 Total deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,590,377 $4,306,955 16 2004 2003 2002 (Dollars in Thousands) Interest expense: Savings and interest bearing demand Domestic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,991 1,806 $ 8,145 2,023 $11,320 2,865 Total savings and interest bearing demand . . . . . . . . . . . . . . . . . . . . . 13,797 10,168 14,185 Time, certificates of deposit $100,000 or more Domestic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,483 17,327 9,314 19,026 13,442 24,743 Less than $100,000 Domestic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total time, certificates of deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,396 4,453 44,659 7,890 4,783 41,013 12,652 7,070 57,907 Total interest expense on deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $58,456 $51,181 $72,092 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, sales programs 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, 2004 were $6,571,104,000, an increase of 48.1% over $4,435,699,000 at December 31, 2003. The increase in deposits from 2003 to 2004 is primarily the result of the LFIN acquisition completed on June 18, 2004, and the Company’s increased sales efforts. Return on Equity and Assets Certain key ratios for the Company for the years ended December 31, 2004, 2003 and 2002 follows (Note 1): Years ended December 31, 2004 2003 2002 Percentage of net income to: Average shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Percentage of average shareholders’ equity to average total assets . . . . . . . Percentage of cash dividends per share to net income per share . . . . . . . . 18.17% 22.68% 20.44% 1.79 1.46 7.89 8.05 26.62 38.42 1.58 7.74 23.92 (Note 1) The average balances for purposes of the above table are calculated on the basis of month-end balances. 17 Liquidity and Capital Resources Liquidity 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. Deposits from persons and entities domiciled in Mexico comprise a stable portion of the deposit base of the Company’s bank subsidiaries. Historically, the Mexico based deposits of the Company’s bank subsidiaries have been a stable source of funding. Such deposits comprised approximately 28%, 39% and 41% of the Company’s bank subsidiaries’ total deposits as of December 31, 2004, 2003 and 2002, respectively. The decline in the concentration of Mexico based deposits can be attributed to recent acquisitions, including LFIN, and the growth in the Company’s deposit base in Texas. Other important funding sources for the Company’s bank subsidiaries 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. Asset/Liability Management The Company’s fund management policy has as its primary focus the measurement and management of the banks’ earnings at risk in the face of rising or 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 statement of condition 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 statement of condition 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. The net interest rate sensitivity at December 31, 2004, is illustrated in the following table. This information reflects the balances of assets and liabilities whose rates are subject to change. As indicated in the table on the following page, the Company is liability sensitive during the early time periods and is asset 18 sensitive in the longer periods. The table shows the sensitivity of the statement of condition at one point in time and is not necessarily indicative of the position at future dates. INTEREST RATE SENSITIVITY (Dollars in Thousands) 3 Months or Less Over 3 Months to 1 Year Rate/Maturity Over 1 Year to 5 Years (Dollars in Thousands) Over 5 Years Total December 31, 2004 Rate sensitive assets Federal funds sold . . . . . . . . . . . . . Time deposits with banks . . . . . . . . Investment securities . . . . . . . . . . . Loans, net of non-accruals . . . . . . . $ 21,000 396 144,675 2,932,781 $ — $ — 536,555 432,095 — $ — 1,050,800 708,756 — $ — 2,145,188 785,108 21,000 396 3,877,218 4,858,740 Total earning assets . . . . . . . . . . . . $ 3,098,852 $ 968,650 $ 1,759,556 $2,930,296 $8,757,354 Cumulative earning assets . . . . . . . . $ 3,098,852 $ 4,067,502 $ 5,827,058 $8,757,354 Rate sensitive liabilities Time deposits . . . . . . . . . . . . . . . . Other interest bearing deposits . . . . Fed funds purchased and securities old under repurchase agreement . Other borrowed funds . . . . . . . . . . Junior subordinated deferrable $ 1,403,276 2,232,102 $ 1,280,123 — $ 503,454 — $ 1,150 $3,188,003 — 2,232,102 215,906 1,670,120 97,179 — 6,721 — 300,000 79 619,806 1,670,199 interest debentures . . . . . . . . . . . 127,523 56,194 — 51,678 235,395 Total interest bearing liabilities . . . . $ 5,648,927 $ 1,433,496 $ 510,175 $ 352,907 $7,945,505 Cumulative sensitive liabilities . . . . $ 5,648,927 $ 7,082,423 $ 7,592,598 $7,945,505 Repricing gap . . . . . . . . . . . . . . . . Cumulative repricing gap . . . . . . . . Ratio of interest-sensitive assets to liabilities . . . . . . . . . . . . . . . . . . Ratio of cumulative, interest- sensitive assets to liabilities . . . . . $(2,550,075) $ (464,846) $ 1,249,381 (1,765,540) (3,014,921) (2,550,075) $2,577,389 811,849 $ 811,849 .549 .549 .676 .574 3.449 .767 8.303 1.102 1.102 The detailed inventory of statement of condition 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 statement of condition 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 19 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, 2004, based on these simulations, a rate shift of 200 basis points in interest rates up or 100 basis points down will not vary earnings by more than 3% of projected 2005 net interest income. The 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. The Company believes that it is properly positioned for a potential rate increase or decrease. 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 statement of condition. 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 21 to the Consolidated Financial Statements. At December 31, 2004, the aggregate amount legally available to be distributed to the Company from bank subsidiaries as dividends was approximately $61,000,000, assuming that each bank subsidiary continues to be classified as ‘‘well capitalized’’ under the applicable regulations and excluding certified surplus. Pursuant to Texas law, a Texas state bank’s lending limit is twenty-five percent of the bank’s capital and certified surplus. The board of directors of the bank determines how much surplus will be certified. Except to absorb losses in excess of undivided profits and uncertified surplus, certified surplus may not be reduced without the prior written approval of the Texas banking commissioner. The restricted capital (capital, surplus and certified surplus) of the bank subsidiaries was approximately $863,604,000 as of December 31, 2004. The undivided profits of the bank subsidiaries were approximately $417,388,000 as of December 31, 2004. At December 31, 2004, the Company has outstanding $1,670,199,000 in other borrowed funds and $235,395,000 in junior subordinated deferrable interest debentures. 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, 2004, shareholders’ equity was $753,090,000 compared to $577,383,000 at December 31, 2003, an increase of $175,706,000, or 30.4%. The increase in shareholders’ equity can be attributed to the retention of earnings and the issuance of 2,114,558 shares of the Company’s Common Stock as part of the LFIN acquisition. 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 6.91% at December 31, 2004 and 8.75% at December 31, 2003. The core deposit intangibles and goodwill of $333,662,000 as of December 31, 2004, 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 substantial increase in core deposit intangibles and goodwill and the resulting decrease in the Company’s leverage ratio can be attributed to the LFIN acquisition. 20 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 10.74% and 17.30% and risk weighted total capital ratios of 11.99% and 19.33% as of December 31, 2004 and 2003, respectively, which are well above the minimum regulatory requirements and exceed the well capitalized ratios (see note 21 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 2004 and 2003 were certain capital expenditures relating to the modernization and improvement of several existing bank facilities and the expansion of the bank branch network. Junior Subordinated Deferrable Interest Debentures In January 2003, the Financial Accounting Standards Board issued FASB Interpretation No. 46 (‘‘FIN 46’’), ‘‘Consolidation of Variable Interest Entities.’’ The intention of FIN 46 was to clarify the application of Accounting Research Bulletin No. 51, ‘‘Consolidated Financial Statements,’’ to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 requires an enterprise considered to be a variable interest entity (‘‘VIE’’) to be consolidated by the primary beneficiary, which represents the enterprise that will absorb the majority of the VIE’s expected losses if they occur, receive a majority of the VIE’s residual returns if they occur, or both. In December 2003, the FASB issued Staff Interpretation No. 46R (‘‘FIN 46R’’), ‘‘Consolidation of Variable Interest Entities, an interpretation of ARB 51 (revised December 2003),’’ which replaces FIN 46, in order to clarify the guidance in the original interpretation. FIN 46 applies to variable interest entities created after January 31, 2003. FIN 46 also applies to all variable interest entities created prior to February 1, 2003 that are considered to be special-purpose entities, as defined in FIN 46R, as of December 31, 2003. FIN 46R must be applied to all variable interest entities no later than the end of the first reporting period that ends after March 15, 2004. The Company early adopted the provisions of FIN 46R as of December 31, 2003. The Company has formed eight statutory business trusts under the laws of the State of Delaware, for the purpose of issuing trust preferred securities. As part of the LFIN acquisition, the Company acquired three additional statutory business trusts previously formed by LFIN for the purpose of issuing trust preferred securities. The eight statutory business trusts formed by the Company and the three business trusts acquired in the LFIN transaction (the ‘‘Trusts’’) have each issued Capital and Common Securities and invested the proceeds thereof in an equivalent amount of junior subordinated debentures (the ‘‘Debentures’’) issued by the Company or LFIN, as appropriate. The Company has succeeded to the obligations of LFIN under the LFIN Debentures, which have an outstanding principal balance of $62,115,000. The Debentures will mature on various dates; however the Debentures may be redeemed at specified prepayment prices, in whole or in part after the optional redemption dates specified in the respective indentures or in whole upon the occurrence of any one of certain legal, regulatory or tax events specified in respective indentures. As of December 31, 2004, the principal amount of debentures outstanding totaled $235,395,000. The Debentures are subordinated and junior in right of payment to all present and future senior indebtedness (as defined in the respective indentures) of the Company, and are pari passu with one 21 another. The interest rate payable on, and the payment terms of the Debentures are 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 on Trusts I through IV and LFIN Trust II and for up to twenty consecutive quarterly periods on Trusts V through VIII and LFIN Trusts I and III. 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 prior to December 31, 2003. Since the Company’s adoption of FIN 46R on December 31, 2003, the Trusts are treated as investments of the Company and not consolidated in the consolidated financial statements. Although the Capital Securities issued by each of the Trusts are not included as a component of shareholders’ equity on the consolidated 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. For December 31, 2004, the total $235,395,000 of the Capital Securities outstanding qualified as Tier 1 capital. In March 2005, the Federal Reserve Board issued a final rule that would continue to allow the inclusion of trust preferred securities in Tier 1 capital, but with stricter quantitative limits. Under the final rule, after a five-year transition period ending March 31, 2009, the aggregate amount of trust preferred securities and certain other capital elements would be limited to 25% of Tier 1 capital elements, net of goodwill, less any associated deferred tax liability. The amount of trust preferred securities and certain other elements in excess of the limit could be included in Tier 2 capital, subject to restrictions. Bank holding companies with significant international operations will be expected to limit trust preferred securities to 15% of Tier 1 capital elements, net of goodwill; however, they may include qualifying mandatory convertible preferred securities up to the 25% limit. The following table illustrates key information about each of the Debentures and their interest rates at December 31, 2004: Junior Subordinated Deferrable Interest Debentures (in thousands) $ 10,183 $ 25,597 $ 33,789 $ 22,405 $ 20,319 $ 25,361 $ 10,310 $ 25,316 $ 41,495 $ 10,310 $ 10,310 $235,395 Trust I . . . . . . . Trust II . . . . . . Trust III . . . . . . Trust IV . . . . . . Trust V . . . . . . Trust VI . . . . . . Trust VII . . . . . . . . . Trust VIII . . LFIN Trust I LFIN Trust II . . LFIN Trust III . Repricing Frequency Interest Rate Interest Rate Index Maturity Date Optional Redemption Date Fixed Semi-Annually Semi-Annually Semi-Annually Quarterly Quarterly Quarterly Quarterly Fixed Semi-Annually Quarterly 10.18% Fixed June 2031 July 2031 June 2011 July 2006 5.74% LIBOR + 3.75 6.44% LIBOR + 3.75 December 2031 December 2006 6.00% LIBOR + 3.70 April 2032 5.72% LIBOR + 3.65 5.74% LIBOR + 3.45 November 2032 November 2007 5.41% LIBOR + 3.25 April 2033 5.12% LIBOR + 3.05 October 2033 9.00% Fixed 5.61% LIBOR + 3.625 July 2032 5.74% LIBOR + 3.45 November 2032 November 2007 April 2008 October 2008 September 2031 September 2006 April 2007 July 2007 July 2007 July 2032 22 Contractual Obligations and Commercial Commitments The following table presents contractual cash obligations of the Company (other than deposit liabilities) as of December 31, 2004: Payments due by Period Contractual Cash Obligations Total Less than One Year One to Three Years Three to Five Years After Five Years Securities sold under repurchase agreements . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank borrowings . Junior subordinated deferrable interest debentures . . . . . . . . . . . . . . . . . . . $ 619,806 1,670,199 $ 316,162 1,430,120 $ 3,544 240,000 235,395 — — Total Contractual Cash Obligations . . . $2,525,400 $1,746,282 $243,544 $100 — — $100 $300,000 79 235,395 $535,474 (Dollars in Thousands) The following table presents contractual commercial commitments of the Company (other than deposit liabilities) as of December 31, 2004: Commercial Commitments Financial and Performance Standby Amount of Commitment Expiration Per Period Total Less than One Year One to Three Years Three to Five Years After Five Years (Dollars in Thousands) Letters of Credit . . . . . . . . . . . . . . . . . Commercial Letters of Credit . . . . . . . . . . . . . . . . . . . . . . . . . . Credit Card Lines Other Commercial Commitments . . . . . . $ 91,171 4,486 27,135 1,283,806 $ 82,692 4,486 27,135 744,439 $ 8,469 — — 413,796 Total Commercial Commitments . . . . . $1,406,598 $858,752 $422,265 $ 10 — — 55,807 $55,817 $ — — — 69,764 $69,764 Due to the nature of the Company’s commercial commitments, including unfunded loan commitments and lines of credit, the amounts presented above do not necessarily reflect the amounts the Company anticipates funding in the periods presented above. 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 accounting policies are described in the footnotes to the consolidated financial statements. Certain accounting policies involve significant subjective 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 as a policy critical to the sound operations of the bank subsidiaries. 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, which includes general economic conditions and other qualitative risk factors both internal and external to the Company. See also discussion regarding the allowance for possible loan losses and provision for possible 23 loan losses included in the results of operations and ‘‘Provision and Allowance for Possible Loan Losses’’ included in Notes 1 and 5 of the Notes to Consolidated Financial Statements for further information regarding the Company’s provision and allowance for possible loan losses policy. 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 a loan has any potential problem and if a loan should be placed on the Company’s internal classified report. Additionally, the Company’s credit department reviews the majority of the loans regardless of whether they are past due and segregates any loans with potential problems for further review. The credit department will discuss the potential problem 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. After the above analysis is completed, the Company will determine if a 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. The Company’s internal classified report is segregated into the following categories: (i) ‘‘Pass Credits,’’ (ii) ‘‘Special Review Credits,’’ (iii) ‘‘Watch List Credits-Pass Credits,’’ or (iv) ‘‘Watch List Credits- Substandard and Doubtful 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’’ or the ‘‘Watch List Credits-Pass Credits’’ category reflect the Company’s opinion that the loans reflect potential weakness which require monitoring on a more frequent basis; however, the ‘‘Special Review Credits’’ or the ‘‘Watch List Credits-Pass 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 ‘‘Watch List Credits-Substandard and Doubtful 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-Substandard and Doubtful Credits’’ are potentially 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 allowance, based on historical loss experience on the Company’s remaining loan portfolio, which includes the ‘‘Pass Credits,’’ ‘‘Special Review Credits,’’ ‘‘Watch List Credits-Pass Credits,’’ and ‘‘Watch List Credits-Substandard and Doubtful Credits’’ is determined by segregating the remaining loan portfolio into certain categories such as commercial loans, installment loans, international loans, loan concentrations and overdrafts. Installment loans are then further segregated by number of days past due. A historical loss percentage, adjusted for (i) management’s evaluation of changes in lending policies and procedures, (ii) current economic conditions in the market area served by the Company, (iii) other risk factors, (iv) the effectiveness of the internal loan review function, (v) changes in loan portfolios, and (vi) the composition and concentration of credit volume is applied to each category. Each category is then added together to determine the allowance allocated under Statement of Financial Accounting Standards No. 5. The Company’s management continually reviews the allowance for loan loss 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 allowance for loan loss. If the basis of the Company’s assumptions change, the allowance for loan loss would either decrease or increase and the Company would increase or decrease the provision for loan loss charged to operations accordingly. 24 Recent Accounting Standards Issued See Note 1—New Accounting Standards in the accompanying notes to the consolidated financial statements for details of recently issued and recently adopted accounting standards and their impact on the Company’s consolidated financial statements. Common Stock and Dividends The Company had issued and outstanding 50,899,550 shares of $1.00 par value Common Stock held by approximately 2,447 holders of record at March 7, 2005. The book value of the stock, adjusted for stock dividends, at December 31, 2004 was $16.49 per share compared with $12.94 per share at December 31, 2003. 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 2003 and 2004, as quoted on the NASDAQ National Market for each of the quarters in the two year period ended December 31, 2004. 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 $36.75 per share at March 7, 2005. 2004: 2003: First quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Second quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Third quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fourth quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . First quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Second quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Third quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fourth quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . High $44.17 43.52 40.42 41.52 High $33.57 39.39 35.66 38.18 Low $36.80 32.20 32.96 35.36 Low $28.60 27.40 28.01 33.20 The Company paid cash dividends to the shareholders in 2004 of $.50 ($.40, adjusted for the effect of stock dividends) and $.40 per share on April 30, 2004 and November 1, 2004, respectively to all holders of record on April 15, 2004 and October 15, 2004, respectively, or $39,767,000 in the aggregate during 2004. In 2003, the Company paid cash dividends of $.27 per share on April 15, and $.40 per share on October 15, adjusted for stock dividends, or $32,625,000 in the aggregate. The Company has no set schedule for paying cash or stock dividends and does not guarantee that they will be declared in the future. In addition, the Company has issued stock dividends during the last five-year period as follows: Date Stock Dividend May 18, 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . May 17, 2001 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . May 20, 2002 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . May 19, 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . May 3, 2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 21 of notes to Consolidated Financial Statements. 25 Stock Repurchase Program The Company expanded its formal stock repurchase program on December 16, 2004. Under the expanded stock repurchase program, the Company is authorized to repurchase up to $175,000,000 of its Common Stock through December 31, 2005. 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 7, 2005, a total of 3,663,577 shares had been repurchased under this program at a cost of $145,650,000, which shares are now reflected as 7,253,456 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 $195,973,000. 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 $195,973,000 cap will occur in the future. As of March 7, 2005, the Company has approximately $166,624,000 invested in treasury shares, which amount has been accumulated since the inception of the Company. Share repurchases are only conducted under publicly announced repurchase programs approved by the Board of Directors. The following table includes information about share repurchases for the quarter ended December 31, 2004. October 1—October 31, 2004 . . . . . . . . . . . . . . . November 1—November 30, 2004 . . . . . . . . . . . . December 1—December 31, 2004 . . . . . . . . . . . . Total Number of Shares Purchased — — 7,324 7,324 Average Price Paid Per Share $ — — 39.90 $39.90 Shares Purchased as Part of a Publicly- Announced Program — — — — Approximate Dollar Value of Shares Available for Repurchase(1) $29,675,000 29,675,000 29,383,000 (1) The formal stock repurchase program was initiated in 1999 and has been expanded periodically. The current program allows for the repurchase of up to $175,000,000 of treasury stock through December 2005 of which $29,383,000 is remaining. Recent Sales of Unregistered Securities On December 31, 2004, 7,324 shares of unregistered Common Stock were issued pursuant to the exercise of options at an exercise price of $13.32, adjusted for stock dividends, by certain employees of the GulfStar Group, who are not executive officers of the Company. Neither the options nor the shares of Common Stock of the Company underlying these options were registered under the Company’s 1996 Stock Option Plan. The shares were issued in a transaction by the Company not involving a public offering, which was exempted from registration pursuant to Section 4(2) of the Securities Act of 1933. The shares of Company Common Stock issued are restricted securities and are subject to resale restrictions. 26 Equity Compensation Plan Information The following table sets forth information as of December 31, 2004, with respect to the Company’s equity 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 . . . . . . . . . . . . . . . . . . . 1,298,745 Equity Compensation plans not approved by security holders(1) . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . 139,160 1,437,905 $14.90 13.32 $14.75 388,157 — 388,157 (1) The Company granted non-qualified stock options exercisable for a total of 139,160 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. 27 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM 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, 2004 and 2003, 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, 2004. 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 the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of International Bancshares Corporation and subsidiaries as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. As discussed in notes 1 and 11 to the consolidated financial statements, effective December 31, 2003, the Company changed its method of accounting for its investment in its statutory business trusts, and as discussed in note 1 to the consolidated financial statements, effective January 1, 2002, the Company changed its method of accounting for goodwill and other intangible assets. We also have audited in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of International Bancshares Corporation and subsidiaries’ internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 15, 2005 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting. /s/ KPMG LLP San Antonio, Texas March 15, 2005 28 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Consolidated Statements of Condition December 31, 2004 and 2003 (Dollars in Thousands, Except Per Share Amounts) 2004 2003 Assets Cash and due from banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal funds sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 174,770 21,000 $ 152,229 63,500 Total cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195,770 215,729 Time deposits with banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 396 100 Investment securities: Held to maturity (Market value of $2,385 on December 31, 2004 and $2,160 on December 31, 2003) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,385 2,160 Available for sale (Amortized cost of $3,851,741 on December 31, 2004 and $3,019,584 on December 31, 2003) . . . . . . . . . . . . . . . . . . . . . . . . . 3,874,833 3,039,341 Total investment securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,877,218 3,041,501 Loans, net of unearned discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less allowance for possible loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,888,974 (84,905) 2,749,000 (48,646) Net loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,804,069 2,700,354 Bank premises and equipment, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Identified intangible assets, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Goodwill, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302,230 41,140 301,578 44,400 289,262 61,888 220,602 28,891 244,113 5,892 67,442 53,686 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9,917,951 $6,578,310 See accompanying notes to consolidated financial statements. 29 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Consolidated Statements of Condition, continued December 31, 2004 and 2003 (Dollars in Thousands, Except Per Share Amounts) 2004 2003 Deposits: Liabilities Demand—non-interest bearing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Savings and interest bearing demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,150,999 2,232,102 3,188,003 $ 814,470 1,395,618 2,225,611 Total deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,571,104 4,435,699 Federal funds purchased and securities sold under repurchase agreements . . . Other borrowed funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Junior subordinated deferrable interest debentures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other liabilities 619,806 1,670,199 235,395 68,357 501,296 845,272 172,254 46,406 Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,164,861 6,000,927 Shareholders’ equity: Common shares of $1.00 par value. Authorized 75,000,000 shares; issued 68,431,225 shares on December 31, 2004 and 52,774,176 shares on December 31, 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated other comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . 68,431 130,597 705,642 15,010 919,680 52,774 37,777 639,606 12,842 742,999 Less cost of shares in treasury, 17,610,126 shares on December 31, 2004 and 14,068,296 shares on December 31, 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . (166,590) (165,616) Total shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 753,090 577,383 Total liabilities and shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . $9,917,951 $6,578,310 See accompanying notes to consolidated financial statements. 30 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Consolidated Statements of Income Years ended December 31, 2004, 2003 and 2002 (Dollars in Thousands, Except Per Share Amounts) 2004 2003 2002 Interest income: Loans, including fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Time deposits with banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal funds sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $236,079 92 1,577 $176,800 9 594 $183,803 36 671 Investment securities: Taxable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tax-exempt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109,092 5,071 467 135,132 5,146 370 164,272 4,990 156 Total interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352,378 318,051 353,928 Interest expense: Savings deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Time deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal funds purchased and securities sold under repurchase agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Junior subordinated deferrable interest debentures . . . . . . . . . . . . Senior notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,797 44,659 19,865 16,746 13,152 383 Total interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108,602 10,168 41,013 18,770 15,839 8,935 — 94,725 14,185 57,907 19,696 17,587 7,040 — 116,415 Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243,776 223,326 237,513 Provision for possible loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,500 8,291 8,541 Net interest income after provision for possible loan losses . . . . . 237,276 215,035 228,972 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73,877 60,022 52,648 19,320 7,083 8,884 13,012 12,640 14,104 11,801 23,390 8,606 9,350 13,000 5,669 2,303 (2,598) 14,623 Total non-interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134,816 127,273 85,645 See accompanying notes to consolidated financial statements. 31 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Consolidated Statements of Income, continued Years ended December 31, 2004, 2003 and 2002 (Dollars in Thousands, Except Per Share Amounts) 2004 2003 2002 Non-interest expense: Employee compensation and benefits . . . . . . . . . . . . . . . . . . . . $ Occupancy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation of bank premises and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Professional fees Stationery and supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of identified intangible assets . . . . . . . . . . . . . . . . Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83,631 $ 18,403 18,975 6,513 5,075 3,681 10,082 48,820 72,860 $ 12,050 18,105 7,545 3,855 1,276 7,011 37,052 Total non-interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . Provision for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195,180 176,912 57,880 159,754 182,554 60,426 65,907 13,211 16,153 6,089 4,079 1,812 6,010 41,582 154,843 159,774 54,013 Income before cumulative effect of a change in accounting principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cumulative effect of a change in accounting principle, net of tax . . 119,032 — 122,128 — 105,761 (5,130) Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 119,032 $ 122,128 $ 100,631 Basic earnings per common share: Weighted average number of shares outstanding: . . . . . . . . . . . . 49,707,319 48,362,449 49,944,476 Income before cumulative effect of a change in accounting principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Cumulative effect of a change in accounting principle, net of tax . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2.39 $ — 2.39 $ 2.53 $ — 2.53 $ 2.12 (.11) 2.01 Fully diluted earnings per common share: Weighted average number of shares outstanding: . . . . . . . . . . . . 50,704,445 49,334,313 51,086,371 Income before cumulative effect of a change in accounting principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Cumulative effect of a change in accounting principle, net of tax . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2.35 $ — 2.35 $ 2.48 $ — 2.48 $ 2.07 (.10) 1.97 See accompanying notes to consolidated financial statements. 32 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Consolidated Statements of Comprehensive Income Years ended December 31, 2004, 2003, and 2002 (Dollars in Thousands) 2004 2003 2002 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $119,032 $122,128 $100,631 Other comprehensive income, net of tax: Net unrealized (losses) gains on securities available for sale arising during the year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reclassification adjustment for gains on securities available for sale included in net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Change in fair value of equity method investee’s derivatives . . . . . . (6,361) (82,728) 31,809 8,529 — 44,997 616 543 (616) Comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $121,200 $ 85,013 $132,367 See accompanying notes to consolidated financial statements. 33 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Consolidated Statements of Shareholders’ Equity Years ended December 31, 2004, 2003 and 2002 (in Thousands) Number Common of Shares Stock Accumulated Other Retained Comprehensive Treasury Income (Loss) Stock Surplus Earnings Total Balance 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 . . . . Balance at December 31, 2002 . . . . . . . . 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 . . . . Balance at December 31, 2003 . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . Dividends: Shares issued . . . . . . . . . . . . . . . . Cash . . . . . . . . . . . . . . . . . . . . . . Purchase of treasury stock . . . . . . . . . Exercise of stock options . . . . . . . . . . Tax benefit for exercise of stock options Stock issued in acquisition . . . . . . . . . Other comprehensive income, net of tax: Net change in unrealized gains and losses on available for sale securities, net of reclassification adjustment . . . . . . . . . . . . . . . . . 33,214 — $33,214 $ 27,564 $490,328 — 100,631 — $ 18,221 — $ (72,299) $497,028 — 100,631 8,331 — — 221 8,331 — — 221 — (8,331) — (22,015) — — — 3,257 — — — — — — — (22,015) (63,594) 3,478 (63,594) — — — 41,766 — 10,510 — — 498 — — 52,774 — 13,229 — — 313 — 2,115 — — 41,766 — 10,510 — — 498 — — 52,774 — 13,229 — — 313 — 2,115 — — — — 32,352 — 32,352 (616) — (616) 30,821 560,613 — 122,128 49,957 — (135,893) 547,264 — 122,128 — (10,510) — (32,625) — — — 6,956 — — — — — — — (32,625) (29,723) 7,454 (29,723) — — — — — 37,777 639,606 — 119,032 — (13,229) — (39,767) — — — 3,761 — 1,192 — 87,867 (37,731) — (37,731) 616 12,842 — — 616 (165,616) 577,383 — 119,032 — — — — — — — — — (39,767) (974) (974) 4,074 — — 1,192 — 89,982 — — — — 2,168 — 2,168 Balance at December 31, 2004 . . . . . . . . 68,431 $68,431 $130,597 $705,642 $ 15,010 $(166,590) $753,090 See accompanying notes to consolidated financial statements. 34 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Consolidated Statements of Cash Flows Years ended December 31, 2004, 2003 and 2002 (Dollars in Thousands) Operating activities: Net income: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to reconcile net income to net cash provided $ 119,032 $ 122,128 $ 100,631 2004 2003 2002 by operating activities: Impairment charges and write downs on investments . . . . Provision for possible loan losses . . . . . . . . . . . . . . . . . . Depreciation of bank premises and equipment . . . . . . . . (Gain) Loss 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 . . . . . . . . . . . . . . . . . . . . . Investment securities transactions, net Accretion of junior subordinated debenture discounts . . . Amortization of identified intangible assets . . . . . . . . . . . Equity in (earnings) loss from affiliates and other investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred tax expense (benefit) . . . . . . . . . . . . . . . . . . . . (Increase) decrease in accrued interest receivable . . . . . . Decrease (increase) in other assets . . . . . . . . . . . . . . . . . Net decrease in other liabilities . . . . . . . . . . . . . . . . . . . — 6,500 18,975 (3,230) 1,687 — (611) 29,215 (8,884) 1,026 3,681 (11,993) 11,353 (3,983) 20,341 (24,840) — 8,291 18,105 121 1,890 — (861) 32,303 (23,390) — 1,276 (6,866) 6,153 6,302 (14,794) (4,756) 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) (896) (11,254) Net cash provided by operating activities . . . . . . . . . . . 158,269 145,902 134,756 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 decrease (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 purchase transaction . . . . . . . . . . . . . . . . . Cash acquired in purchase transaction . . . . . . . . . . . . . . Cash disposed in sale transactions . . . . . . . . . . . . . . . . . 29,558 875,816 (2,223,915) 791,425 87,400 (296) 55,697 (5,161) 53,227 (51,866) 4,648 (276,555) 66,009 — 5,400 1,239,766 (3,098,209) 1,818,213 — (1) 16,704 (30,565) 2,562 (54,003) 652 — — — 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) Net cash used in investing activities . . . . . . . . . . . . . . . (594,013) (99,481) (335,781) See accompanying notes to consolidated financial statements. 35 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Consolidated Statements of Cash Flows (Continued) Years ended December 31, 2004, 2003 and 2002 (Dollars in Thousands) 2004 2003 2002 Financing activities: Net increase (decrease) in non-interest bearing demand deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103,547 130,504 (11,272) Net increase in savings and interest bearing demand deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net increase (decrease) in time deposits . . . . . . . . . . . . . Net increase (decrease) in securities sold under 70,306 24,361 132,711 (67,415) 107,068 (95,459) repurchase agreements . . . . . . . . . . . . . . . . . . . . . . . . 74,372 43,381 (256,760) Proceeds from issuance of other borrowed funds and long term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Principal payments on other borrowed funds . . . . . . . . . . Principal payments on senior notes . . . . . . . . . . . . . . . . . Proceeds from issuance of junior subordinated deferrable interest debentures . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchase of treasury stock . . . . . . . . . . . . . . . . . . . . . . . Proceeds from stock transactions . . . . . . . . . . . . . . . . . . Payments of cash dividends . . . . . . . . . . . . . . . . . . . . . . Payments of cash dividends in lieu of fractional shares . . Net cash provided by financing activities . . . . . . . . . . . Increase (decrease) in cash and cash equivalents . . . . . . . . . . Cash and cash equivalents at beginning of year . . . . . . . . . . . Cash and cash equivalents at end of year . . . . . . . . . . . . . . . Supplemental cash flow information: Interest paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income taxes paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ 2,335,000 (2,134,455) (21,295) 3,140,000 (3,345,585) — 2,055,329 (1,646,768) — — (974) 4,690 (39,729) (38) 415,785 (19,959) 215,729 195,770 96,709 36,277 $ $ 36,402 (29,723) 7,454 (32,599) (26) 15,104 61,525 154,204 215,729 93,337 54,866 — (63,594) 3,478 (21,984) (31) 70,007 (131,018) $ $ 285,222 154,204 123,963 51,759 See accompanying notes to consolidated financial statements. 36 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. All significant inter-company balances and transactions have been eliminated in consolidation. The Company early adopted the provisions of FIN 46R as of December 31, 2003 and deconsolidated its investment in eight statutory business trusts formed for the purpose of issuing trust preferred securities. Three statutory business trusts that were acquired in the Company’s acquisition of Local Financial Corporation are also deconsolidated under the provisions of FIN 46R. 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, Central, and Southeast Texas and the state of Oklahoma. 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 assumptions 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 37 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (1) Summary of Significant Accounting Policies (Continued) value. Unrealized holding gains and losses are included in net income for those securities classified as ‘‘trading’’, while unrealized holding gains and losses related to those securities classified as ‘‘available-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 two year period ended December 31, 2004. Mortgage-backed securities held at December 31, 2004 and 2003 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. Loans Loans are reported at the principal balance outstanding, net of unearned discounts. Interest income on loans is reported on an accrual basis. Loan fees and costs associated with originating the loans are amortized over the life of the loan. 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 38 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (1) Summary of Significant Accounting Policies (Continued) or when, in management’s opinion, the debtor’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 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. Recognition of deferred tax assets is based on management’s belief that the benefit related to certain temporary differences, tax operating loss carryforwards, and tax credits are more likely than not to be realized. A valuation allowance is recorded for the amount of the deferred tax items for which it is more likely than not that the tax benefits will not be realized. Stock Options In December 2002, the Financial Accounting Standards Board (‘‘FASB’’) issued Statement of Financial 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 Statement ‘‘Accounting for Stock-Based of Financial Accounting Standards No. 123 (‘‘SFAS No. 123’’), 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.’’ In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123R (‘‘SFAS No. 123R’’), ‘‘Share-Based Payment (Revised 2004).’’ SFAS 123R eliminates the ability to account for stock-based compensation using Accounting Principles Board Opinion No. 25 (‘‘APB 25’’), ‘‘Accounting for Stock Issued to Employees,’’ 39 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (1) Summary of Significant Accounting Policies (Continued) and requires that such transactions be recognized as compensation expense in the consolidated statement of income based on their fair values on the date of the grant. The Company will be required to adopt the provisions of SFAS No. 123R on July 1, 2005. See further discussion in this note under the heading ‘‘New Accounting Standards.’’ At December 31, 2004, the Company had one stock-based employee compensation plan and certain options granted outside the plan. The Company accounts for options 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 had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table, as prescribed by SFAS No. 148, illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock based employee compensation. Net income, as reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deduct: Total stock-based compensation expense determined under fair value based method for all awards, net of tax related effects . . Years Ended December 31, 2004 2003 2002 (Dollars in Thousands, except per share data) $119,032 $122,128 $100,631 (473) (604) (972) Pro forma net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $118,559 $121,524 $ 99,659 Earnings per share: Basic earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . As reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Pro forma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted earnings As reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Pro forma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ $ $ 2.39 2.39 2.35 2.34 $ $ 2.53 2.51 2.48 2.46 2.01 2.00 1.97 1.95 Advertising Advertising costs are expensed as incurred. 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 40 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (1) Summary of Significant Accounting Policies (Continued) straight-line basis over their estimated periods of benefit. In addition, the Company reviewed its intangible assets periodically for other-than-temporary indicated, recoverability of the asset was assessed based on expected undiscounted net cash flows. impairments. If such impairments were 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 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 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 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. As of January 1, 2002, the Company performed an assessment of whether there was an indication that goodwill was impaired. The Company concluded that it was probable that the goodwill related to its investment services reporting unit was impaired. The amount of the impairment was $7,893,000 or $5,130,000, net of tax, which has been reported as a cumulative effect of a change in accounting principle, net of tax for the year ended December 31, 2002. The fair value of the investment services unit was estimated using a combination of capitalized cash flows, discounted cash flows and multiples based on publicly traded companies’ market capitalization to sales. 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 was effective October 1, 41 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (1) Summary of Significant Accounting Policies (Continued) 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. In accordance with SFAS No. 144, long-lived assets, such as property, plant and equipment, and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying value of the asset to the estimated undiscounted future cash flows expected to be generated by the asset. If the carrying value of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying value of the asset exceeds the fair value of the asset. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying value or fair value less costs to sell, and are no longer depreciated. The assets and liabilities of a disposed group classified as held for sale would be presented separately in the appropriate asset and liability sections of the statement of condition. 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. 42 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (1) Summary of Significant Accounting Policies (Continued) 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 operates as one segment. The operating information used by the Company’s chief executive officer for purposes of assessing performance and making operating decisions about the Company is the consolidated statements presented in this report. The Company has four active operating subsidiaries, namely, the bank subsidiaries, otherwise known as International Bank of Commerce, Laredo, Commerce Bank, International Bank of Commerce, Zapata and International Bank of Commerce, Brownsville. 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. None of the Company’s other subsidiaries meets the 10% threshold for disclosure under SFAS No. 131. 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. Guarantor’s Accounting and Disclosure Requirements for Guarantees In November 2002, the FASB issued FASB Interpretation No. 45 (‘‘FIN 45’’), ‘‘Guarantor’s Accounting 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 has been 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 were 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 were 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 a significant impact on the Company’s consolidated financial statements. 43 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (1) Summary of Significant Accounting Policies (Continued) 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. New Accounting Standards In May 2003, the Financial Accounting Standards Board issued SFAS No. 150, (‘‘SFAS No. 150’’), ‘‘Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.’’ SFAS No. 150 establishes standards for how an issuer classifies, measures and discloses in its financial statements certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 requires that an issuer classify financial instruments that are within its scope as liabilities, in most circumstances. Such financial instruments include (i) financial instruments that are issued in the form of shares that are mandatorily redeemable; (ii) financial instruments that embody an obligation to repurchase the issuer’s equity shares, or are indexed to such an obligation, and that require the issuer to settle the obligation by transferring assets; (iii) financial instruments that embody an obligation that the issuer may settle by issuing a variable number of its equity shares if, at inception, the monetary value of the obligation is predominantly based on a fixed amount, variations in something other than the fair value of the issuer’s equity shares or variations inversely related to changes in the fair value of the issuer’s equity shares; and (iv) certain freestanding financial instruments. SFAS No. 150 was originally effective for contracts entered into or modified after May 31, 2003, and was otherwise effective at the beginning of the first interim period beginning after June 15, 2003. At its October 29, 2003, meeting, the Financial Accounting Standards Board decided to defer the effective date of SFAS No. 150, as it relates to classification and measurement requirements for manditorily redeemable financial instruments that become subject to SFAS No. 150 solely as a result of consolidation. Adoption of the remaining provisions of SFAS No. 150 on July 1, 2003 did not have an impact on the Company’s consolidated financial statements. In April 2003, the Financial Accounting Standards Board issued SFAS No. 149, (‘‘SFAS No. 149’’), ‘‘Amendment of Statement 133 on Derivative Instruments and Hedging Activities.’’ SFAS No. 149 amends SFAS No. 133, ‘‘Accounting for Derivative Instruments and Hedging Activities’’ and clarifies financial accounting and reporting for derivative instruments including certain derivative instruments embedded in other contracts and for hedging activities. SFAS No. 149 improves financial reporting by requiring that contracts with comparable characteristics to be accounted for similarly. In particular, SFAS No. 149 clarifies under what circumstances a contract with an initial net investments meets the characteristics of a derivative, clarifies when a derivative contains a financing component, amends the definition of underlying to conform to the language in Financial Accounting Standards Board Interpretation No. 45, and amends certain other existing pronouncements. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003; however, the provisions of SFAS No. 149 that relate to SFAS No. 133 implementation issues that have been effective for fiscal quarters that began prior to June 15, 2003, should continue to be applied in accordance with their respective effective dates. The adoption of SFAS No. 149 did not have a significant impact on the Company’s consolidated financial statements. In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123R, (‘‘SFAS No. 123R’’), ‘‘Share-Based Payment, an Amendment of Statements No. 123 and 95.’’ The revision to the existing SFAS No. 123 eliminates the ability of public companies to account for stock-based compensation using Accounting Principles Board Opinion No. 25 44 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (1) Summary of Significant Accounting Policies (Continued) (‘‘APB 25’’), ‘‘Accounting for Stock Issues to Employees’’ and requires such transactions be recognized as compensation expense in the Company’s consolidated financial statements based on the fair value of the options issued as of their grant date. Companies transitioning to the fair value method of accounting for stock-based compensation are required to do so under the ‘‘modified prospective method.’’ Under this transitional method, SFAS No. 123R applies to new awards and to awards modified, repurchased, or cancelled after the required effective date. Compensation expense for that portion of existing options for which the requisite service period has not been met and are still outstanding, shall be recognized as the service is rendered on or after the required effective date. The compensation cost for those awards shall be based on the fair value on the grant date of those awards as calculated for either recognition or pro-forma disclosures under SFAS No. 123. SFAS No. 123R would be effective for the Company for interim and reporting periods after June 15, 2005. Based on the stock-based compensation awards outstanding as of December 31, 2004 for which the requisite service is not expected to be fully rendered prior to July 1, 2005, the Company expects to recognize additional pre-tax quarterly compensation cost of $97,000 beginning in the third quarter of 2005 as a result of the adoption of SFAS No. 123R. Future levels of compensation cost recognized related to stock-based compensation awards (including the aforementioned expected costs during the period of adoption) may be impacted by new awards and/or modifications, repurchases and cancellations of existing awards before and after the adoption of SFAS No. 123R. In December 2003, the American Institute of Certified Public Accountants issued Statement of Position 03-3 (‘‘SOP 03-3’’), ‘‘Accounting for Certain Loans or Debt Securities Acquired in a Transfer.’’ SOP 03-3 addresses accounting for differences between the contractual cash flows of certain loans and debt securities and the cash flows expected to be collected when loans or debt securities are acquired in a transfer and those cash flow differences are attributable, at least in part, to credit quality. As such, SOP 03-3 applies to loans and debt securities acquired individually, in pools or as part of a business combination and does not apply to originated loans. The application of SOP 03-3 limits the interest income, including the accretion of purchase price discounts, that may be recognized for certain loans and debt securities. Additionally, SOP 03-3 does not allow the excess of contractual cash flows over cash flows expected to be collected to be recognized as an adjustment of yield, loss accrual or valuation allowance, such as the allowance for possible loan losses. SOP 03-3 requires that increases in expected cash flows subsequent to the initial investment be recognized prospectively through adjustment of the yield on the loan or debt security over its remaining life. Decreases in expected cash flows should be recognized as impairment. In the case of loans acquired in a business combination where the loans show signs of credit deterioration, SOP 03-3 represents a significant change from current purchase accounting practice whereby the acquiree’s allowance for loan losses is typically added to the acquirer’s allowance for loan losses. SOP 03-3 is effective for loans and debt securities acquired by the Company beginning January 1, 2005. The adoption of this new standard is not expected to have a significant impact on the Company’s consolidated financial statements. In December 2003, SFAS No. 132, ‘‘Employers’ Disclosures about Pensions and Other Postretirement Benefits,’’ was issued. SFAS No. 132 (revised) prescribes employers’ disclosures about pension plans and other postretirement benefit plans; it does not change the measurement or recognition of those plans. The Statement revises the disclosure requirements contained in the original SFAS No. 132. It also requires additional disclosures about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other postretirement benefit plans. The Statement generally is effective for fiscal years ending after December 15, 2003. The adoption of SFAS No. 132 did not have an impact on the Company’s consolidated financial statements. 45 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (1) Summary of Significant Accounting Policies (Continued) In January 2003, the Financial Accounting Standards Board issued FASB Interpretation No. 46 (‘‘FIN 46’’), ‘‘Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.’’ The intention of FIN 46 was to clarify the application of Accounting Research Bulletin No. 51, ‘‘Consolidated Financial Statements,’’ to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 requires an enterprise considered to be a variable interest entity (‘‘VIE’’), to be consolidated by the primary beneficiary, which represents the enterprise that will absorb the majority of the VIE’s expected losses if they occur, receive a majority of the VIE’s residual returns if they occur, or both. In December 2003, the FASB issued Staff Interpretation No. 46R (‘‘FIN 46R’’), ‘‘Consolidation of Variable Interest Entities, an interpretation of ARB 51 (revised December 2003),’’ which replaces FIN 46, in order to clarify the guidance in the original interpretation. FIN 46 applies to variable interest entities created after January 31, 2003. FIN 46 also applies to all variable interest entities created prior to February 1, 2003 that are considered to be special-purpose entities, as defined in FIN 46R, as of December 31, 2003. FIN 46R must be applied to all variable interest entities no later than the end of the first reporting period that ends after March 15, 2004. The Company early adopted FIN 46R in connection with its consolidated financial statements as of December 31, 2003. The implementation of FIN 46R requires the Company to de-consolidate the statutory business trusts formed for the purpose of issuing trust preferred securities as of December 31, 2003. (2) Acquisition On June 18, 2004, the Company acquired Local Financial Corporation (‘‘LFIN’’), an Oklahoma based bank holding company with approximately $3.0 billion in assets. The acquisition was effected pursuant to the Agreement and Plan of Merger dated as of January 22, 2004 (the ‘‘Merger Agreement’’). The Company paid consideration totaling approximately $276.6 million in cash and 2.11 million shares of Company common stock. The aggregate purchase price was $367.4 million. Under the terms of the Merger Agreement, LFIN shareholders were entitled to elect to receive either cash or Company common stock in the merger, subject to the requirement that 75% of LFIN’s shares be exchanged for cash and 25% be exchanged for Company common stock. Based on the elections of LFIN shareholders and the terms of the Merger Agreement, LFIN shares held by LFIN shareholders who elected to receive shares of Company common stock in the Merger and LFIN shareholders who did not timely make a cash/stock election were exchanged entirely for shares of Company common stock. As to those LFIN shares for which an election to receive cash was timely made, each such share was exchanged for approximately $20.59 in cash and 0.033 shares of Company common stock. The exchange rate for those LFIN shareholders receiving Company common stock in the Merger was 0.5170 shares of Company common stock for each share of LFIN. 46 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (2) Acquisition (Continued) The following table summarizes the estimated fair value of the assets acquired and liabilities assumed at the date of the acquisition, in thousands. The Company has completed its valuations of certain intangible assets, and as a result the allocation of the purchase price has been completed. As of June 18, 2004 (Dollars in thousands) Assets Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . Time deposits with banks . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bank premises and equipment Accrued interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . Other investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Identified intangible asset . . . . . . . . . . . . . . . . . . . . . . . . . . . Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets acquired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Liabilities Demand deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Savings deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Time deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities sold under repurchase agreements . . . . . . . . . . . . . Other borrowed funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Senior notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 66,009 87,400 331,656 2,152,912 50,155 8,266 93,538 42,188 221,814 30,230 3,084,168 232,982 766,178 938,031 44,138 624,382 21,295 89,764 Total liabilities assumed . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,716,770 Net assets acquired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 367,398 47 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (2) Acquisition (Continued) The following table reflects the pro forma results of operations for the years ended December 31, 2004 and 2003, as though the acquisition had been completed as of January 1, 2003 (dollars in thousands, except per share data): Year Ended December 31, 2004 Year Ended December 31, 2003 Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $417,945 136,886 Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for possible loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . Non-interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281,059 18,000 150,917 267,923 146,053 47,962 $468,855 161,032 307,823 14,891 161,047 232,301 221,678 71,455 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 98,091 $150,223 Per common share: Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ 1.97 1.93 $ $ 3.11 3.05 Included in the non-interest expense of the combined operations for the year ended December 31, 2004 are certain costs associated with contractual obligations related to the closing of the transaction. 48 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, 2004 are as follows: Held to Maturity Amortized cost Gross unrealized gains Gross unrealized losses Estimated fair value Carrying value (Dollars in Thousands) Other securities . . . . . . . . . . . . . . . . . . . . Total investment securities . . . . . . . . . . . . $ $ 2,385 2,385 $ — $ — $ $ — $ — $ 2,385 2,385 $ $ 2,385 2,385 U.S. Treasury securities . . . . . . . . . . . . . . Mortgage-backed securities . . . . . . . . . . . Obligations of states and political subdivisions . . . . . . . . . . . . . . . . . . . . . Other securities . . . . . . . . . . . . . . . . . . . . Equity securities . . . . . . . . . . . . . . . . . . . Available for Sale Amortized cost Gross unrealized gains Gross unrealized losses Estimated fair value Carrying value (Dollars in Thousands) $ 9,285 3,725,751 $ — $ 20,617 (9) (3,143) $ 9,276 3,743,225 $ 9,276 3,743,225 99,240 5,140 12,325 5,084 — 926 (7) (360) (16) 104,317 4,780 13,235 104,317 4,780 13,235 Total investment securities . . . . . . . . . . . . $3,851,741 $26,627 $(3,535) $3,874,833 $3,874,833 The amortized cost and estimated fair value of investment securities at December 31, 2004, 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 235 2,150 — — — — (Dollars in Thousands) $ $ 9,285 235 — 2,150 2,300 — — 102,080 — 3,725,751 12,325 — $ 9,276 — 2,397 106,700 3,743,225 13,235 Total investment securities . . . . . . . . . . . . . . . . . . . . . . $ 2,385 $ 2,385 $3,851,741 $3,874,833 49 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, 2003 are as follows: Held to Maturity Amortized cost Gross unrealized gains Gross unrealized losses Estimated fair value Carrying value (Dollars in Thousands) Other securities . . . . . . . . . . . . . . . . . . . . Total investment securities . . . . . . . . . . . . $ $ 2,160 2,160 $ — $ $ — $ — $ — $ 2,160 2,160 $ $ 2,160 2,160 U.S. Treasury securities . . . . . . . . . . . . . . Mortgage-backed securities . . . . . . . . . . . Obligations of states and political subdivisions . . . . . . . . . . . . . . . . . . . . . Other securities . . . . . . . . . . . . . . . . . . . . Equity securities . . . . . . . . . . . . . . . . . . . Available for Sale Amortized cost Gross unrealized gains Gross unrealized losses Estimated fair value Carrying value (Dollars in Thousands) $ 21,825 2,859,050 $ 187 19,283 $ — $ (10,040) 22,011 2,868,293 $ 22,011 2,868,293 104,736 24,148 9,825 5,654 4,052 629 (8) — — 110,382 28,200 10,455 110,382 28,200 10,455 Total investment securities . . . . . . . . . . . . $3,019,584 $29,805 $(10,048) $3,039,341 $3,039,341 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 (‘‘Ginnie 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 $1,887,879,000 and $1,904,736,000, respectively, at December 31, 2004. Proceeds from the sale of securities available-for-sale were $875,816,000, $1,239,766,000 and $330,152,000 during 2004, 2003 and 2002, respectively. Gross gains of $12,818,000, $29,517,000 and $2,396,000 and gross losses of $3,934,000, $6,127,000 and $93,000 were realized on the sales in 2004, 2003 and 2002, respectively. 50 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (3) Investment Securities (Continued) Gross unrealized losses on investment securities and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2004 were as follows: Less than 12 months 12 months or more Total Fair Value Unrealized Losses Fair Value Unrealized Losses Fair Value Unrealized Losses (Dollars in Thousands) Available for sale: U.S. Treasury securities . . . . . . . . . . . . . $ Mortgage-backed securities . . . . . . . . . . . Obligations of states and political 7,979 $ (9) $ — $ — $ 7,979 $ 590,883 (2,164) 264,647 (979) 855,530 (9) (3,143) subdivisions . . . . . . . . . . . . . . . . . . . . Other securities . . . . . . . . . . . . . . . . . . . — 9,765 — (376) 125 — (7) — 125 9,765 (7) (376) $608,627 $(2,549) $264,772 $(986) $873,399 $(3,535) The unrealized losses on investments in mortgage-backed securities and U.S. treasury securities are caused by changes in market interest rates. The contractual cash obligations of the securities are guaranteed by Freddie Mac, Fannie Mae, Ginnie Mae and the U.S. Treasury. The decrease in fair value is due to market interest rates and not other factors, and because the Company has the ability to hold these investments until a market price recovery, maturity of the securities, or a modification of the Company’s investment strategy, it is the conclusion of the Company that the investments are not considered other-than-temporarily impaired. The unrealized losses on investments in obligations of state and political subdivisions and other securities are caused by fluctuations in market interest rates. The underlying cash obligations of the securities are guaranteed by the municipality or entity underwriting the debt instrument. It is the belief of the Company that the municipality or entity issuing the debt will honor its interest payment schedule, as well as the full debt at maturity. The securities are purchased by the Company for their economic value. The decrease in fair value is primarily due to market interest rates and not other factors, and because the Company has the ability to hold these investments until a market price recovery, maturity of the securities, or a modification of the Company’s investment strategy, it is the conclusion of the Company that the investments are not considered other-than-temporarily impaired. 51 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (4) Loans A summary of net loans, by loan type at December 31, 2004 and 2003 is as follows: December 31, 2004 2003 (Dollars in thousands) Commercial, financial and agricultural . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate—mortgage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate—construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,710,270 960,599 749,689 229,302 239,622 $1,400,173 495,481 492,208 139,987 222,797 Total loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,889,482 2,750,646 Unearned discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (508) (1,646) Loans, net of unearned discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,888,974 $2,749,000 (5) Allowance for Possible Loan Losses A summary of the transactions in the allowance for possible loan losses for the years ended December 31, 2004, 2003 and 2002 is as follows: 2004 2003 2002 (Dollars in Thousands) Balance at December 31, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $48,646 $44,213 $40,065 Losses charged to allowance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Recoveries credited to allowance . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net losses charged to allowance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision charged to operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Acquired (disposed) in purchase or sale transactions . . . . . . . . . . . . . . (9,513) 5,407 (4,106) 6,500 33,865 (4,943) 1,085 (3,858) 8,291 — (5,257) 1,329 (3,928) 8,541 (465) Balance at December 31, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $84,905 $48,646 $44,213 Loans accounted for on a non-accrual basis at December 31, 2004, 2003 and 2002 amounted to $30,773,000, $20,960,000 and $3,649,000, respectively. The effect of such non-accrual loans reduced interest income by $1,203,000, $1,870,000 and $567,000 for the years ended December 31, 2004, 2003 and 2002, 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. The increase in non-accrual loans from 2003 to 2004 can be attributed to certain loans the Company acquired in the LFIN acquisition. The increase in non-accrual loans from 2002 to 2003 can be attributed to two fully secured credits the Company placed on non-accrual status, totaling approximately $17,800,000. On January 7, 2004, management determined that one of the fully secured credits be returned to accrual status and on March 1, 2004, management determined that the second of the two fully secured credits also be returned to accrual status. 52 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (5) Allowance for Possible Loan Losses (Continued) 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. The following table details key information regarding the Company’s impaired loans: 2004 2003 2002 (Dollars in Thousands) Balance of impaired loans where there is a related allowance for loan loss . . $37,037 — Balance of impaired loans where there is no related allowance for loan loss . $24,216 — $3,428 — Total impaired loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $37,037 $24,216 $3,428 Allowance allocated to impaired loans . . . . . . . . . . . . . . . . . . . . . . . . . . $15,666 $ 899 $ 720 The impaired loans included in the table above were primarily comprised of collateral dependent commercial loans, which have not been fully charged off. The average recorded investment in impaired loans was $34,226,000, $13,090,000, and $4,289,000 for the years ended December 31, 2004, 2003 and 2002, respectively. The increase in impaired loans can be attributed to the LFIN acquisition. The interest recognized on impaired loans was not significant. 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 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, 2004 was adequate to absorb probable losses from loans in the portfolio at that date. 53 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (6) Bank Premises and Equipment A summary of bank premises and equipment, by asset classification, at December 31, 2004 and 2003 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 2004 2003 (Dollars in Thousands) $ 229,007 159,289 52,701 $ 171,352 132,699 37,819 970 (139,737) 1,021 (122,289) $ 302,230 $ 220,602 (7) Goodwill and Other Intangible Assets The Company’s identified intangibles are all in the form of amortizable core deposit premium. The Company acquired $42,188,000 in identified intangibles in the form of core deposit premium in the LFIN acquisition, which will be amortized over a ten year period. Information on the Company’s identified intangible assets follows: Carrying Amount Accumulated Amortization Net (Dollars in Thousands) December 31, 2004 Core deposit premium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $56,338 $11,938 $44,400 December 31, 2003: Core deposit premium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14,150 $ 8,258 $ 5,892 Amortization expense of intangible assets for the years ended December 31, 2004, 2003 and 2002, was $3,681,000, $1,276,000 and $1,812,000, respectively. Estimated amortization expense for each of the five succeeding fiscal years, and thereafter, is as follows: Fiscal year ending: 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2006 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Thereafter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total (in thousands) $ 5,205 4,837 4,837 4,837 4,837 19,847 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $44,400 54 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (7) Goodwill and Other Intangible Assets (Continued) There were no changes in the carrying amount of goodwill for the year ended December 31, 2003. Changes in the carrying amount of goodwill for the year ended December 31, 2004 were as follows: Balance at December 31, 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to deferred tax asset and goodwill relating to a 2004 acquisition . . . . . . . . . . Acquisition of goodwill related to the acquisition of LFIN (note 2) . . . . . . . . . . . . . . . . . $ 67,442 6 221,814 Balance as of December 31, 2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $289,262 (8) Deposits Deposits as of December 31, 2004 and 2003 and related interest expense for the years ended December 31, 2004, 2003 and 2002 were as follows: 2004 2003 (Dollars in Thousands) Deposits: Demand—non-interest bearing Domestic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,028,651 122,348 $ 726,500 87,970 Total demand non-interest bearing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,150,999 814,470 Savings and interest bearing demand Domestic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,882,791 349,311 1,060,365 335,253 Total savings and interest bearing demand . . . . . . . . . . . . . . . . . . . . . . . . . . 2,232,102 1,395,618 Time, certificates of deposit $100,000 or more Domestic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 914,078 1,005,930 Less than $100,000 Domestic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 916,781 351,214 510,766 956,986 417,302 340,557 Total time, certificates of deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,188,003 2,225,611 Total deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,571,104 $4,435,699 55 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (8) Deposits (Continued) Interest expense: Savings and interest bearing demand Domestic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,991 1,806 $ 8,145 2,023 $11,320 2,865 Total savings and interest bearing demand . . . . . . . . . . . . . . . . . . . . . 13,797 10,168 14,185 2004 2003 2002 (Dollars in Thousands) Time, certificates of deposit $100,000 or more Domestic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,483 17,327 9,314 19,026 13,442 24,743 Less than $100,000 Domestic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total time, certificates of deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,396 4,453 44,659 7,890 4,783 41,013 12,652 7,070 57,907 Total interest expense on deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $58,456 $51,181 $72,092 (9) Federal Funds Purchased and 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 $526,447,000 and $473,365,000 during 2004 and 2003, respectively, and the maximum amount outstanding at any month end during 2004 and 2003 $572,320,000 and $501,296,000, respectively. 56 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (9) Federal Funds Purchased and Securities Sold Under Repurchase Agreements (Continued) Further information related to repurchase agreements at December 31, 2004 and 2003 is set forth in the following table: Collateral Securities Repurchase Borrowing Book Value of Securities Sold Fair Value of Securities Sold Balance of Liability (Dollars in Thousands) Weighted Average Interest Rate December 31, 2004 term: Overnight agreements . . . . . . . . . . . . . . . . . . . 1 to 29 days . . . . . . . . . . . . . . . . . . . . . . . . . . 30 to 90 days . . . . . . . . . . . . . . . . . . . . . . . . . Over 90 days . . . . . . . . . . . . . . . . . . . . . . . . . $129,589 — 55,771 619,040 $129,959 — 56,568 628,508 $ 99,216 — 31,848 488,742 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $804,400 $815,035 $619,806 December 31, 2003 term: Overnight agreements . . . . . . . . . . . . . . . . . . . 1 to 29 days . . . . . . . . . . . . . . . . . . . . . . . . . . 30 to 90 days . . . . . . . . . . . . . . . . . . . . . . . . . Over 90 days . . . . . . . . . . . . . . . . . . . . . . . . . $ 46,561 1,239 19,520 496,241 $ 46,827 1,274 19,806 502,167 $ 33,531 362 15,516 451,887 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $563,561 $570,074 $501,296 1.49% — 1.69 4.01 3.49% 1.22% 1.00 1.29 4.09 3.81% 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. (10) Other Borrowed Funds Other borrowed funds include Federal Home Loan Bank borrowings, which are short and long 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 and a portion of the Company’s loan portfolio. 57 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (10) Other Borrowed Funds (Continued) Further information regarding the Company’s other borrowed funds at December 31, 2004 and 2003 is set forth in the following table: December 31 2004 2003 (Dollars in Thousands) Federal Home Loan Bank advances—short term Balance at year end . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Rate on balance outstanding at year end . . . . . . . . . . . . . . . . . . . . . . . . . . Average daily balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Maximum amount outstanding at any month end . . . . . . . . . . . . . . . . . . . $1,430,120 $ 305,000 2.24% 1.07% $ 794,577 $ 771,041 1.50% 1.14% $1,430,120 $1,804,700 Federal Home Loan Bank advances—long term Balance at year end . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Rate on balance outstanding at year end . . . . . . . . . . . . . . . . . . . . . . . . . . Average daily balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Maximum amount outstanding at any month end . . . . . . . . . . . . . . . . . . . $ 240,079 $ 540,272 2.25% 1.13% $ 240,083 $ 516,833 1.43% 1.23% $ 240,102 $ 540,695 (11) Junior Subordinated Deferrable Interest Debentures The Company has formed eight statutory business trusts under the laws of the State of Delaware, for the purpose of issuing trust preferred securities. As part of the LFIN acquisition, the Company acquired three additional statutory business trusts previously formed by LFIN for the purpose of issuing trust preferred securities. The eight statutory business trusts formed by the Company and the three business trusts acquired in the LFIN transaction (the ‘‘Trusts’’) have each issued Capital and Common Securities and invested the proceeds thereof in an equivalent amount of junior subordinated debentures (the ‘‘Debentures’’) issued by the Company or LFIN, as appropriate. The Company has succeeded to the obligations of LFIN under the LFIN Debentures, which have an outstanding principal balance of $62,115,000. The Debentures will mature on various dates; however the Debentures may be redeemed at specified prepayment prices, in whole or in part after the optional redemption dates specified in the respective indentures or in whole upon the occurrence of any one of certain legal, regulatory or tax events specified in respective indentures. As of December 31, 2004, the principal amount of debentures outstanding totaled $235,395,000. The Debentures are subordinated and junior in right of payment to all present and future senior indebtedness (as defined in the respective indentures) of the Company, and are pari passu with one another. The interest rate payable on, and the payment terms of the Debentures are 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 on Trusts I through IV and LFIN Trust II and for up to twenty consecutive quarterly periods on Trusts V through VIII and LFIN Trusts I and III. If interest payments on any of the Debentures are deferred, distributions on both the Capital and Common 58 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (11) Junior Subordinated Deferrable Interest Debentures (Continued) 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 prior to December 31, 2003. Since the Company’s adoption of FIN 46R on December 31, 2003, the Trusts are treated as investments of the Company and not consolidated in the consolidated financial statements. Although the Capital Securities issued by each of the Trusts are not included as a component of shareholders’ equity on the consolidated 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. For December 31, 2004, the total $235,395,000 of the Capital Securities outstanding qualified as Tier 1 capital. In March 2005, the Federal Reserve Board issued a final rule that would continue to allow the inclusion of trust preferred securities in Tier 1 capital, but with stricter quantitative limits. Under the final rule, after a five-year transition period ending March 31, 2009, the aggregate amount of trust preferred securities and certain other capital elements would be limited to 25% of Tier 1 capital elements, net of goodwill, less any associated deferred tax liability. The amount of trust preferred securities and certain other elements in excess of the limit could be included in Tier 2 capital, subject to restrictions. Bank holding companies with significant international operations will be expected to limit trust preferred securities to 15% of Tier 1 capital elements, net of goodwill; however, they may include qualifying mandatory convertible preferred securities up to the 25% limit. The following table illustrates key information about each of the Capital Securities and their interest rate at December 31, 2004: Junior Subordinated Deferrable Interest Debentures (in thousands) Repricing Frequency Interest Rate Interest Rate Index Maturity Date Optional Redemption Date Trust I . . . . . . . Trust II . . . . . . Trust III . . . . . . Trust IV . . . . . . Trust V . . . . . . Trust VI . . . . . . Trust VII . . . . . Trust VIII . . . . LFIN Trust I . . LFIN Trust II . . LFIN Trust III . Fixed Semi-Annually Semi-Annually Semi-Annually $ 10,183 $ 25,597 $ 33,789 $ 22,405 $ 20,319 Quarterly $ 25,361 Quarterly $ 10,310 Quarterly $ 25,316 Quarterly $ 41,495 $ 10,310 $ 10,310 Quarterly Fixed Semi-Annually 10.18% Fixed June 2011 July 2006 June 2031 July 2031 5.74% LIBOR + 3.75 6.44% LIBOR + 3.75 December 2031 December 2006 6.00% LIBOR + 3.70 April 2032 5.72% LIBOR + 3.65 July 2032 5.74% LIBOR + 3.45 November 2032 November 2007 5.41% LIBOR + 3.25 April 2033 5.12% LIBOR + 3.05 October 2033 9.00% Fixed 5.61% LIBOR + 3.625 July 2032 5.74% LIBOR + 3.45 November 2032 November 2007 April 2008 October 2008 September 2031 September 2006 April 2007 July 2007 July 2007 $235,395 Prior to the issuance of FIN No. 46R, the eight statutory business trusts formed by the Company were considered fully consolidated subsidiaries of the Company and reported on the consolidated statement of 59 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (11) Junior Subordinated Deferrable Interest Debentures (Continued) condition under the heading ‘‘Other borrowed funds.’’ With the early adoption of FIN 46R, the Company deconsolidated the eight statutory business trusts and as a result the Debentures issued by the trust are reported in a separate line item, ‘‘Junior subordinated deferrable interest debentures.’’ (12) Earnings per Share 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 potential common shares outstanding during the reporting period. The calculation of the basic EPS and the diluted EPS for the years ended December 31, 2004, 2003, and 2002 is set forth in the following table: Net Income (Numerator) Shares (Denominator) Per Share Amount (Dollars in Thousands, Except Per Share Amounts) December 31, 2004: Basic EPS Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Potential dilutive common shares . . . . . . . . . . . . . . . . . . . . . . $119,032 — 49,707,319 997,126 $2.39 Diluted EPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $119,032 50,704,445 $2.35 December 31, 2003: Basic EPS Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Potential dilutive common shares . . . . . . . . . . . . . . . . . . . . . . $122,128 — 48,362,449 971,864 $2.53 Diluted EPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $122,128 49,334,313 $2.48 December 31, 2002: Basic EPS Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Potential dilutive common shares . . . . . . . . . . . . . . . . . . . . . . $100,631 — 49,944,476 1,141,895 $2.01 Diluted EPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,631 51,086,371 $1.97 (13) 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 $3,823,000, $2,897,000 and $2,662,000 were charged to income for the years ended December 31, 2004, 2003, and 2002, respectively. 60 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (14) 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. International 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. A summary of assets attributable to international operations at December 31, 2004 and 2003 are as follows: Loans: 2004 2003 (Dollars in Thousands) Commercial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Others . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $179,068 60,554 $161,707 61,090 Less allowance for possible loan losses . . . . . . . . . . . . . . . . 239,622 (2,327) 222,797 (1,058) Net loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $237,295 $221,739 Accrued interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,370 $ 1,243 At December 31, 2004, the Company had $95,657,000 in outstanding standby and 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. Revenues directly attributable to international operations was $11,077,000, $11,626,000 and $14,128,000 for the years ended December 31, 2004, 2003 and 2002, respectively. (15) 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: 2004 2003 2002 (Dollars in Thousands) Current . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . U.S. State . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $45,969 523 35 $54,199 — 74 $54,550 — 118 Total current taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46,527 54,273 54,668 Deferred . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,353 6,153 (655) Total income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $57,880 $60,426 $54,013 61 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (15) Income Taxes (Continued) Total income tax expense differs from the amount computed by applying the U.S. Federal income tax rate of 35% for 2004, 2003 and 2002 to income before income taxes. The reasons for the differences for the years ended December 31 are as follows: 2004 2003 2002 (Dollars in Thousands) Computed expected tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $61,919 $63,894 $55,921 Change in taxes resulting from: Tax-exempt interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leasing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Employee benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . State tax, net of federal income taxes . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,847) — (2,523) 340 (9) (1,762) (461) (2,113) — 868 (1,692) 3,031 (2,707) — (540) Actual tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $57,880 $60,426 $54,013 The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2004 and 2003 are reflected below: 2004 2003 (Dollars in Thousands) Deferred tax assets: Loans receivable, principally due to the allowance for possible loan losses . . . . Other real estate owned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . State net operating loss carryforwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Valuation allowance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 29,481 513 3,181 2,295 3,416 (801) 3,367 $ 15,088 534 2,859 — — — 138 Total deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41,452 18,619 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Identified intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (8,082) (20,991) (16,632) (6,503) (18,052) (2,317) (6,915) (19,244) (4,336) (5,887) (4,109) (660) Total deferred tax liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (72,577) (41,151) Net deferred tax liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(31,125) $(22,532) The net deferred tax liability of $31,125,000 and $22,532,000 at December 31, 2004 and 2003, respectively, is included in other liabilities in the consolidated statements of condition. 62 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (15) Income Taxes (Continued) As part of the Local Financial Corporation acquisition, the Company assumed $2,206,381 in net deferred tax assets. The valuation allowance included in the Company’s deferred tax assets at December 31, 2004, represent state net operating loss carryforwards for which it is more likely than not that realization of the tax benefits related to the losses will occur. The state operating losses were acquired as part of various deferred tax items in the LFIN acquisition. (16) 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 $0 and $948,000 for the years ended December 31, 2004 and 2003, respectively. Because of the losses from operations that AFT has reported as a result of the events of September 11 and the resulting impact on the airline industry, the Company evaluated its investment, which resulted in the Company recording an impairment charge of $6,081,000 in 2002. At December 31, 2004 and 2003, the Company’s investment in AFT, excluding its proportionate share of the fair value of the AFT derivatives was $0. The Company’s investment including the proportionate share of the fair value of the AFT derivatives at December 31, 2004 and 2003, was $0. (17) 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 Corporation 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 139,160 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. 63 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (17) Stock Options (Continued) The following schedule summarizes the pertinent information (adjusted for stock distributions) with regard to the Company’s stock options. Balance at December 31, 2001 . . . . . . . . . . . . . . . . . . . Terminated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance at December 31, 2002 . . . . . . . . . . . . . . . . . . . Terminated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance at December 31, 2003 . . . . . . . . . . . . . . . . . . . Terminated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance at December 31, 2004 . . . . . . . . . . . . . . . . . . . Option price per share Options outstanding $6.44 - 17.43 5.15 - 17.43 $8.04 - 21.79 23.04 - 36.32 6.44 - 21.79 $9.90 - 27.40 32.00 - 41.80 9.90 - 27.40 2,210,195 (26,932) — (221,052) 1,962,211 (13,444) 122,890 (316,719) 1,754,938 (26,192) 22,562 (313,403) 1,437,905 At December 31, 2004, 2003, and 2002, 1,141,590, 944,096, and 760,121 options were exercisable, respectively, and as of December 31, 2004, 388,157 shares were available for future grants under the 1996 Plan, as amended. All options granted under the1987 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, 2004: Range of Exercise Prices $ 6.38 - 12.58 . . . . . . . . . . . . . . . . . . . . . . . . 12.58 - 13.04 . . . . . . . . . . . . . . . . . . . . . . . . 12.06 - 14.10 . . . . . . . . . . . . . . . . . . . . . . . . 12.70 - 13.46 . . . . . . . . . . . . . . . . . . . . . . . . 15.57 - 18.69 . . . . . . . . . . . . . . . . . . . . . . . . 23.04 - 36.32 . . . . . . . . . . . . . . . . . . . . . . . . 32.00 - 41.80 . . . . . . . . . . . . . . . . . . . . . . . . Options Outstanding Options Exercisable Number Outstanding at 12/31/04 381,989 47,880 332,988 162,126 376,841 115,518 20,563 Weighted- Average Remaining Contractual Life .5 years 1.1 years 3.3 years 4.1 years 5.9 years 6.6 years 7.7 years Weighted- Average Exercise Price Number Exercisable at 12/31/04 Weighted Average Exercise Price $10.06 12.65 12.53 13.25 17.46 27.26 33.93 381,989 47,880 332,988 129,526 226,104 23,103 $10.06 12.65 12.53 13.25 17.46 27.26 — 33.93 $ 6.38 - 41.80 . . . . . . . . . . . . . . . . . . . . . . . . 1,437,905 1,141,590 64 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (17) 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) . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividend yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 5 2.50% 2.50% 3.59% 2.96% 25.29% 30.86% 2004 2003 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. (18) Commitments, Contingent Liabilities and Other Tax Matters 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 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, 2004, 2003 and 2002 and non-cancellable lease commitments at December 31, 2004 were not significant. Cash of approximately $50,411,000 and $35,865,000 at December 31, 2004 and 2003, respectively, was maintained to satisfy regulatory reserve requirements. 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 was the owner of a ninety-nine percent (99%) limited partnership interest. The IRS has issued separate Notice of Final Partnership Administrative Adjustments (‘‘FPAA’’) 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. If it is determined that the amount of tax due, if any, related to the lease-financing transactions is less than the amount of the deposits, the remaining amount of the deposits would be returned to the Company. In order to curtail the accrual of additional interest related to the disputed tax benefits and because interest rates were unfavorable, on March 7, 2003, the Company submitted to the IRS a total of $13,640,797, which constitutes the interest that would have accrued based on the adjustments proposed in the FPAAs related to both of the lease-financing transactions. If it is determined that the amount of 65 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (18) Commitments, Contingent Liabilities and Other Tax Matters (Continued) interest due, if any, related to the lease-financing transactions is less than the $13,640,797, the remaining amount of the prepaid interest will be refunded to the Company, plus interest thereon. 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 Partnerships’ lease-financing transactions would be in question and penalties and interest could be assessed by the IRS. The Company has accrued approximately $12 million at December 31, 2004 in connection with the lawsuits. Management intends to continue to evaluate the merits of each matter and make appropriate revisions to the accrued amount as deemed necessary. As part of the LFIN acquisition, the Company acquired two tax matters. The first relates to deductions taken on amended returns filed by LFIN during 2003 for the tax years ended June 30, 1999 through December 31, 2001. The refunds requested on the amended returns amounted to approximately $7,000,000. At December 31, 2003, LFIN had received approximately $2,000,000 of the total refund requested. Because all the refunds are under review by the IRS, LFIN had established a reserve equal to the $2,000,000 received and did not recognize any benefit for the remaining $5,000,000. The second tax contingency, which is also approximately $7,000,000, relates to permanent differences applicable to prior periods taken as deductions in 2002 and was received by LFIN during 2003. LFIN had recorded a reserve equal to the amounts received pending final resolution with the IRS. Both reserves are included in the current income taxes payable of the Company. The Company will continue to monitor the IRS reviews. (19) Transactions with Related Parties In the ordinary course of business, the subsidiaries of the Company 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 $56,211,000 and $48,431,000 at December 31, 2004 and 2003, respectively. (20) 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 consolidated statement of condition. The contract amounts of these instruments reflect the extent of involvement the bank subsidiaries have in particular classes of financial instruments. At December 31, 2004, the following financial amounts of instruments, whose contract amounts represent credit risks, were outstanding: Commitments to extend credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . Credit card lines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Standby letters of credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial letters of credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,283,806,000 27,135,000 91,171,000 4,486,000 66 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (20) Financial Instruments with Off-Statement of Condition Risk and Concentrations of Credit Risk (Continued) 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, 2004, the maximum potential amount of future payments is $91,171,000. At December 31, 2004, the fair value of these guarantees is not significant. 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 South, Central and Southeast Texas and the State of Oklahoma. 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. (21) 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, 2004, the subsidiary banks could pay dividends of up to $61,000,000 to the Company without prior regulatory approval and without adversely affecting their ‘‘well capitalized’’ status. 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 67 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (21) Dividend Restrictions and Capital Requirements (Continued) 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, 2004, that the Company and each of the bank subsidiaries met all capital adequacy requirements to which it is subject. As of December 31, 2004, the most recent notification from the Federal Deposit Insurance Corporation 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. 68 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (21) Dividend Restrictions and Capital Requirements (Continued) The Company’s and the bank subsidiaries’ actual capital amounts and ratios for 2004 are 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, 2004: Total Capital (to Risk Weighted Assets): (Dollars in Thousands) Consolidated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $714,612 11.99% $476,782 420,674 International Bank of Commerce, Laredo . . . . . . . . . . 27,955 International Bank of Commerce, Brownsville . . . . . . . 10,796 International Bank of Commerce, Zapata . . . . . . . . . . 14,426 Commerce Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . 534,464 10.16 65,994 18.89 29,474 21.84 35,241 19.54 8.00% $595,977 525,843 8.00 34,944 8.00 13,495 8.00 18,033 8.00 10.00% 10.00 10.00 10.00 10.00 Tier 1 Capital (to Risk Weighted Assets): Consolidated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $639,875 10.74% $238,391 210,337 International Bank of Commerce, Laredo . . . . . . . . . . 13,978 International Bank of Commerce, Brownsville . . . . . . . 5,398 International Bank of Commerce, Zapata . . . . . . . . . . 7,213 Commerce Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . 468,510 8.91 62,911 18.00 28,543 21.15 32,970 18.28 4.00% $357,586 315,506 4.00 20,966 4.00 8,097 4.00 10,820 4.00 Tier 1 Capital (to Average Assets): Consolidated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $639,875 468,510 International Bank of Commerce, Laredo . . . . . . . . . . 62,911 International Bank of Commerce, Brownsville . . . . . . . 28,543 International Bank of Commerce, Zapata . . . . . . . . . . 32,970 Commerce Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.91% $370,523 319,979 5.86 29,928 8.41 11,464 9.96 15,692 8.40 4.00% $463,154 399,974 4.00 37,410 4.00 14,330 4.00 19,614 4.00 6.00% 6.00 6.00 6.00 6.00 5.00% 5.00 5.00 5.00 5.00 69 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (21) Dividend Restrictions and Capital Requirements (Continued) The Company’s and the bank subsidiaries’ actual capital amounts and ratios for 2003 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, 2003: Total Capital (to Risk Weighted Assets): (Dollars in Thousands) Consolidated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $708,940 19.33% $293,409 244,507 International Bank of Commerce, Laredo . . . . . . . . . . 24,971 International Bank of Commerce, Brownsville . . . . . . . 9,519 International Bank of Commerce, Zapata . . . . . . . . . . 13,345 Commerce Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . 540,856 17.70 66,515 21.31 33,387 28.06 37,003 22.18 8.00% $366,761 305,634 8.00 31,213 8.00 11,898 8.00 16,681 8.00 10.00% 10.00 10.00 10.00 10.00 Tier 1 Capital (to Risk Weighted Assets): Consolidated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $634,525 17.30% $146,704 122,254 International Bank of Commerce, Laredo . . . . . . . . . . 12,485 International Bank of Commerce, Brownsville . . . . . . . 4,759 International Bank of Commerce, Zapata . . . . . . . . . . 6,672 Commerce Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . 502,536 16.44 63,442 20.33 32,503 27.32 34,895 20.92 4.00% $220,057 183,380 4.00 18,728 4.00 7,139 4.00 10,008 4.00 Tier 1 Capital (to Average Assets): 8.75% $290,122 Consolidated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $634,525 232,796 8.63 502,536 International Bank of Commerce, Laredo . . . . . . . . . . 30,363 63,442 International Bank of Commerce, Brownsville . . . . . . . 8.36 11,571 32,503 11.24 International Bank of Commerce, Zapata . . . . . . . . . . 15,159 9.21 34,895 Commerce Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.00% $362,653 290,995 4.00 37,954 4.00 14,464 4.00 18,948 4.00 6.00% 6.00 6.00 6.00 6.00 5.00% 5.00 5.00 5.00 5.00 (22) Fair Value of Financial Instruments The fair value estimates, methods, and assumptions for the Company’s financial instruments at December 31, 2004 and 2003 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 approximates fair market value. 70 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (22) Fair Value of Financial Instruments (Continued) Investment Securities For investment securities, which include U. S. Treasury securities, obligations of other U. S. government 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, 2004 and 2003, the carrying amount of fixed rate performing loans was $1,681,916,000 and $765,458,000 respectively, and the estimated fair value was $1,679,719,000 and $775,280,000, 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, 2004 and 2003, 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, 2004 and 2003. 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, 2004 and 2003, the carrying amount of time deposits was $3,188,003,000 and $2,225,611,000, respectively, and the estimated fair value was $3,197,198,000 and $2,211,589,000, respectively. Federal Funds Purchased and Securities Sold Under Repurchase Agreements and Other Borrowed Funds Due to the contractual terms of these financial instruments, the carrying amounts approximated fair value at December 31, 2004 and 2003. 71 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (22) Fair Value of Financial Instruments (Continued) Junior Subordinated Deferrable Interest Debentures Due to the contractual terms of these financial instruments, the carrying amounts approximated fair value at December 31, 2004. 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. 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. 72 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (23) International Bancshares Corporation (Parent Company Only) Financial Information Statements of Condition (Parent Company Only) December 31, 2004 and 2003 (Dollars in Thousands) ASSETS Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Repurchase Agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Premises & fixed assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment in subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004 2003 $ 387 4,400 25,425 5,775 6,057 946,665 3,088 $ 1,170 4,100 16,199 11,525 — 716,323 2,729 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 991,797 $ 752,045 LIABILITIES AND SHAREHOLDERS’ EQUITY Liabilities: Junior subordinated deferrable interest debentures . . . . . . . . . . . . . . . . . . . Due to IBC Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 235,395 21 3,291 $ 172,254 21 2,387 Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238,707 174,662 Shareholders’ equity: Common shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated other comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . 68,431 130,597 705,642 15,010 919,680 52,774 37,777 639,606 12,842 742,999 Less cost of shares in treasury . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (166,590) (165,616) Total shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 753,090 577,383 Total liabilities and shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . $ 991,797 $ 752,045 73 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (24) International Bancshares Corporation (Parent Company Only) Financial Information Statements of Income (Parent Company Only) Years ended December 31, 2004, 2003 and 2002 (Dollars in Thousands) 2004 2003 2002 Income: Dividends from subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest income on notes receivable . . . . . . . . . . . . . . . . . . . . . . . Interest income on other investments . . . . . . . . . . . . . . . . . . . . . . Other interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sale of other securities . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sale of assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 62,950 682 1,437 511 151 1,659 5,683 $ 8,000 1,330 876 — 100 — 2,522 $ 27,500 2,297 778 — — — 2,334 Total income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73,073 12,828 32,909 Expenses: Interest expense (Debentures) . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense (Senior Notes) . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,152 383 1,271 Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,806 9,125 — 554 9,679 7,040 — 1,126 8,166 Income before federal income taxes and equity in undistributed net income of subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . 58,267 3,149 24,743 Income tax benefit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,559) (1,394) (1,578) Income before equity in undistributed net income of subsidiaries . 59,826 4,543 26,321 Equity in undistributed net income of subsidiaries . . . . . . . . . . . . . . . 59,206 117,585 74,310 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $119,032 $122,128 $100,631 74 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (25) International Bancshares Corporation (Parent Company Only) Financial Information Statements of Cash Flows (Parent Company Only) Years ended December 31, 2004, 2003 and 2002 (Dollars in Thousands) 2004 2003 2002 Operating activities: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $119,032 $ 122,128 $100,631 Adjustments to reconcile net income to net cash provided by operating activities: Gain on sale of other investments . . . . . . . . . . . . . . . . . . . . . . Gain on sale of assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accretion of junior subordinated interest deferrable debentures . Depreciation of bank premises and equipment . . . . . . . . . . . . . Increase in other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity in undistributed net income of subsidiaries . . . . . . . . . . . (151) (1,659) 1,026 15 904 (59,206) (58) — — — 567 (117,585) — — — 553 (74,310) Net cash provided by operating activities . . . . . . . . . . . . . . . . . 59,961 5,052 26,874 Investing activities: Contributions to subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds (repurchase) of repurchase agreement with banks . . . . Purchase of available for sale other securities . . . . . . . . . . . . . . Proceeds of sales of available for sale securities . . . . . . . . . . . . Principal collected on mortgage-backed securities . . . . . . . . . . . Proceeds from sales of bank premises and equipment . . . . . . . . Net decrease in notes receivable . . . . . . . . . . . . . . . . . . . . . . . (Decrease) increase in other assets . . . . . . . . . . . . . . . . . . . . . . (9,581) 300 (5,068) 5,010 — 2,598 5,750 (2,982) (8,227) 8,650 — 85 93 — 8,849 377 (8,937) (10,150) — — 1,556 — 10,309 (289) Net cash used in investing activities . . . . . . . . . . . . . . . . . . . . . (3,973) 9,827 (7,511) Financing activities: Proceeds from issuance of subordinated debentures . . . . . . . . . . Principal payments on senior notes . . . . . . . . . . . . . . . . . . . . . . Proceeds from stock transactions . . . . . . . . . . . . . . . . . . . . . . . Payments of cash dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . Payments of cash dividends in lieu of fractional shares . . . . . . . . Purchase of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . — (21,295) 5,265 (39,729) (38) (974) 36,402 — 7,454 (32,599) (26) (29,723) 67,000 — 3,478 (21,984) (31) (63,594) Net cash used in financing activities . . . . . . . . . . . . . . . . . . . . . (56,771) (18,492) (15,131) (Decrease) increase in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (783) (3,613) 4,232 Cash at beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,170 4,783 551 Cash at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 387 $ 1,170 $ 4,783 75 INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Condensed Average Statements of Condition (Dollars in Thousands, Except Per Share Amounts) (Unaudited) Distribution of Assets, Liabilities and Shareholders’ Equity The following table sets forth a comparative summary of average interest earning assets and average interest bearing liabilities and related interest yields for the years ended December 31, 2004, 2003, and 2002: 2004 2003 2002 Average Balance Average Interest Rate/Cost Average Balance Average Interest Rate/Cost Average Balance Average Interest Rate/Cost (Dollars in Thousands) Assets Interest earning assets: Loan, net of unearned discounts: Domestic . . . . . . . . . . . . $3,757,015 $225,002 11,077 Foreign . . . . . . . . . . . . . 225,565 5.99% $2,530,318 $165,174 11,626 225,685 4.91 6.53% $2,416,259 $169,675 14,128 248,597 5.15 7.02% 5.68 Investment securities: Taxable . . . . . . . . . . . . . Tax-exempt . . . . . . . . . . . Time deposits with banks . . . Federal funds sold . . . . . . . . Other . . . . . . . . . . . . . . . . Total interest-earning 2,996,046 111,671 5,459 129,731 6,153 109,092 5,071 92 1,577 467 3.64 4.54 1.69 1.22 7.59 3,233,500 106,876 161 64,885 3,695 135,132 5,146 9 594 370 4.18 4.81 5.59 .92 10.01 2,927,420 101,585 294 43,784 3,430 164,272 4,990 36 671 156 5.61 4.91 2.18 1.53 4.55 assets . . . . . . . . . . . 7,231,640 352,378 4.87% 6,165,120 318,051 5.16% 5,741,369 353,928 6.16% Non-interest earning assets: Cash and due from banks . . . Bank premises and equipment, net . . . . . . . . . . . . . . . . . . . Other assets Less allowance for possible 162,278 260,671 552,880 loan losses . . . . . . . . . . . (69,324) Total . . . . . . . . . . . . . $8,138,145 Liabilities and Shareholders’ Equity Interest bearing liabilities: Savings and interest bearing 126,451 199,637 377,218 (46,928) $6,821,498 129,252 185,958 349,820 (42,376) $6,364,023 demand deposits . . . . . . . $1,832,714 $ 13,797 .75% $1,317,746 $ 10,168 .77% $1,222,190 $ 14,185 1.16% Time deposits: Domestic . . . . . . . . . . . . Foreign . . . . . . . . . . . . . 1,590,229 1,178,775 22,879 21,780 1.44 1.85 922,845 1,314,387 17,204 23,809 Securities sold under repurchase agreements and federal funds purchased . . . Other borrowings . . . . . . . . Junior subordinated interest deferrable debentures . . . . . . . . . . . . . . . Senior notes Total interest bearing 545,572 1,083,222 206,272 3,340 19,865 16,746 13,152 383 3.64 1.55 6.38 11.47 473,365 1,300,153 18,770 15,839 149,615 — 8,935 — 1.86 1.81 3.97 1.22 5.97 — 954,084 1,377,924 26,093 31,814 2.73 2.31 498,869 974,150 19,696 17,817 98,231 — 6,810 — 3.95 1.83 6.93 — liabilities . . . . . . . . . 6,440,124 108,602 1.69% 5,478,111 94,725 1.73% 5,125,448 116,415 2.27% Non-interest bearing liabilities: Demand Deposits . . . . . . . . . . . . . . . . . Other liabilities Shareholders’ equity . . . . . . . . 988,659 54,261 655,101 Total . . . . . . . . . . . . . $8,138,145 751,977 53,174 538,236 $6,821,498 688,644 57,670 492,261 $6,364,023 Net interest income . . $243,776 $223,326 $237,513 Net yield on interest earning assets . . . . . . 3.37% 3.62% 4.14% (Note 1) The average balances for purposes of the above table are calculated on the basis of month-end balances. 76 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 2004 Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $107,117 35,240 $101,787 30,362 $72,504 22,281 $70,970 20,719 Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for possible loan losses . . . . . . . . . . . . . . . . . . . Non-interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income taxes . . . . . . . . . . . . . . . . . . . . . . 71,877 1,717 39,462 59,690 49,932 71,425 2,066 35,951 56,913 48,397 50,223 1,375 31,090 40,889 39,049 50,251 1,342 28,313 37,688 39,534 Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,819 15,226 12,820 13,015 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 33,113 $ 33,171 $26,229 $26,519 Per common share: Basic Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ .65 .64 $ $ .65 .64 $ $ .54 .52 $ $ .54 .54 77 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 2003 Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $76,967 23,107 $80,510 23,923 $78,601 23,702 $81,973 23,993 Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for possible loan losses Non-interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . 53,860 2,101 32,713 41,465 43,007 56,587 2,077 34,051 38,009 50,552 54,899 2,124 31,364 42,193 41,946 57,980 1,989 29,145 38,087 47,049 Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,537 16,694 13,471 15,724 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $28,470 $33,858 $28,475 $31,325 Per common share: Basic Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ .59 $ .70 $ .59 $ .64 Diluted Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ .58 $ .69 $ .58 $ .63 Net income and per common share amounts for the first three quarters have been re-stated to reflect the reversal of $792,000 of amortization expense in accordance with SFAS No. 147. (See Note 1 to the consolidated financial statements) 78 INTERNATIONAL BANCSHARES CORPORATION OFFICERS AND DIRECTORS OFFICERS DIRECTORS DENNIS E. NIXON Chairman of the Board and President R. DAVID GUERRA Vice President EDWARD 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 LESTER AVIGAEL Retail Merchant Chairman of the Board International Bank of Commerce IRVING GREENBLUM Retail Merchant R. DAVID GUERRA President International Bank of Commerce Branch in McAllen, TX DANIEL B. HASTINGS, JR. Licensed U. S. Custom Broker President Daniel B. Hastings, Inc. RICHARD E. HAYNES Attorney at Law Real Estate Investments IMELDA NAVARRO Senior Executive Vice President International Bank of Commerce SIOMA NEIMAN International Entrepreneur PEGGY J. NEWMAN Investments LEONARDO SALINAS Investments ANTONIO R. SANCHEZ, JR. Chairman of the Board Sanchez Oil & Gas Corporation Investments 79 List of Subsidiaries Subsidiaries of International Bancshares Corporation Exhibit 21 Name Business % of Ownership IBC Subsidiary Corporation . . . . . . . . . . . Bank Holding Company IBC Life Insurance Company . . . . . . . . . . Credit Life Insurance IBC Trading Company . . . . . . . . . . . . . . . Export Trading IBC Capital Corporation . . . . . . . . . . . . . Investments 100% 100% 100% 100% Subsidiaries of IBC Subsidiary Corporation Name Business % of Ownership International Bank of Commerce . . . . . . . Commerce Bank . . . . . . . . . . . . . . . . . . . International Bank of Commerce, Zapata . International Bank of Commerce, Brownsville . . . . . . . . . . . . . . . . . . . . . . . Gulfstar Group I, Ltd. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gulfstar Group II, Ltd. State Bank State Bank State Bank State Bank Investment and Merchant Banking Investment Banking 100% 100% 100% 100% 70% 70% EXHIBIT 23 CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors International Bancshares Corporation: We consent to the incorporation by reference in the Registration Statement No. 33-15655 on Form S-8 of International Bancshares Corporation of our reports dated March 15, 2005, with respect to the consolidated statements of condition of International Bancshares Corporation and subsidiaries as of December 31, 2004 and 2003, 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, 2004, management’s assessment of the effectiveness of internal control over financial reporting as of December 31, 2004 and the effectiveness of internal control over financial reporting as of December 31, 2004, which reports are incorporated by reference in the December 31, 2004 annual report on Form 10-K of International Bancshares Corporation. Our report on the consolidated financial statements refers to a change in the method of accounting for the Company’s investment in its statutory business trusts in 2003 and for its goodwill and other intangible assets in 2002. /s/ KPMG LLP San Antonio, Texas March 15, 2005 Exhibit 31a I, Dennis E. Nixon, certify that: Certification 1. I have reviewed this report on Form 10-K of International Bancshares Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a. Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b. Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c. Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end the period covered by this report based on such evaluation; and d. Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and 5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions): a. All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and b. Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting. By: /s/ DENNIS E. NIXON Dennis E. Nixon President Date: March 15, 2005 Exhibit 31b I, Imelda Navarro, certify that: Certification 1. I have reviewed this report on Form 10-K of International Bancshares Corporation; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a. Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b. Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c. Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end the period covered by this report based on such evaluation; and d. Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and 5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions): a. All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and b. Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting. By: /s/ IMELDA NAVARRO Imelda Navarro Treasurer Date: March 15, 2005 Exhibit 32a CERTIFICATION PURSUANT TO 18 U.S.C. 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of International Bancshares Corporation (the ‘‘Company’’) on Form 10-K for the year ended December 31, 2004, as filed with the Securities and Exchange Commission on the date hereof (the ‘‘Report’’), I, Dennis E. Nixon, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes- Oxley Act of 2002, that: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o(d)), as applicable; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. By: /s/ DENNIS E. NIXON Dennis E. Nixon President Date: March 15, 2005 The foregoing certification is being furnished solely to accompany the Report pursuant to 18U.S.C. 1350, and not being filed for purposes of Section 18 of the Securities Exchange Act, as amended, and is not to be incorporated by reference into any filing of the Company, whether on and before or after the date hereof, regardless of any general incorporation language in such filing. A signed original of this written statement required by Section 906 has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission or its staff upon request. CERTIFICATION PURSUANT TO 18 U.S.C. 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 Exhibit 32b In connection with the Annual Report of International Bancshares Corporation (the ‘‘Company’’) on Form 10-K for the year ended December 31, 2004, as filed with the Securities and Exchange Commission on the date hereof (the ‘‘Report’’), I, Imelda Navarro, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes- Oxley Act of 2002, that: (3) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o(d)), as applicable; and (4) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. By: /s/ IMELDA NAVARRO Imelda Navarro Treasurer Date: March 15, 2005 The foregoing certification is being furnished solely to accompany the Report pursuant to 18U.S.C. 1350, and not being filed for purposes of Section 18 of the Securities Exchange Act, as amended, and is not to be incorporated by reference into any filing of the Company, whether on and before or after the date hereof, regardless of any general incorporation language in such filing. A signed original of this written statement required by Section 906 has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission or its staff upon request. 

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