SOUTHSIDE BANCSHARES INC - 10-K Annual Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

Form 10-K
(MARK ONE)
X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
- ----------- EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
- ----------- EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
------- -------

COMMISSION FILE NUMBER 0-12247

Southside Bancshares, Inc.
(Exact name of registrant as specified in its charter)

TEXAS 75-1848732
(State of incorporation) (I.R.S. Employer Identification No.)

1201 S. BECKHAM AVENUE, TYLER, TEXAS 75701
(Address of Principal Executive Offices) (Zip Code)

Registrant's telephone number, including area code: (903) 531-7111

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

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

COMMON STOCK
(Title of Class)

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

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

As of March 1, 2002, 7,803,539 shares of common stock of Southside
Bancshares, Inc. were outstanding. The aggregate market value of common stock
held by nonaffiliates of the registrant as of January 31, 2002 was $75,395,249.

DOCUMENTS INCORPORATED BY REFERENCE

Registrant's Proxy Statement to be filed for the Annual Meeting of
Shareholders to be held April 18, 2002. (Part III)

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PART I

ITEM 1. BUSINESS

GENERAL

Southside Bancshares, Inc. (the "Company"), incorporated in Texas in
1982, is a bank holding company for Southside Bank (the "Bank" or "Southside
Bank"), headquartered in Tyler, Texas. Tyler has a metropolitan area population
of approximately 175,000 and is located approximately 90 miles east of Dallas,
Texas and 90 miles west of Shreveport, Louisiana. The Bank has the largest
deposit base in the Tyler metropolitan area and is the largest bank based on
asset size headquartered in East Texas.

At December 31, 2001, the Company had total assets of $1.3 billion, total
loans of $537.9 million, deposits of $758.0 million, and shareholders' equity of
$68.6 million. The Company had net income of $11.7 million and $9.8 million and
diluted earnings per share of $1.26 and $1.18 for the years ended December 31,
2001 and 2000, respectively. The Company has paid a cash dividend every year
since 1970.

The Bank is a community-focused financial institution that offers a full
range of financial services to individuals, businesses and nonprofit
organizations in the communities it serves. These services include consumer and
commercial loans, deposit accounts, trust services, safe deposit services and
brokerage services.

The Bank's consumer loan services include 1-4 family residential mortgage
loans, home equity, home improvement loans, automobile loans and other
installment loans. Commercial loan services include short-term working capital
loans for inventory and accounts receivable, short and medium-term loans for
equipment or other business capital expansion and commercial real estate loans.
The Bank also offers construction loans primarily for owner-occupied 1-4 family
residential and commercial real estate.

The Bank offers a variety of deposit accounts having a wide range of
interest rates and terms, including savings, money market, interest and
noninterest bearing checking accounts and certificate accounts. The Bank's trust
services include investment, management, administration and advisory services,
primarily for individuals and, to a lesser extent, partnerships and
corporations. At December 31, 2001, the Bank's trust department managed
approximately $333 million of trust assets. Through its 25% owned securities
brokerage affiliate, BSC Securities, L.C., the Bank offers full retail
investment services to its customers. Countywide Loans, Inc. ("Countywide"), the
Company's consumer finance subsidiary, provides basic financial services such as
small loans, check cashing and money orders to individuals, which at December
31, 2001, had $766,000 in loans outstanding.

The Company and the Bank are subject to comprehensive regulation,
examination and supervision by the Board of Governors of the Federal Reserve
System (the "FRB"), the Texas Department of Banking (the "TDB") and the Federal
Depository Insurance Corporation (the "FDIC"), and are subject to numerous laws
and regulations relating to the extension of credit and making of loans to
individuals.

The administrative offices of the Company are located at 1201 S. Beckham
Avenue, Tyler, Texas 75701, and the telephone number is 903-531-7111. The
Company's website can be found at www.southside.com.

MARKET AREA

The Company considers its primary market area to be all of Smith and
Gregg Counties in East Texas, and to a lesser extent, portions of adjoining
counties. During 2001, the Bank opened one branch in Smith County. During the
first quarter of 2002, the Bank opened one branch in Gregg County and one branch
in Smith County. The Bank plans to open two additional branches, both in Smith
County, which should open during the second quarter of 2002. The Company expects
its presence in the Gregg County market area to continue to increase in the
future, however, the city of Tyler in Smith County presently represents the
Company's primary market area.

1

The principal economic activities in the Company's market area include
retail, distribution, manufacturing, medical services, education and oil and gas
industries. Additionally, Tyler's industry base includes conventions and
tourism, as well as retirement relocation. All of these support a growing
regional system of medical service, retail and education centers. Tyler is home
to several nationally recognized health care systems. Tyler hospitals represent
all major specialties and employ over 7,000 individuals.

The Bank serves its markets through fifteen full service branch
locations, eight of which are located in grocery stores. The branches are
located in and around Tyler, Longview, Lindale and Whitehouse. The Company's
television and radio advertising has extended into these market areas for
several years, providing the Bank name recognition throughout Smith and Gregg
counties. Continued advertising combined with strategically placed full service
branches have expanded Southside's name recognition.

The Bank also maintains six motor bank facilities and Countywide
maintains one location. The Bank's customers may also access various banking
services through 25 ATMs owned by the Bank and ATMs owned by others, through
debit cards, and through the Bank's automated telephone, internet and electronic
banking products. These products allow the Bank's customers to apply for loans,
access account information and conduct various transactions from their
telephones and computers.

LENDING ACTIVITIES

The Company's main objective is to seek attractive lending opportunities
in East Texas, primarily in Smith and Gregg Counties. Substantially all of the
Bank's loans are made to borrowers who live in and conduct business in East
Texas, with the exception of selected municipal loans. Total loans as of
December 31, 2001 increased $56.5 million or 11.7% while the average balance was
up $75.9 million or 17.5% when compared to 2000.

Real estate loans as of December 31, 2001 increased $30.1 million or
10.7% from December 31, 2000. Loans to individuals increased $4.6 million or
5.0% from December 31, 2000 and commercial loans decreased $1.2 million or 1.5%.

The increase in real estate loans is due to a stronger real estate market
and a strong commitment by the Company to residential mortgage lending. The
growth of loans made to municipalities in Texas was a result of the Company's
continued strong commitment in this area. Loans to individuals increased due to
greater penetration in the Company's market area. In the portfolio, loans
dependent upon private household income represent a significant concentration.
Due to the number of customers involved who work in all sectors of the local
economy, the Company believes the risk in this portion of the portfolio is
adequately spread throughout the economic community, which assists in mitigating
this concentration.

The aggregate amount of loans that the Bank is permitted to make under
applicable bank regulations to any one borrower, including related entities, is
25% of unimpaired certified capital and surplus. The Bank's legal lending limit
at December 31, 2001 was $12 million. The Bank's largest loan relationship at
December 31, 2001 was approximately $10.5 million.

The average yield on loans for the year ended December 31, 2001 decreased
to 8.17% from 8.45% for the year ended December 31, 2000. This decrease was
reflective of the repricing characteristics of the loans and the decrease in
lending rates during 2001.

2

LOAN PORTFOLIO COMPOSITION AND ASSOCIATED RISK

The following table sets forth loan totals net of unearned discount by
category for the years presented:

For purposes of this discussion, the Company's loans are divided into
four categories: Real Estate Loans, Commercial Loans, Municipals Loans and Loans
to Individuals.

REAL ESTATE LOANS

Real estate loans represent the Company's greatest concentration of
loans. However, the amount of risk associated with this group of loans is
mitigated in part due to the type of loans involved. At December 31, 2001, the
majority of the Company's real estate loans were collateralized by properties
located in Smith and Gregg Counties. Of the $311.3 million in real estate loans,
$147.8 million or 47.5% represent loans collateralized by residential dwellings
that are primarily owner occupied. Historically, the amount of losses suffered
on this type of loan has been significantly less than those on other properties.
The Company's loan policy requires appraisal prior to funding any real estate
loans and also outlines the requirements for appraisals on renewals.

Management pursues an aggressive policy of reappraisal on any real estate
loan that becomes troubled and potential exposures are recognized and reserved
for as soon as they are identified. However, the slow pace of absorption for
certain types of properties could adversely affect the volume of nonperforming
real estate loans held by the Company.

Real estate loans are divided into three categories: 1-4 Family
Residential Mortgage Loans, Construction Loans and Commercial Real Estate Loans.

1-4 Family Residential Mortgage Loans

Residential loan originations are generated by the Company's in-house
originations staff, marketing efforts, present customers, walk-in customers and
referrals from real estate agents, mortgage brokers and builders. The Company
focuses its lending efforts primarily on the origination of loans secured by
first mortgages on owner-occupied, 1-4 family residences. Substantially all of
the Company's 1-4 family residential mortgage originations are secured by
properties located in Smith and Gregg Counties. Historically, the Company has
sold a portion of its loan originations to secondary market investors pursuant
to ongoing purchase commitments.

The Company's fixed rate 1-4 family residential mortgage loans generally
have maturities ranging from five to 30 years. These loans are typically fully
amortizing with monthly payments sufficient to repay the total amount of the
loan or amortizing with a balloon feature, typically due in fifteen years or
less.

The Company reviews information concerning the income, financial
condition, employment and credit history when evaluating the creditworthiness of
the applicant.

The Company also makes home equity loans and at December 31, 2001, these
loans totaled $20.8 million.

3

Construction Loans

The Company's construction loans are collateralized by property located
primarily in the Company's market area. The Company's emphasis for construction
loans is directed toward properties that will be owner occupied. Occasionally,
construction loans for projects built on speculation are financed, but these
typically have substantial secondary sources of repayment. The Company's
construction loans to individuals have both adjustable and fixed interest rates
during the construction period. Construction loans to individuals are typically
made in connection with the granting of the permanent loan on the property.

Commercial Real Estate Loans

In determining whether to originate commercial real estate loans, the
Company generally considers such factors as the financial condition of the
borrower and the debt service coverage of the property. Commercial real estate
loans are made at both fixed and adjustable interest rates for terms generally
up to 20 years. Commercial real estate loans primarily include commercial office
buildings, retail, medical and warehouse facilities, hotels and churches. The
majority of these loans, with the exception of those for hotels and churches,
are collateralized by owner occupied properties.

COMMERCIAL LOANS

The Company's commercial loans are diversified to meet most business
needs. Loan types include short-term working capital loans for inventory and
accounts receivable and short- and medium-term loans for equipment or other
business capital expansion. Management does not consider there to be any
material concentration of risk in any one industry type, other than medical, in
this loan category since no industry classification represents over 10% of
loans. The medical community represents a concentration of risk in the Company's
Commercial loan and Commercial Real Estate loan portfolio (see "Market Area").
Risk in the medical community is mitigated because it is spread among multiple
practice types and multiple specialties.

In its commercial business loan underwriting, the Company assesses the
creditworthiness, ability to repay, and the value and liquidity of the
collateral being offered. Terms are generally granted commensurate with the
useful life of the collateral offered.

MUNICIPAL LOANS

The Company formed a special lending department during 1998 that makes
loans to municipalities and school districts throughout the state of Texas. The
majority of the loans to municipalities and school districts have tax or revenue
pledges which additionally support these loans in addition to collateral. Total
loans to municipalities and school districts as of December 31, 2001 increased
$22.9 million while the average balance was up $19.4 million when compared to
2000. At December 31, 2001, the Company had commercial loans to municipalities
and school districts of $53.1 million and real estate loans to municipalities
and school districts of $1.2 million.

LOANS TO INDIVIDUALS

The Bank is a major consumer lender in its trade territory and has been
for many years. The majority of consumer loans outstanding are collateralized by
vehicles, which accounted for approximately $79.3 million at December 31, 2001.
Additionally, the Company makes loans for a full range of other consumer
purposes, which may be secured or unsecured depending on the credit quality and
purpose of the loan.

At this point, the economy in the Bank's trade territory has shown some
signs of slowing but appears stable. Two areas of concern are the nationwide
slowdown, or recession and the personal bankruptcy rate. Management expects
these two events to have some adverse effect on the Company's net charge-offs.
Most of the Company's loans to individuals are collateralized, which management
believes should limit the exposure in this area should current bankruptcy levels
continue.

4

Consumer loan terms vary according to the type and value of collateral,
length of contract and creditworthiness of the borrower. The underwriting
standards employed by the Company for consumer loans include an application, a
determination of the applicant's payment history on other debts, with greatest
weight being given to payment history with the Company, and an assessment of the
borrower's ability to meet existing obligations and payments on the proposed
loan. Although creditworthiness of the applicant is a primary consideration, the
underwriting process also includes a comparison of the value of the collateral,
if any, in relation to the proposed loan amount.

LOAN MATURITIES AND SENSITIVITY TO CHANGES IN INTEREST RATES

The following table represents loan maturities and sensitivity to changes
in interest rates. The amounts of total loans outstanding at December 31, 2001,
which, based on remaining scheduled repayments of principal, are due in (1) one
year or less*, (2) more than one year but less than five years, and (3) more
than five years*, are shown in the following table. The amounts due after one
year are classified according to the sensitivity to changes in interest rates.

* The volume of commercial loans due within one year reflects the
Company's general policy of limiting such loans to a short-term
maturity. Loans are shown net of unearned discount. Nonaccrual loans are
reflected in the due after five years column.

LOANS TO AFFILIATED PARTIES

In the normal course of business, the Company's subsidiary, Southside
Bank, makes loans to certain of the Company's, as well as its own, officers,
directors, employees and their related interests. As of December 31, 2001 and
2000, these loans totaled $8.1 million and $8.9 million or 11.8% and 17.2% of
Shareholders' Equity, respectively. Such loans are made in the normal course of
business at normal credit terms, including interest rate and collateral
requirements and do not represent more than normal credit risks contained in the
rest of the loan portfolio for loans of similar types.

5

LOAN LOSS EXPERIENCE AND RESERVE FOR LOAN LOSSES

The loan loss reserve is based on the most current review of the loan
portfolio at that time. Several methods are used to maintain the review in the
most current manner. First, the servicing officer has the primary responsibility
for updating significant changes in a customer's financial position.
Accordingly, each officer prepares status updates on any credit deemed to be
experiencing repayment difficulties which, in the officer's opinion, would place
the collection of principal or interest in doubt. Second, an internal review
officer from the Company is responsible for an ongoing review of the Company's
entire loan portfolio with specific goals set for the volume of loans to be
reviewed on an annual basis. Independent Bank Services, L.C., a partially owned
subsidiary of the Bank, supplements the internal review officer's process by
performing additional loans reviews designed to achieve overall goals of
penetration. Third, Southside Bank is regulated and examined by the FDIC and/or
the Texas Department of Banking on an annual basis.

At each review of a credit, a subjective analysis methodology is used to
grade the respective loan. Categories of grading vary in severity to include
loans which do not appear to have a significant probability of loss at the time
of review to grades which indicate a probability that the entire balance of the
loan will be uncollectible. If full collection of the loan balance appears
unlikely at the time of review, estimates or appraisals of the collateral
securing the debt are used to allocate the necessary reserves. A list of loans,
which are graded as having more than the normal degree of risk associated with
them, is maintained by the internal review officer. This list is updated on a
periodic basis, but no less than quarterly by the servicing officer in order to
properly allocate necessary reserves and keep management informed on the status
of attempts to correct the deficiencies noted in the credit.

Industry experience shows that a portion of the Company's loans will
become delinquent and a portion of the loans will require partial or entire
charge-off. Regardless of the underwriting criteria utilized, losses may be
experienced as a result of various factors beyond the Company's control,
including, among other things, changes in market conditions affecting the value
of properties and problems affecting the credit of the borrower. Management's
determination of the adequacy of allowance for loan losses is based on various
considerations, including an analysis of the risk characteristics of various
classifications of loans, previous loan loss experience, specific loans which
would have loan loss potential, delinquency trends, estimated fair value of the
underlying collateral, current economic conditions, the views of the regulators
(who have the authority to require additional reserves), and geographic and
industry loan concentration.

In addition to maintaining an ongoing review of the loan portfolio, the
internal review officer maintains a history of the loans that have been
charged-off without first being identified as problems. This history is used to
assist in gauging the amount of nonspecifically allocated reserve necessary, in
addition to the portion which is specifically allocated by loan. The internal
review officer also uses the loan portfolio data collected to determine the
allocation of reserve for loan loss appropriate for the risk in each of the
Company's major loan categories.

As of December 31, 2001, the Company's review of the loan portfolio
indicates that a loan loss reserve of $5.9 million is adequate.

6

The following table presents information regarding the average amount of
net loans outstanding, changes in the reserve for loan losses, the ratio of net
loans charged-off to average net loans outstanding, and an allocation of the
reserve for loan loss.

LOAN LOSS EXPERIENCE AND RESERVE FOR LOAN LOSSES

Allocation of Reserve for Loan Loss (dollars in thousands):

See "Consolidated Financial Statements - Note 6.
Loans and Reserve for Possible Loan Losses."

7

NONPERFORMING ASSETS

Nonperforming assets consist of delinquent loans over 90 days past due,
nonaccrual loans, other real estate owned and restructured loans. Nonaccrual
loans are those loans which are more than 90 days delinquent and collection in
full of both the principal and interest is in doubt. Additionally, some loans
that are not delinquent may be placed on nonaccrual status due to doubts about
full collection of principal or interest. When a loan is categorized as
nonaccrual, the accrual of interest is discontinued and the accrued balance is
reversed for financial statement purposes. Other Real Estate Owned (OREO)
represents real estate taken in full or partial satisfaction of debts previously
contracted. The OREO consists of three real estate properties. The Company is
actively marketing the properties and they are not held for investment purposes.
Restructured loans represent loans which have been renegotiated to provide a
reduction or deferral of interest or principal because of deterioration in the
financial position of the borrowers. Categorization of a loan as nonperforming
is not in itself a reliable indicator of potential loan loss. Other factors,
such as the value of collateral securing the loan and the financial condition of
the borrower must be considered in judgments as to potential loan loss.

The following table of nonperforming assets is classified according to
bank regulatory call report guidelines:

Total nonperforming assets decreased $75,000 or 3.0% between December 31,
2000 and December 31, 2001. Nonperforming assets as a percentage of assets
decreased .03% from the previous year and as a percentage of loans decreased
.06%. Nonperforming assets represent a drain on the earning ability of the
Company. Earnings losses are due both to the loss of interest income and the
costs associated with maintaining the OREO, for taxes, insurance and other
operating expenses. In addition to the nonperforming assets, at December 31,
2001 in the opinion of management, the Company had $397,000 of loans identified
as potential problem loans. A potential problem loan is a loan where information
about possible credit problems of the borrower is known, causing management to
have serious doubts about the ability of the borrower to comply with the present
loan repayment terms and may result in a future classification of the loan in
one of the nonperforming asset categories.

8

The following is a summary of the Company's recorded investment in loans
(primarily nonaccrual loans) for which impairment has been recognized in
accordance with FAS114:

For the years ended December 31, 2001 and 2000, the average recorded
investment in impaired loans was approximately $801,000 and $567,000,
respectively. During the years ended December 31, 2001 and 2000, the amount of
interest income reversed on impaired loans placed on nonaccrual and the amount
of interest income subsequently recognized on the cash basis was not material.

The net amount of interest recognized on loans that were nonaccruing or
restructured during the year was $70,000, $122,000 and $125,000 for the years
ended December 31, 2001, 2000 and 1999, respectively. If these loans had been
accruing interest at their original contracted rates, related income would have
been $113,000, $138,000 and $137,000 for the years ended December 31, 2001, 2000
and 1999, respectively.

The following is a summary of the Allowance for Losses on Other Real
Estate Owned for the years presented:

9

SECURITIES ACTIVITY

The securities portfolio of the Company plays a primary role in
management of the interest rate sensitivity of the Company and, therefore, is
managed in the context of the overall balance sheet. The securities portfolio
generates a substantial percentage of the Company's interest income and serves
as a necessary source of liquidity.

The Company accounts for debt and equity securities as follows:

Held to Maturity (HTM). Debt securities that management has the positive
intent and ability to hold until maturity are classified as HTM and are
carried at their remaining unpaid principal balance, net of unamortized
premiums or unaccreted discounts. Premiums are amortized and discounts
are accreted using the level interest yield method over the estimated
remaining term of the underlying security.

Available for Sale (AFS). Debt and equity securities that will be held
for indefinite periods of time, including securities that may be sold in
response to changes in market interest or prepayment rates, needs for
liquidity and changes in the availability of and the yield of alternative
investments are classified as AFS. These assets are carried at market
value. Market value is determined using published quotes as of the close
of business. Unrealized gains and losses are excluded from earnings and
reported net of tax as a separate component of shareholders' equity until
realized.

Management attempts to deploy investable funds into instruments which are
expected to increase the overall return of the portfolio given the current
assessment of economic and financial conditions, while maintaining acceptable
levels of capital, interest rate and liquidity risk.

The following table sets forth the carrying amount of investment
securities, mortgage-backed securities and marketable equity securities at
December 31, 2001 and 2000:

10

The Company invests in mortgage-backed and related securities, including
mortgage participation certificates, which are insured or guaranteed by U.S.
Government agencies and government sponsored enterprises, and collateralized
mortgage obligations and real estate mortgage investment conduits.
Mortgage-backed securities (which also are known as mortgage participation
certificates or pass-through certificates) represent a participation interest in
a pool of single-family or multi-family mortgages, the principal and interest
payments on which are passed from the mortgage originators, through
intermediaries (generally U.S. Government agencies, government sponsored
enterprises, and direct whole loans) that pool and repackage the participation
interests in the form of securities, to investors such as the Company. U.S.
Government agencies and government sponsored enterprises, which guarantee the
payment of principal and interest to investors, primarily include the Federal
Home Loan Mortgage Corporation, the Federal National Mortgage Association and
the Government National Mortgage Association. The whole loans the Company
purchases are all AAA rated collateralized mortgage obligations and real estate
mortgage investment conduit tranches rated AAA due to credit support and/or
insurance coverage.

Mortgaged-backed securities typically are issued with stated principal
amounts, and the securities are backed by pools of mortgages that have loans
with interest rates that are within a range and have varying maturities. The
characteristics of the underlying pool of mortgages, i.e., fixed-rate or
adjustable-rate, as well as prepayment risk, are passed on to the certificate
holder. The term of a mortgaged-backed pass-through security thus approximates
the term of the underlying mortgages.

The Company's mortgaged-backed derivative securities include
collateralized mortgage obligations, which include securities issued by entities
which have qualified under the Internal Revenue Code as real estate mortgage
investment conduits. Collateralized mortgage obligations and real estate
mortgage investment conduits (collectively collateralized mortgage obligations)
have been developed in response to investor concerns regarding the uncertainty
of cash flows associated with the prepayment option of the underlying mortgagor
and are typically issued by governmental agencies, government sponsored
enterprises and special purpose entities, such as trusts, corporations or
partnerships, established by financial institutions or other similar
institutions. A collateralized mortgage obligation can be collateralized by
loans or securities which are insured or guaranteed by Federal National Mortgage
Association, Federal Home Loan Mortgage Corporation, the Government National
Mortgage Association, or whole loans which, in the Company's case, are all rated
AAA. In contrast to pass-through mortgage-backed securities, in which cash flow
is received pro rata by all security holders, the cash flow from the mortgages
underlying a collateralized mortgage obligation is segmented and paid in
accordance with a predetermined priority to investors holding various
collateralized mortgage obligation classes. By allocating the principal and
interest cash flows from the underlying collateral among the separate
collateralized mortgage obligation classes, different classes of bonds are
created, each with its own stated maturity, estimated average life, coupon rate
and prepayment characteristics.

Like most fixed-income securities, mortgage-backed and related securities
are subject to interest rate risk. However, unlike most fixed-income securities,
the mortgage loans underlying a mortgage-backed or related security generally
may be prepaid at any time without penalty. The ability to prepay a mortgage
loan generally results in significantly increased price and yield volatility
(with respect to mortgage-backed and related securities) than is the case with
non-callable fixed income securities. Furthermore, mortgage-backed derivative
securities often are more sensitive to changes in interest rates and prepayments
than traditional mortgage-backed securities and are, therefore, even more
volatile.

11

The combined Investment securities, mortgage-backed securities, and
marketable equity securities portfolio increased to $634.2 million on December
31, 2001, compared to $593.8 million on December 31, 2000, an increase of $40.4
million or 6.8%. Mortgage-backed securities increased $41.8 million or 10.1%
during 2001 when compared to 2000. State and Political Subdivisions increased
$26.3 million or 26.2% during 2001. U.S. Treasury securities increased during
2001 compared to 2000 by $5.1 million or 84.0%, U. S. Government Agency
securities decreased $22.2 million or 51.1%. Other stocks and bonds decreased
$10.6 million or 33.1% in 2001 compared to 2000 due to sales of corporate bonds
which more than offset increases of $1.1 million or 5.2% due to FHLB Dallas
stock dividends and purchases in 2001 compared to 2000. During 2001, interest
rates declined and the yield curve steepened as short-term interest rates
decreased significantly more than long-term interest rates. The Company used
this low interest rate environment to reposition the securities portfolio in an
attempt to reduce the overall duration. Several lower coupon, longer duration
mortgage-backed securities were replaced with higher coupon or shorter duration
mortgage-backed securities. Long duration U. S. Government agency securities
were replaced with long duration municipal securities. Specific municipal
securities with final maturities greater than twenty years and larger blocks of
long term municipal security zero coupon bonds were both replaced with thirteen
to twenty year coupon municipal securities.

On January 1, 2001, Southside adopted Financial Accounting Standard No.
133, "Accounting for Derivative Instruments and Hedging Activities," (FAS133).
As allowed by FAS133, at the date of initial application of this statement,
Southside transferred held to maturity securities into the available for sale
category and the trading category. Southside sold the securities transferred
into the trading category during the first quarter of 2001. The effect of
selling the securities in the trading category is shown as a cumulative effect
of a change in accounting principle and reduced net income by $994,000 (net of
taxes) during the first quarter of 2001. During 2001, Southside sold available
for sale securities which resulted in realized gains of $4.1 million or an after
tax gain of $2.7 million. These separate transactions allowed Southside to
reduce the overall duration of and reposition the securities portfolio.

During the second quarter ended June 30, 2000, the Company issued $54.6
million of long-term brokered CDs with one-year call options and additional call
options every six months thereafter, until the CDs mature. The average yield on
these CDs was 8.19% with an average life of 10.8 years. Obtaining this long-term
funding enabled the Bank to take advantage of the higher interest rate
environment, during the first half of 2000 primarily through the purchase of
securities without incurring significant additional interest rate risk. The
options associated with these CDs provided the Bank with valuable balance sheet
opportunities. The higher cost associated with these callable CDs had a negative
impact on net interest spread during the five quarters ended June 30, 2001. In
conjunction with the issuance of these long-term brokered CDs, securities were
purchased with an overall duration and yield approximately that of the brokered
CDs.

During March 2001, the Company notified CD holders that $24.6 million of
brokered CDs were being called April 12, 2001. The Company recorded $195,000 of
additional interest expense associated with the call of the CDs during the first
quarter ended March 31, 2001. Gains on sales of securities were used to offset
this expense. During April 2001, the Company notified CD holders that the
remaining $30.0 million of brokered CDs would be called May 24, 2001. An
additional $357,000 of expense was incurred during the second quarter ending
June 30, 2001, associated with the call of the brokered CDs. These CDs were
replaced with long-term advances from the FHLB at an average rate of
approximately 5.40% and an average life of approximately 4.9 years. As a result,
the Company's interest expense on this $54.6 million declined after the CDs were
called.

12

The market value of the Securities portfolio at December 31, 2001 was
$634.2 million, which represented a net unrealized gain on that date of $9.0
million. The net unrealized gain was comprised of $10.6 million in unrealized
gains and $1.6 million of unrealized losses. Net unrealized gains and losses on
AFS securities, which is a component of Shareholders' Equity on the consolidated
balance sheet, can fluctuate significantly as a result of changes in interest
rates. Because management cannot predict the future direction of interest rates,
the effect on Shareholders' Equity in the future cannot be determined; however,
this risk is monitored closely through the use of shock tests on the AFS
securities portfolio using an array of interest rate assumptions.

During the month ended January 31, 2000, the Company transferred
securities totaling $91.7 million from AFS to HTM due to changes in market
conditions. Of the total transferred, $21.2 million were investment securities
and $70.5 million were mortgage-backed securities. The unrealized loss on the
securities transferred from AFS to HTM was $2.6 million, net of tax, at the date
of transfer. There were no sales from the HTM portfolio during the years ended
December 31, 2001 or 2000. There were no securities classified as HTM for the
year ended December 31, 2001.

The maturities classified according to the sensitivity to changes in
interest rates of the December 31, 2001 securities portfolio and the weighted
yields are presented below. Tax-exempt obligations are shown on a taxable
equivalent basis. Mortgage-backed securities are classified according to
repricing frequency and cash flows from street estimates of principal
prepayments.

13

DEPOSITS AND BORROWED FUNDS

Deposits provide the Company with its primary source of funds. The
increase of $37.3 million or 5.2% in total deposits during 2001 provided the
Company with funds for a portion of the growth in loans. Time deposits decreased
$534,000 or 0.2% during 2001 compared to 2000. This decrease was due to $54.6
million of brokered CDs called during the second quarter ended June 30, 2001.
Time deposits not including brokered CDs increased $54.1 million or 18.5% during
2001 compared to 2000, due in part to State of Texas time deposits increasing
$27.1 million. Noninterest bearing demand deposits increased $4.9 million or
2.9% during 2001. Interest bearing demand deposits increased $27.4 million or
14.9% and Saving Deposits increased $5.6 million or 23.4% during 2001. The
latter three categories, which are considered the lowest cost deposits,
comprised 54.4% of total deposits at December 31, 2001 compared to 51.9% at
December 31, 2000. The increase in total deposits was reflective of overall bank
growth and branch expansion.

The following table sets forth the Company's deposits by category at
December 31, 2001 and 2000:

During the year ended December 31, 2001, total time deposits of $100,000
or more decreased $11.8 million or 7.8% from December 31, 2000. This decrease
was due to $54.6 million of brokered CDs called during the second quarter ended
June 30, 2001. Total time deposits of $100,000 or more not including brokered
CDs actually increased $42.8 million or 44.4% during 2001 compared to 2000 due
in part to State of Texas time deposits increasing $27.1 million.

The table below sets forth the maturity distribution of time deposits of
$100,000 or more issued by the Company at December 31, 2001 and 2000:

14

Short-term Obligations, consisting primarily of FHLB Dallas advances and
Federal Funds Purchased, decreased $13.7 million or 8.7% during 2001 when
compared to 2000. FHLB Dallas advances are collateralized by FHLB Dallas stock,
nonspecified real estate loans and securities.

(1) The average amount outstanding during the period was computed by
dividing the total daily outstanding principal balances by the number
of days in the period.

(2) The weighted average interest rate during the period was computed by
dividing the actual interest expense by the average balance
outstanding during the period.

Long-term Obligations primarily consisting of FHLB Dallas advances and
junior subordinated debentures increased $81.1 million during 2001 to $297.7
million or a 37.4% increase when compared to $216.6 million in 2000. The
increase was primarily the result of the Company replacing $54.6 million of
long-term callable brokered CDs the Company called during 2001 with long-term
FHLB Dallas advances. The Company also added additional long-term FHLB Dallas
advances as long-term interest rates decreased.

On November 2, 2000, the Company through its wholly-owned subsidiary,
Southside Capital Trust II (the "Trust II Issuer"), sold 1,695,000 cumulative
convertible preferred securities (the "junior subordinated convertible
debentures") at a liquidation amount of $10 per convertible preferred security
for an aggregate amount of $16,950,000. These securities have a convertible
feature that allows the owner to convert each security to a share of the
Company's common stock at a conversion price of $9.52 per common share. These
securities have a distribution rate of 8.75% per annum payable at the end of
each calendar quarter.

On May 18, 1998, the Company through its wholly-owned subsidiary,
Southside Capital Trust (the "Trust Issuer"), sold 2,000,000 preferred
securities (the "junior subordinated debentures") at a liquidation amount of $10
per preferred security for an aggregate amount of $20,000,000. These securities
have a distribution rate of 8.50% per annum payable at the end of each calendar
quarter.

THE BANKING INDUSTRY IN TEXAS

The banking industry is affected by general economic conditions such as
interest rates, inflation, recession, unemployment and other factors beyond the
Company's control. During the mid to late 1980's, declining oil prices had an
indirect effect on the Company's business, and the deteriorating real estate
market caused a significant portion of the increase in the Company's
nonperforming assets during that period. During the early 1990's the East Texas
economy entered into a recovery and growth period that continued throughout the
year 2000. During the last ten years the East Texas economy has diversified,
decreasing the overall impact of declining oil prices, however, the East Texas
economy is still affected by the oil industry. During 2001 the economy in the
Bank's trade territory has shown some signs of slowing but appears stable. The
two areas of concern are the nationwide economic slowdown or recession and the
personal bankruptcy rate. Management expects these trends to have some effect on
the Company's net charge-offs. Management of the Company, however, cannot
predict whether current economic conditions will improve, remain the same or
decline.

15

COMPETITION

The activities engaged in by the Company and its subsidiary, Southside
Bank, are highly competitive. Financial institutions such as savings and loan
associations, credit unions, consumer finance companies, insurance companies,
brokerage companies and other financial institutions with varying degrees of
regulatory restrictions compete more vigorously for a share of the financial
services market. Brokerage companies continue to become more competitive in the
financial services arena and pose an ever increasing challenge to banks.
Legislative changes also greatly affect the level of competition the Company
faces. During 1998 federal legislation allowed credit unions to expand their
membership criteria. This allows credit unions to use their expanded membership
capabilities combined with tax-free status to compete more fiercely for
traditional bank business. Because banks do not enjoy a tax-free status, credit
unions have a competitive advantage. Currently, the Company must compete against
several institutions located in East Texas and elsewhere in the Company's
service area which have capital resources and legal loan limits substantially in
excess of those available to the Company and Southside Bank. The Company expects
the competition to increase.

EMPLOYEES

At December 31, 2001, the Company employed approximately 388 full time
equivalent persons. None of the employees are represented by any unions or
similar groups, and the Company has not experienced any type of strike or labor
dispute. The Company considers the relationship with its employees to be good.

EXECUTIVE OFFICERS OF THE REGISTRANT

The executive officers of the Company and Southside Bank as of December
31, 2001, were as follows:

B. G. Hartley (Age 72), Chairman of the Board and Chief Executive Officer of the
Company since 1983. He also serves as Chairman of the Board and Chief Executive
Officer of the Company's subsidiary, Southside Bank, having served in these
capacities since the Bank's inception in 1960.

Sam Dawson (Age 54), President, Secretary and Director of the Company.
President, Chief Operations Officer and Director of the Company's subsidiary,
Southside Bank since 1996. He became an officer of the Company in 1982 and of
Southside Bank during 1975.

Robbie N. Edmonson (Age 69), Vice Chairman of the Board of the Company and the
Company's subsidiary, Southside Bank. He joined Southside Bank as a vice
president in 1968.

Jeryl Story (Age 50), Executive Vice President of the Company. Senior Executive
Vice President - Loan Administration, Senior Lending Officer and Director of the
Company's subsidiary, Southside Bank, since 1996. He joined Southside Bank in
1979 as an officer in Loan Documentation.

Lee R. Gibson (Age 45), Executive Vice President and Chief Financial Officer of
the Company and of the Company's subsidiary, Southside Bank. He is also a
Director of Southside Bank. He became an officer of the Company in 1985 and of
Southside Bank during 1984.

All the individuals named above serve in their capacity as officers of
the Company and/or Southside Bank at the pleasure of each entities' Board of
Directors.

16

SUPERVISION AND REGULATION

Banking is a complex, highly regulated industry. Consequently, the
Company's growth and earnings performance can be affected not only by management
decisions and general and local economic conditions, but also by the statutes
administered by, and the regulations and policies of, various governmental
authorities. These authorities include, but are not limited to, the board of
governors of the Federal Reserve System, the Federal Deposit Insurance
Corporation, the Department of Banking of the State of Texas, the Internal
Revenue Service and state taxing authorities. The effect of these statutes,
regulations and policies and any changes to any of them can be significant and
cannot be predicted.

The primary goals of the bank regulatory scheme are to maintain a safe
and sound banking system and to facilitate the conduct of sound monetary policy.
In furtherance of these goals, Congress has created several largely autonomous
regulatory agencies and enacted numerous laws that govern banks, bank holding
companies and the banking industry. The system of supervision and regulation
applicable to the Bank and the Company establishes a comprehensive framework for
the Company's respective operations and is intended primarily for the protection
of the Federal Deposit Insurance Corporation's deposit insurance funds, the
Bank's depositors and the public, rather than the Company's shareholders and
creditors. The following is an attempt to summarize some of the relevant laws,
rules and regulations governing banks and bank holding companies, but does not
purport to be a complete summary of all applicable laws, rules and regulations
governing banks and bank holding companies. The descriptions are qualified in
their entirety by reference to the specific statutes and regulations discussed.

Southside

General. As bank holding companies under the Bank Holding Company Act of
1956, as amended, the Company and Southside Delaware are registered with and
subject to regulation by the Federal Reserve. The Company and Southside Delaware
are both required to file annual and other reports with, and furnish information
to, the Federal Reserve, which makes periodic inspections of the Company and
Southside Delaware.

The Bank Holding Company Act provides that a bank holding company must
obtain the prior approval of the Federal Reserve for the acquisition of more
than five percent of the voting stock or substantially all the assets of any
bank or bank holding company. In addition, the Bank Holding Company Act
restricts the extension of credit to any bank holding company by its subsidiary
bank. The Bank Holding Company Act also provides that, with certain exceptions,
a bank holding company may not engage in any activities other than those of
banking or managing or controlling banks and other authorized subsidiaries or
own or control more than five percent of the voting shares of any company that
is not a bank. The Federal Reserve has deemed limited activities to be closely
related to banking and therefore permissible for a bank holding company.

The Federal Reserve has cease-and-desist powers over bank holding
companies and their nonbanking subsidiaries where their actions would constitute
a serious threat to the safety, soundness or stability of a subsidiary bank.
Federal regulatory agencies also have authority to regulate debt obligations
(other than commercial paper) issued by bank holding companies. This authority
includes the power to impose interest ceilings and reserve requirements on such
debt obligations. A bank holding company and its subsidiaries are also
prohibited from engaging in certain tie-in arrangements in connection with any
extension of credit, lease or sale of property or furnishing of services.

The Modernization Act. Traditionally, the activities of bank holding
companies had been limited to the business of banking and activities closely
related or incidental to banking. The Gramm-Leach-Bliley Financial Services
Modernization Act of 1999, which became effective on March 11, 2000, amended the
Bank Holding Company Act and expanded the types of activities in which a bank
holding company may engage by electing to become a "financial holding company."
A financial holding company may affiliate with securities firms and insurance
companies and engage in other activities that are "financial in nature." In
addition to traditional lending activities, activities that are deemed
"financial in nature" include securities underwriting, dealing in or making a
market in securities, sponsoring mutual funds and investment companies,
insurance underwriting and agency activities, certain merchant banking
activities and activities that the Federal Reserve considers to be closely
related to banking.

17

A bank holding company may become a financial holding company under the
Modernization Act if each of its subsidiary banks is "well capitalized" under
the Federal Deposit Insurance Corporation Improvement Act prompt corrective
action provisions, is "well managed" and has at least a "satisfactory" rating
under the Community Reinvestment Act. In addition, the bank holding company must
file a declaration with the Federal Reserve that the bank holding company elects
to become a financial holding company. A bank holding company that falls out of
compliance with these requirements may be required to cease engaging in some of
its activities.

In a similar manner, the Modernization Act expanded the types of
activities in which a bank may engage. Generally, a bank may engage in
activities that are financial in nature through a "financial subsidiary" if the
bank and each of its depository institution affiliates are "well capitalized",
"well managed" and have at least a "satisfactory" rating under the Community
Reinvestment Act. However, applicable law and regulation provide that the amount
of investment in these activities generally are limited to 45% of the total
assets of the bank, and these investments are not aggregated with the bank for
determining compliance with capital adequacy guidelines. Further, the
transactions between the bank and this type of subsidiary are subject to a
number of limitations.

Under the Modernization Act, the Federal Reserve serves as the primary
"umbrella" regulator of financial holding companies, with supervisory authority
over each parent company and limited authority over its subsidiaries. Expanded
financial activities of financial holding companies generally will be regulated
according to the type of such financial activity: banking activities by banking
regulators, securities activities by securities regulators and insurance
activities by insurance regulators. The Modernization Act also imposes
additional restrictions and heightened disclosure requirements regarding private
information collected by financial institutions. All implementing regulations
under the Modernization Act have not yet become effective in final form, and the
Company cannot predict the full sweep of the new legislation and have not yet
determined whether it will elect to become a financial holding company or if the
Company will conduct any activities through financial subsidiaries.

Interstate Banking. Federal banking law generally provides that a bank
holding company may acquire or establish banks in any state of the United
States, subject to certain aging and deposit concentration limits. In addition,
Texas banking laws permit a bank holding company which owns stock of a bank
located outside the State of Texas to acquire a bank or bank holding company
located in Texas. This type of acquisition may occur only if the Texas bank to
be directly or indirectly controlled by the out-of-state bank holding company
has existed and continuously operated as a bank for a period of at least five
years. In any event, a bank holding company may not own or control banks in
Texas the deposits of which would exceed 20% of the total deposits of all
federally-insured deposits in Texas. The Company has no present plans to acquire
or establish banks outside the State of Texas but have not eliminated the
possibility of doing so.

Capital Adequacy. The Federal Reserve monitors the capital adequacy of
bank holding companies, such as Southside Delaware and the Company, and the
Federal Deposit Insurance Corporation monitors the capital adequacy of the Bank.
The federal bank regulators use a combination of risk-based guidelines and
leverage ratios to evaluate capital adequacy and consider the Company's capital
levels when taking action on various types of applications and when conducting
supervisory activities related to the safety and soundness of the Company and
the Bank.

The Federal Reserve's capital adequacy regulations are based upon a risk
based capital determination, whereby a bank holding company's capital adequacy
is determined in light of the risk, both on- and off-balance sheet, contained in
the company's assets. Different categories of assets are assigned risk
weightings and are counted at a percentage of their book value.

The regulations divide capital between Tier 1 capital (core capital) and
Tier 2 capital. For a bank holding company, Tier 1 capital consists primarily of
common stock, related surplus, noncumulative perpetual preferred stock, minority
interests in consolidated subsidiaries and a limited amount of qualifying
cumulative preferred securities. Goodwill and certain other intangibles are
excluded from Tier 1 capital. Tier 2 capital consists of an amount equal to the
allowance for loan and lease losses up to a maximum of 1.25% of risk weighted
assets, limited other types of preferred stock not included in Tier 1 capital,
hybrid capital instruments and term subordinated debt. Investments in and loans
to unconsolidated banking and finance subsidiaries that constitute capital of
those subsidiaries are excluded from capital. The sum of Tier 1 and Tier 2
capital constitutes qualifying total capital, and the Tier 1 component must
comprise at least 50% of qualifying total capital.

18

Under regulatory capital guidelines, the Company must maintain a minimum
Tier 1 capital ratio of at least 4.0% and a minimum total capital ratio of at
least 8.0%. In addition, banks and bank holding companies are required to
maintain a minimum leverage ratio of Tier 1 capital to average total
consolidated assets (leverage capital ratio) of at least 3.0% for the most
highly-rated, financially sound banks and bank holding companies and a minimum
leverage ratio of at least 4.0% for all other banks. As of December 31, 2001,
the Company's total risk-based capital ratio was 17.08%, the Company's Tier 1
risk-based capital ratio was 13.44% and the Company's leverage capital ratio was
6.50%.

The guidelines also provide that banking organizations experiencing
internal growth or making acquisitions will be expected to maintain strong
capital positions substantially above the minimum supervisory level, without
significant reliance on intangible assets and that the Federal Reserve will
continue to consider a "Tangible Tier 1 Leverage Ratio" in evaluating proposals
for expansion or new activities. The Tangible Tier 1 Leverage Ratio is the ratio
of Tier 1 capital, less intangibles not deducted from Tier 1 capital, to
quarterly average total assets. As of December 31, 2001, the Federal Reserve had
not advised us of any specific minimum Tangible Tier 1 Leverage Ratio applicable
to the Company.

Dividends. As a bank holding company that does not, as an entity,
currently engage in separate business activities of a material nature, the
Company's ability to pay cash dividends depends upon the cash dividends it
receives from the bank through Southside Delaware. The Company's sources of
income are dividends paid by the Bank. The Company must pay all of its operating
expenses from funds the Company received from the Bank. Therefore, shareholders
may receive dividends from the Company only to the extent that funds are
available after payment of the Company's operating expenses. In addition, in
November 1985 the Federal Reserve adopted a policy statement concerning payment
of cash dividends, which generally prohibits bank holding companies from paying
dividends except out of operating earnings, and the prospective rate of earnings
retention appears consistent with the bank holding company's capital needs,
asset quality and overall financial condition. The Company is also subject to
certain restrictions on the payment of dividends as a result of the requirement
that the Company maintain an adequate level of capital as described above.

The Bank

The Bank is subject to various requirements and restrictions under the
laws of the United States and the State of Texas, and to regulation, supervision
and regular examination by the Texas Department of Banking and the Federal
Deposit Insurance Corporation. The Texas Department of Banking and the Federal
Deposit Insurance Corporation have the power to enforce compliance with
applicable banking statutes and regulations. These requirements and restrictions
include requirements to maintain reserves against deposits, restrictions on the
nature and amount of loans that may be made and the interest that may be charged
thereon and restrictions relating to investments and other activities of the
bank.

USA Patriot Act of 2001. On October 26, 2001, President Bush signed into
law the United and Strengthening America by Providing Appropriate Tools Required
to Intercept and Obstruct Terrorism Act of 2001. Also known as the "Patriot
Act," the law enhances the powers of the federal government and law enforcement
organizations to combat terrorism, organized crime and money laundering. The
Patriot Act significantly amends and expands the application of the Bank Secrecy
Act, including enhanced measures regarding customer identity, new suspicious
activity reporting rules and enhanced anti-money laundering programs. Under the
Act, each financial institution is required to establish and maintain anti-money
laundering programs, which include, at a minimum, the development of internal
policies, procedures, and controls; the designation of a compliance officer; an
ongoing employee training program; and an independent audit function to test
programs. In addition, the Act requires the bank regulatory agencies to consider
the record of a bank or bank holding company in combating money laundering
activities in their evaluation of bank and bank holding company merger or
acquisition transactions. Regulations proposed by the U.S. Department of the
Treasury to effectuate certain provisions of the Patriot Act provide that all
transaction or other correspondent accounts held by a U.S. financial institution
on behalf of any foreign bank must be closed within ninety days after the final
regulations are issued, unless the foreign bank has provided the U.S. financial
institution with a means of verification that the institution is not a "shell
bank." Proposed regulations interpreting other provisions of the Patriot Act are
expected to be issued during 2002.

19

Transactions with Affiliates. The Bank may not engage in specified
transactions (including, for example, loans) with its affiliates unless the
terms and conditions of those transactions are substantially the same or at
least as favorable to the Bank as those prevailing at the time for comparable
transactions with or involving other nonaffiliated entities. In the absence of
comparable transactions, any transaction between the Bank and its affiliates
must be on terms and under circumstances, including credit standards, that in
good faith would be offered or would apply to nonaffiliated companies. In
addition, transactions referred to as "covered transactions" between the Bank
and its affiliates may not exceed 10% of the Bank's capital and surplus per
affiliate and an aggregate of 20% of its capital and surplus for covered
transactions with all affiliates. Certain transactions with affiliates, such as
loans, also must be secured by collateral of specific types and amounts. The
Bank also is prohibited from purchasing low quality assets from an affiliate.
Every company under common control with the Bank, including the Company and
Southside Delaware, are deemed to be affiliates of the Bank.

Loans to Insiders. Federal law also constrains the types and amounts of
loans that the Bank may make to its executive officers, directors and principal
shareholders. Among other things, these loans must be approved by the Bank's
board of directors in advance, must be on terms and conditions as favorable to
the Bank as those available to an unrelated person and are limited in amount.

Regulation of Lending Activities. Loans made by the Bank are also subject
to numerous federal and state laws and regulations, including the
Truth-In-Lending Act, Federal Consumer Credit Protection Act, the Texas Consumer
Credit Code, the Texas Consumer Protection Code, the Equal Credit Opportunity
Act, the Real Estate Settlement Procedures Act and adjustable rate mortgage
disclosure requirements. Remedies to the borrower or consumer and penalties to
the Bank are provided if the Bank fails to comply with these laws and
regulations. The scope and requirements of these laws and regulations have
expanded significantly in recent years.

Branch Banking. Pursuant to the Texas Finance Code, all banks located in
Texas are authorized to branch statewide. Accordingly, a bank located anywhere
in Texas has the ability, subject to regulatory approval, to establish branch
facilities near any of our facilities and within our market area. If other banks
were to establish branch facilities near our facilities, it is uncertain whether
these branch facilities would have a material adverse effect on the business of
the Bank.

In 1994 Congress adopted the Reigle-Neal Interstate Banking and Branching
Efficiency Act of 1994. That statute provides for nationwide interstate banking
and branching, subject to certain aging and deposit concentration limits that
may be imposed under applicable state laws. Texas law permits interstate
branching in two manners, with certain exceptions. First, a financial
institution with its main office outside of Texas may establish a branch in the
State of Texas by acquiring a financial institution located in Texas that is at
least five years old, so long as the resulting institution and its affiliates
would not hold more than 20% of the total deposits in the state after the
acquisition. In addition, a financial institution with its main office outside
of Texas generally may establish a branch in the State of Texas on a de novo
basis if the financial institution's main office is located in a state that
would permit Texas institutions to establish a branch on a de novo basis in that
state.

The Federal Deposit Insurance Corporation has adopted regulations under
the Riegle-Neal Act to prohibit an out-of-state bank from using the interstate
branching authority primarily for the purpose of deposit production. These
regulations include guidelines to insure that interstate branches operated by an
out-of-state bank in a host state are reasonably helping to meet the credit
needs of the communities served by the out-of-state bank.

Governmental Monetary Policies. The commercial banking business is
affected not only by general economic conditions but also by the monetary
policies of the Federal Reserve. Changes in the discount rate on member bank
borrowings, control of borrowings, open market operations, the imposition of and
changes in reserve requirements against member banks, deposits and assets of
foreign branches, the imposition of and changes in reserve requirements against
certain borrowings by banks and their affiliates and the placing of limits on
interest rates which member banks may pay on time and savings deposits are some
of the instruments of monetary policy available to the Federal Reserve. Those
monetary policies influence to a significant extent the overall growth of all
bank loans, investments and deposits and the interest rates charged on loans or
paid on time and savings deposits. The nature of future monetary policies and
the effect of such policies on the future business and earnings of the Bank,
therefore, cannot be predicted accurately.

20

Dividends. All dividends paid by the Bank are paid to the Company, the
sole indirect shareholder of the Bank, through Southside Delaware. The general
dividend policy of the Bank is to pay dividends at levels consistent with
maintaining liquidity and preserving applicable capital ratios and servicing
obligations. The dividend policy of the Bank is subject to the discretion of the
board of directors of the Bank and will depend upon such factors as future
earnings, financial conditions, cash needs, capital adequacy, compliance with
applicable statutory and regulatory requirements and general business
conditions.

The ability of the Bank, as a Texas banking association, to pay dividends
is restricted under applicable law and regulations. The Bank generally may not
pay a dividend reducing its capital and surplus without the prior approval of
the Texas Banking Commissioner. All dividends must be paid out of net profits
then on hand, after deducting expenses, including losses and provisions for loan
losses. The Federal Deposit Insurance Corporation has the right to prohibit the
payment of dividends by the Bank where the payment is deemed to be an unsafe and
unsound banking practice. The Bank is also subject to certain restrictions on
the payment of dividends as a result of the requirements that it maintain an
adequate level of capital in accordance with guidelines promulgated from time to
time by the Federal Deposit Insurance Corporation.

The exact amount of future dividends on the stock of the Bank will be a
function of the profitability of the Bank in general and applicable tax rates in
effect from year to year. The Bank's ability to pay dividends in the future will
directly depend on the Banks future profitability, which cannot be accurately
estimated or assured.

Capital Adequacy. In 1990, the federal Banking regulators promulgated
capital adequacy regulations to which all national and state banks, such as the
Bank, are subject. These requirements are similar to the Federal Reserve
requirements promulgated with respect to bank holding companies discussed
previously.

Community Reinvestment Act. Under the Community Reinvestment Act, the
Bank has a continuing and affirmative obligation consistent with safe and sound
banking practices to help meet the needs of its entire community, including low-
and moderate-income neighborhoods served by the Bank. The Community Reinvestment
Act does not establish specific lending requirements or programs for financial
institutions nor does it limit the Bank's discretion to develop the types of
products and services that it believes are best suited to its particular
community. On a periodic basis, the Federal Deposit Insurance Corporation is
charged with preparing a written evaluation of the Bank's record of meeting the
credit needs of the entire community and assigning a rating. The bank regulatory
agencies will take that record into account in their evaluation of any
application made by the Bank or the Company for, among other things, approval of
the acquisition or establishment of a branch or other deposit facility, an
office relocation, a merger or the acquisition of shares of capital stock of
another financial institution. An unsatisfactory Community Reinvestment Act
rating may be used as the basis to deny an application. In addition, as
discussed above, a bank holding company may not become a financial holding
company unless each of its subsidiary banks have a Community Reinvestment Act
rating of at least satisfactory. The Bank was last examined for compliance with
the Community Reinvestment Act on October 9, 2001 and received a rating of
"outstanding."

Enforcement Authority. The federal banking laws also contain civil and
criminal penalties available for use by the appropriate regulatory agency
against certain "institution-affiliated parties" primarily including management,
employees and agents of a financial institution, as well as independent
contractors such as attorneys and accountants and others who participate in the
conduct of the financial institution's affairs and who caused or are likely to
cause more than minimum financial loss to or a significant adverse affect on the
institution, who knowingly or recklessly violate a law or regulation, breach a
fiduciary duty or engage in unsafe or unsound practices. These practices can
include the failure of an institution to timely file required reports or the
submission of inaccurate reports. These laws authorize the appropriate banking
agency to issue cease and desist orders that may, among other things, require
affirmative action to correct any harm resulting from a violation or practice,
including restitution, reimbursement, indemnification or guarantees against
loss. A financial institution may also be ordered to restrict its growth,
dispose of certain assets or take other action as determined by the ordering
agency to be appropriate.

21

Annual Audits. Every bank with total assets in excess of $500 million,
such as the Bank, must have an annual independent audit made of the bank's
financial statements by a certified public accountant to verify that the
financial statements of the bank are presented in accordance with generally
accepted accounting principles and comply with such other disclosure
requirements as prescribed by the Federal Deposit Insurance Corporation.

Prompt Corrective Action. Banks are subject to restrictions on their
activities depending on their level of capital. The Federal Deposit Insurance
Corporation's "prompt corrective action" regulations divides banks into five
different categories, depending on their level of capital. Under these
regulations, a bank is deemed to be "well capitalized" if it has a total
risk-based capital ratio of 10% or more, a core capital ratio of six percent or
more and a leverage ratio of five percent or more, and if the bank is not
subject to an order or capital directive to meet and maintain a certain capital
level. Under these regulations, a bank is deemed to be "adequately capitalized"
if it has a total risk-based capital ratio of eight percent or more, a core
capital ratio of four percent or more and a leverage ratio of four percent or
more (unless it receives the highest composite rating at its most recent
examination and is not experiencing or anticipating significant growth, in which
instance it must maintain a leverage ratio of three percent or more). Under
these regulations, a bank is deemed to be "undercapitalized" if it has a total
risk-based capital ratio of less than eight, a core capital ratio of less than
four percent or a leverage ratio of less than four percent. Under these
regulations, a bank is deemed to be "significantly undercapitalized" if it has a
risk-based capital ratio of less than six percent, a core capital ratio of less
than three percent and a leverage ratio of less than three percent. Under such
regulations, a bank is deemed to be "critically undercapitalized" if it has a
leverage ratio of less than or equal to two percent. In addition, the Federal
Deposit Insurance Corporation has the ability to downgrade a bank's
classification (but not to "critically undercapitalized") based on other
considerations even if the bank meets the capital guidelines.

If a state nonmember bank, such as the Bank, is classified as
undercapitalized, the bank is required to submit a capital restoration plan to
the Federal Deposit Insurance Corporation. An undercapitalized bank is
prohibited from increasing its assets, engaging in a new line of business,
acquiring any interest in any company or insured depository institution, or
opening or acquiring a new branch office, except under certain circumstances,
including the acceptance by the Federal Deposit Insurance Corporation of a
capital restoration plan for the bank.

If a state nonmember bank is classified as undercapitalized, the Federal
Deposit Insurance Corporation may take certain actions to correct the capital
position of the bank. If a bank is classified as significantly undercapitalized,
the Federal Deposit Insurance Corporation would be required to take one or more
prompt corrective actions. These actions would include, among other things,
requiring sales of new securities to bolster capital, improvements in
management, limits on interest rates paid, prohibitions on transactions with
affiliates, termination of certain risky activities and restrictions on
compensation paid to executive officers. If a bank is classified as critically
undercapitalized, the bank must be placed into conservatorship or receivership
within 90 days, unless the Federal Deposit Insurance Corporation determines
otherwise.

The capital classification of a bank affects the frequency of
examinations of the bank and impacts the ability of the bank to engage in
certain activities and affects the deposit insurance premiums paid by the bank.
The Federal Deposit Insurance Corporation is required to conduct a full-scope,
on-site examination of every bank at least once every twelve months.

Banks also may be restricted in their ability to accept brokered
deposits, depending on their capital classification. "Well capitalized" banks
are permitted to accept brokered deposits, but all banks that are not well
capitalized are not permitted to accept such deposits. The Federal Deposit
Insurance Corporation may, on a case-by-case basis, permit banks that are
adequately capitalized to accept brokered deposits if the Federal Deposit
Insurance Corporation determines that acceptance of such deposits would not
constitute an unsafe or unsound banking practice with respect to the bank.

Deposit Insurance. The Bank's deposits are insured up to $100,000 per
depositor by the Bank Insurance Fund. As insurer, the Federal Deposit Insurance
Corporation imposes deposit premiums and is authorized to conduct examinations
of and to require reporting by the Bank. The Federal Deposit Insurance
Corporation assesses insurance premiums on a bank's deposits at a variable rate
depending on the probability that the deposit insurance fund will incur a loss
with respect to the bank. The Federal Deposit Insurance Corporation determines
the deposit insurance assessment rates on the basis of the bank's capital
classification and supervisory evaluations. There is currently a 27 basis point
spread between the highest and the lowest

22

assessment rates, so that banks classified as strongest were subject in 2001 to
0% assessment, and banks classified as weakest were subject to an assessment
rate of .27%. In addition to the insurance assessment, each insured bank was
subject in 2001 to an assessment of approximately $1.90 per one hundred dollars
of deposits to service debt issued by the Financing Corporation, a federal
agency established to finance the recapitalization of the former Federal Savings
and Loan Insurance Corporation. Under these assessment criteria, the Bank was
required to pay annual deposit premiums to the Bank Insurance Fund in 2001 in
the amount of $1.90 per hundred dollars of deposits. The Bank's deposits
insurance assessments may increase or decrease depending upon the risk
assessment classification to which the Bank is assigned by the Federal Deposits
Insurance Corporation. Any increase in insurance assessments could have an
adverse effect on the Bank's earnings.

All of the above laws and regulations add to the cost of the Company's
operations and thus have a negative impact on profitability. You should note
that there has been a tremendous expansion experienced in recent years by
financial service providers that are not subject to the same rules and
regulations as are applicable to Southside Delaware and the Company. The
Company's management and the Bank's management cannot predict what other
legislation might be enacted or what other regulations might be adopted or the
effects thereof.

CAPITAL GUIDELINES

Southside Bank is regulated by the TDB and the FDIC. The FDIC requires
minimum levels of Tier 1 capital and risk-based capital for FDIC-insured
institutions. The FDIC requires a minimum leverage ratio of 3% of adjusted total
assets for the highest rated banks. Other banks are required to meet a leverage
standard of 4% or more, determined on a case-by-case basis.

On December 31, 2001, the minimum ratio for qualifying total risk-based
capital was 8% of which 4% must be Tier 1 capital. Southside Bank's actual
capital to total assets and risk-based capital ratios at December 31, 2001 were
in excess of the minimum requirements.

Also see discussion of "Capital Resources" under Item 7.

USURY LAWS

Texas usury laws limit the rate of interest that may be charged by state
banks. Certain Federal laws provide a limited preemption of Texas usury laws.
The maximum rate of interest that Southside Bank may charge on direct business
loans under Texas law varies between 18% per annum and (i) 28% per annum for
business and agricultural loans above $250,000 or (ii) 24% per annum for other
direct loans. Texas floating usury ceilings are tied to the 26-week United
States Treasury Bill Auction rate. Other ceilings apply to open-end credit card
loans and dealer paper purchased by Southside Bank. A Federal statute removes
interest ceilings under usury laws for loans by Southside Bank which are secured
by first liens on residential real property.

ECONOMIC ENVIRONMENT

The monetary policies of regulatory authorities, including the FRB, have
a significant effect on the operating results of bank holding companies and
their subsidiaries. The FRB regulates the national supply of bank credit. Among
the means available to the FRB are open market operations in United States
Government Securities, changes in the discount rate on member bank borrowings,
changes in reserve requirements against member and nonmember bank deposits, and
loans and limitations on interest rates which member banks may pay on time or
demand deposits. These methods are used in varying combinations to influence
overall growth and distribution of bank loans, investments and deposits. Their
use may affect interest rates charged on loans or paid for deposits.

Also see discussion of "Banking Industry in Texas" above.

23

ITEM 2. PROPERTIES

Southside Bank owns or operates the following properties:

o A two story building in Tyler, Texas, at 1201 South Beckham
Avenue and the property adjacent to the main bank building,
known as the Southside Bank Annex. These properties house the
executive offices of Southside Bancshares, Inc.

o Property and a building directly adjacent to the building
housing the Southside Bank Annex. The building is referred to
as the Operations Annex, where various back office lending,
accounts payable operations, other support areas and training
facilities are located.

o Land and building located at 1010 East First Street in Tyler
where motor bank facilities are located.

o Property and a building located at the intersection of South
Broadway Avenue and Grande Boulevard in Tyler. The tract is
occupied by Southside Bank's South Broadway branch, which
currently provides a full line of banking services.

o Property and a building on South Broadway Avenue near the
South Broadway branch where motor bank facilities are located.

o Building located in the downtown square of Tyler which houses
Southside Bank's Downtown branch, providing a full line of
banking services.

o Gentry Parkway branch and motor bank facility at 2121 West
Gentry Parkway in Tyler.

o Longview main branch and motor bank facility at 2001 Judson
Road in Longview, Texas.

o Property on U.S. Highway 69 in Lindale, Texas, where the
Company constructed a branch facility complete with motor bank
facilities.

o Property in Whitehouse, Texas, where the Company constructed a
branch facility complete with motor bank facilities.

o Twenty-five Automatic Teller Machines (ATM) facilities located
throughout Smith and Gregg Counties.

The Company completed the construction of the Lindale branch and motor
bank facility on Highway 69 during the fourth quarter of 2001. Construction of
the branch and motor bank facility in Whitehouse was completed and the branch
opened during February 2002. The Company opened a third full service branch in a
grocery store in Longview in January 2002.

The Company currently operates full service banks in eight grocery
stores in the following locations:

o One in Lindale, Texas

o Three in Longview, Texas

o Four in Tyler, Texas

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ITEM 3. LEGAL PROCEEDINGS

Southside Bank is party to legal proceedings arising in the normal
conduct of business. Management of the Company believes that such litigation is
not material to the financial position or results of the operations of the
Company or Southside Bank.

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

During the three months ended December 31, 2001, there were no meetings,
annual or special, of the shareholders of the Company. No matters were submitted
to a vote of the shareholders, nor were proxies solicited by management or any
other person.

PART II

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

MARKET INFORMATION

The Company's common stock began trading on the Nasdaq National Market on
May 14, 1998 under the symbol "SBSI." Prior to that the Company's common stock
was not actively traded on any established public trading market. The high/low
prices shown below represent the closing prices on the Nasdaq National Market
for the period from January 1, 2000 to December 31, 2001. During the third
quarter of 2001, the Company declared and paid a 5% stock dividend. During the
second and fourth quarter of 2000, the Company declared and paid a two for one
stock split and a 5% stock dividend, respectively. During the third quarter of
1999, the Company declared and paid a 5% stock dividend. Stock prices listed
below have been adjusted to give retroactive recognition to stock splits and
stock dividends.

See "Item 7. Capital Resources" for a discussion of the Company's common
stock repurchase program.

STOCKHOLDERS

There were approximately 1,075 holders of record of the Company's common
stock, the only class of equity securities currently issued and outstanding, as
of February 28, 2002.

DIVIDENDS

Cash dividends declared and paid were $0.25 and $0.225 per share for the
years ended December 31, 2001 and 2000, respectively. Cash dividends declared
and paid were $.20 per share for the year ended December 31, 1999. Stock
dividends of 5% were also declared and paid during each of the years ended
December 31, 2001, 2000 and 1999. The Company has paid a cash dividend at least
once every year since 1970. Future dividends will depend on the Company's
earnings, financial condition and other factors which the Board of Directors of
the Company considers to be relevant.

25

ITEM 6. SELECTED FINANCIAL DATA

The following table sets forth selected financial data regarding the
Company's results of operations and financial position for, and as of the end
of, each of the fiscal years in the five-year period ended December 31, 2001.
This information should be read in conjunction with "Item 7. Management's
Discussion and Analysis of Financial Condition and Results of Operations," as
set forth in this report.

26

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

The following discussion and analysis provides a comparison of the
Company's results of operations for the years ended December 31, 2001, 2000 and
1999 and financial condition as of December 31, 2001 and 2000. This discussion
should be read in conjunction with the financial statements and related notes.
All share data has been adjusted to give retroactive recognition to stock splits
and stock dividends.

CRITICAL ACCOUNTING POLICIES

The Company has established various accounting policies which govern the
application of accounting principles generally accepted in the United States in
the preparation of the Company's financial statements. The significant
accounting policies of the Company are described in the footnotes to the
consolidated financial statements. Certain accounting policies involve
significant judgements 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
judgements and assumptions used by management are based on historical experience
and other factors, which are believed to be reasonable under the circumstances.
Because of the nature of the judgements and assumptions made by management,
actual results could differ from these judgements and estimates which could have
a material impact on the carrying values of assets and liabilities and the
results of operations of the Company.

The Company believes the allowance for loan losses is a critical
accounting policy that requires the most significant judgements and estimates
used in preparation of its consolidated financial statements. Refer to Item 1
entitled Loan Loss Experience and Reserve for Loan Loss and Notes to Financial
Statements No. 1, Summary of Significant Accounting and Reporting Policies for a
detailed description of the Company's estimation process and methodology related
to the allowance for loan losses.

FORWARD-LOOKING INFORMATION

Certain statements of other than historical fact that are contained in
this document and in written material, press releases and oral statements issued
by or on behalf of the Company may be considered to be "forward-looking
statements" as that term is defined in the Private Securities Litigation Reform
Act of 1995. These statements may include words such as "expect," "estimate,"
"project," "anticipate," "should," "intend," "probability," "risk," "target,"
"objective" and similar expressions. Forward-looking statements are subject to
significant risks and uncertainties and the Company's actual results may differ
materially from the results discussed in the forward-looking statements. For
example, certain market risk disclosures are dependent on choices about key
model characteristics and assumptions and are subject to various limitations.
See "Item 1 - Business" and "Item 7 - Management's Discussion and Analysis of
Financial Condition and Results of Operations." By their nature, certain of the
market risk disclosures are only estimates and could be materially different
from what actually occurs in the future. As a result, actual income gains and
losses could materially differ from those that have been estimated. Other
factors that could cause actual results to differ materially from
forward-looking statements include, but are not limited to general economic
conditions, either nationally or in the State of Texas, legislation or
regulatory changes which adversely affect the businesses in which the Company is
engaged, changes in the interest rate environment which reduce interest margins,
significant increases in competit