CULLEN FROST BANKERS INC - 10-K Annual Report

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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549-1004

FORM 10-K

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

FOR THE FISCAL YEAR ENDED DECEMBER 31, 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 0-7275

CULLEN/FROST BANKERS, INC.
(Exact name of registrant as specified in its charter)

TEXAS 74-1751768
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

100 W. HOUSTON STREET
SAN ANTONIO, TEXAS 78205
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(Address of principal executive (Zip Code)
offices)

REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE:
(210) 220-4011

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
NONE

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

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

The aggregate market value of the voting stock held by non-affiliates of
the registrant was $1,746,517,082 based on the closing price of such stock as of
March 15, 2002.

Indicate the number of shares outstanding of each of the registrant's
classes of common stock, as of the latest practicable date.

DOCUMENTS INCORPORATED BY REFERENCE

(1) Proxy Statement for Annual Meeting of Shareholders to be held May 22, 2002
(Part III)
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TABLE OF CONTENTS

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PART I

ITEM 1. BUSINESS
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GENERAL
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Cullen/Frost Bankers, Inc. ("Cullen/Frost" or "Corporation"), a Texas
business corporation incorporated in 1977 and headquartered in San Antonio,
Texas, is a financial holding company within the meaning of the Bank Holding
Company Act of 1956, as partially amended by the Gramm-Leach-Bliley Act (the
"Modernization Act") (collectively "the BHC Act"), and, as such, is registered
with the Board of Governors of the Federal Reserve System ("Federal Reserve
Board"). The New Galveston Company, incorporated under the laws of Delaware, is
a wholly-owned second-tier financial holding company subsidiary which owns all
banking and non-banking subsidiaries with the exception of Cullen/Frost Capital
Trust I, a Delaware statutory business trust and wholly-owned subsidiary of the
Corporation. At December 31, 2001, Cullen/Frost's principal assets consisted of
all of the capital stock of The Frost National Bank ("Frost Bank"). Frost Bank
operates 80 financial centers across Texas with 17 locations in the San Antonio
area, 22 in the Houston/Galveston area, 15 in the Fort Worth area, 8 in the
Corpus Christi area, 6 in Austin, 4 in Dallas, 3 in San Marcos, 2 in McAllen, 2
in the Boerne/Fair Oaks area, and 1 in New Braunfels. At December 31, 2001,
Cullen/Frost had consolidated total assets of $8.4 billion and total deposits of
$7.1 billion. Based on information from the Federal Reserve Board, at September
30, 2001, Cullen/Frost was the largest of the 124 bank holding companies
headquartered in Texas.

Cullen/Frost's operations are managed along three distinct operating
segments consisting of Banking, the Financial Management Group and its
investment banking subsidiary, Frost Securities Inc. (See Results of Segment
Operations on page 22 and Note U on page 71).

Cullen/Frost provides policy direction to Frost Bank in, among others, the
following areas: (i) asset and liability management; (ii) accounting, budgeting,
planning, insurance and investment banking; (iii) capitalization; (iv)
regulatory compliance and (v) investor relations.

Frost Bank is a separate entity that operates under the management of its
own officers and also maintains a separate board of directors. Frost Bank, the
origin of which can be traced to a mercantile partnership organized in 1868, was
chartered as a national banking association in 1899. At December 31, 2001, Frost
Bank, was the largest commercial bank headquartered in San Antonio and South
Texas.

SERVICES OFFERED BY FROST BANK
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Commercial Banking

Frost Bank provides commercial services for corporations and other business
clients. Loans are made for a wide variety of general corporate purposes,
including interim construction financing on industrial and commercial
properties, and financing on equipment, inventories, accounts receivable, and
acquisition financing, as well as commercial leasing. Frost Bank provides
financial services to business clients on both a national and international
basis.

Consumer Services

Frost Bank provides a full range of consumer banking services, including
checking accounts, savings programs, automated teller machines, installment and
real estate loans, home equity loans, drive-in and night deposit services, safe
deposit facilities, and brokerage services.

International Banking

Frost Bank provides international banking services to customers residing in
or dealing with businesses located in Mexico. These services consist of
accepting deposits (in United States dollars only), making loans
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(in United States dollars only), issuing letters of credit, handling foreign
collections, transmitting funds and, to a limited extent, dealing in foreign
exchange. Reference is made to pages 29 and 37 of this document.

Correspondent Banking

Frost Bank acts as correspondent for approximately 315 financial
institutions, primarily banks in Texas. These banks maintain deposits with Frost
Bank, which offers them a full range of services including check clearing,
transfer of funds, loan participations, fixed income security services, and
securities custody and clearance.

Insurance

Frost Insurance Agency, Inc., is a wholly-owned subsidiary of Frost Bank
and brokers corporate and personal property and casualty insurance as well as
group health and life insurance products to individuals and businesses.

Trust Services

Frost Bank provides a wide range of trust, investment, agency and custodial
services for individual and corporate clients. These services include the
administration of estates and personal trusts, as well as the management of
investment accounts for individuals, employee benefit plans and charitable
foundations. At December 31, 2001, trust assets with a market value of $13.3
billion were being administered by Frost Bank. These assets were comprised of
managed assets of $6.0 billion and custody assets of $7.3 billion.

Brokerage Services

Frost Brokerage Services, a wholly-owned subsidiary of Frost Bank, was
formed in March 1986 to provide brokerage services and perform other
transactions or operations related to the sale and purchase of securities of all
types.

SERVICES OFFERED BY THE CULLEN/FROST NON-BANKING SUBSIDIARIES
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Frost Securities, Inc. ("FSI") is a full-service investment bank offering
financial advisory services, mergers and acquisitions support, equity research,
and institutional equity sales and trading. The firm provides institutional
investors with in-depth research coverage in energy and communications
technology.

Main Plaza Corporation ("Main Plaza") is a wholly-owned non-banking
subsidiary. Main Plaza occasionally makes loans to qualified borrowers. Loans
are funded with borrowings against Cullen/Frost's current cash or borrowings
against credit lines.

Daltex General Agency, Inc. ("Daltex"), a wholly-owned non-banking
subsidiary, is a managing general insurance agency. Daltex provides vendor's
single interest insurance.

Cullen/Frost Capital Trust I is a Delaware statutory business trust that
issued $100 million in Trust Preferred Capital Securities in 1997, which are
guaranteed by the Corporation.

COMPETITION
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Frost Bank experiences a very competitive environment in its commercial
banking businesses, primarily from other banks located in its respective service
areas. Frost Bank also competes with insurance companies, finance and mortgage
companies, savings and loan institutions, credit unions, money market funds,
investment banks and other financial institutions. In the case of some larger
customers, competition exists with institutions in other major metropolitan
areas in Texas and in the remainder of the United States, some of which are
larger than Frost Bank in terms of capital, resources and personnel.

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Cullen/Frost and Frost Bank have been impacted by the Modernization Act, as
it eliminated barriers between commercial banking, investment banking, and
insurance sales. The elimination of barriers has created the potential for more
competition by increasing the number of non-bank competitors.

SUPERVISION AND REGULATION
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Cullen/Frost

Cullen/Frost is a legal entity separate and distinct from its bank
subsidiary and was designated a financial holding company under the
Modernization Act effective March 11, 2000. The Modernization Act: (i) allows
financial holding companies meeting management, capital and CRA standards to
engage in a substantially broader range of financial activities and activities
incidental to financial activities than was previously permissible, including
insurance underwriting and making merchant banking investments in commercial and
financial companies; (ii) allows insurers and other financial services companies
to acquire banks; (iii) removes various restrictions that previously applied to
bank holding company ownership of securities firms and mutual fund advisory
companies; and (iv) established the overall regulatory structure applicable to
bank holding companies that also engage in insurance and securities operations.

Cullen/Frost is primarily regulated by the Federal Reserve Board, which has
established guidelines with respect to the maintenance of appropriate levels of
capital and payment of dividends by financial holding companies. If Frost Bank
ceases to be "well capitalized" under applicable regulatory standards, the
Federal Reserve Board may, among other actions, order Cullen/Frost to divest of
Frost Bank or to conform its activities to those permissible for a bank holding
company. In addition, if Frost Bank receives a rating under the CRA Act of less
than satisfactory, Cullen/Frost will be prohibited from engaging in new
activities or acquiring companies other than bank holding companies, banks or
savings associations.

The Modernization Act also modified laws related to financial privacy and
community reinvestment. The new financial privacy provisions, which were not
mandatory until July 1, 2001, generally prohibit financial institutions,
including Cullen/Frost, from disclosing nonpublic personal financial information
to third parties unless customers have the opportunity to "opt out" of the
disclosure.

The Federal Reserve Act and the Federal Deposit Insurance Act ("FDIA")
impose restrictions on loans by Frost Bank to Cullen/Frost and certain of its
subsidiaries, on investments in securities thereof and on the taking of such
securities as collateral for loans. Such restrictions generally prevent
Cullen/Frost from borrowing from Frost Bank unless the loans are secured by
marketable obligations. Further, such secured loans, other transactions, and
investments by Frost Bank are limited in amount as to Cullen/Frost or to certain
other subsidiaries to ten percent of Frost Bank's capital and surplus and as to
Cullen/Frost and all such subsidiaries to an aggregate of 20 percent of Frost
Bank's capital and surplus.

Under Federal Reserve Board policy, Cullen/Frost is expected to act as a
source of financial strength to Frost Bank and to commit resources to support
such bank in circumstances where it might not do so absent such policy. In
addition, any loans by Cullen/Frost to its bank would be subordinate in right of
payment to deposits and to certain other indebtedness of Frost Bank. In the
event of a financial holding company's bankruptcy, any commitment by the
financial holding company to a federal bank regulatory agency to maintain the
capital of a subsidiary bank will be assumed by the bankruptcy trustee and be
entitled to a priority of payment.

Subsidiary Bank

Frost Bank is organized as a national banking association under the
National Bank Act and is subject to regulation and examination by the Office of
the Comptroller of the Currency (the "Comptroller of the Currency").

Federal and state laws and regulations of general application to banks have
the effect, among others, of regulating the scope of Frost Bank's business,
investments, cash reserves, purpose and nature of loans, collateral for loans,
maximum interest rates chargeable on loans, amount of dividends that may be
declared
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and required capitalization ratios. Federal law imposes restrictions on Frost
Bank's extensions of credit to, and certain other transactions with,
Cullen/Frost and other subsidiaries, investments in stock or other securities
thereof and taking of such securities as collateral for loans to other
borrowers.

The Comptroller of the Currency has authority to prohibit a bank from
engaging in activities that, in such agency's opinion, constitute an unsafe or
unsound practice in conducting its business. It is possible, depending on the
financial condition of the bank in question and other factors, that such agency
could claim that the payment of dividends or other payments might, under some
circumstances, be such an unsafe or unsound practice.

The principal source of Cullen/Frost's cash revenues is dividends from
Frost Bank and there are certain limitations on the payment of dividends to
Cullen/Frost by Frost Bank. The prior approval of the Comptroller of the
Currency is required if the total of all dividends declared by a national bank
in any calendar year would exceed the bank's net profits, as defined, for that
year combined with its retained net profits for the preceding two calendar
years, less any regulatory required transfers to surplus. In addition, a
national bank may not pay dividends in an amount in excess of its undivided
profits less certain bad debts specified in regulatory requirements. Although
not necessarily indicative of amounts available to be paid in future periods,
Frost Bank had approximately $110.9 million available for the payment of
dividends, without prior regulatory approval, at December 31, 2001.

Capital Adequacy

Bank regulators have adopted risk-based capital guidelines for financial
holding companies and banks. The minimum ratio of qualifying total capital to
risk-weighted assets (including certain off-balance sheet items) is eight
percent. At least half of the total capital is to be comprised of common stock,
retained earnings, non-cumulative perpetual preferred stocks, minority
interests, (and for financial holding companies, a limited amount of qualifying
cumulative perpetual preferred stock), less certain intangibles including
goodwill ("Tier 1 capital"). The remainder ("Tier 2 capital") may consist of
other preferred stock, certain other instruments, and limited amounts of
subordinated debt and the allowance for loan and lease losses.

In addition, bank regulators have established minimum leverage ratio (Tier
1 capital to average total assets) guidelines for financial holding companies
and banks. These guidelines provide for a minimum leverage ratio of three
percent for financial holding companies and banks that meet certain specified
criteria, including that they have the highest regulatory rating. All other
banking organizations will be required to maintain a leverage ratio of at least
four percent plus an additional cushion where warranted. 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 levels, without significant levels of intangible
assets. The bank regulators have not advised Cullen/Frost or Frost Bank of any
specific minimum leverage ratio applicable to it. For information concerning
Cullen/Frost's capital ratios, see the discussion under the caption "Capital and
Liquidity" on page 38 and Note L "Capital" on page 58.

Prompt Corrective Action

The Federal Deposit Insurance Corporation Improvements Act of 1991
("FDICIA"), among other things, requires the Federal banking agencies to take
"prompt corrective action" with respect to depository institutions that do not
meet minimum capital requirements. FDICIA established five capital tiers: "well
capitalized," "adequately capitalized," "undercapitalized," "significantly
undercapitalized" and "critically undercapitalized". Under the final rules
adopted by the Federal banking regulators relating to these capital tiers, an
institution is deemed to be: well capitalized if the institution has a total
risk-based capital ratio of ten percent or greater, a Tier 1 risk-based capital
ratio of six percent or greater, and a leverage ratio of five percent or
greater, and the institution is not subject to an order, written agreement,
capital directive, or prompt corrective action directive to meet and maintain a
specific capital level for any capital measure; adequately capitalized if the
institution has a total risk-based capital ratio of eight percent or greater, a
Tier 1 risk-based capital ratio of four percent or greater, and a leverage ratio
of four percent or greater (or a leverage ratio of three percent for financial
holding companies which meet certain specified criteria, including having the

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highest regulatory rating); undercapitalized if the institution has a total
risk-based capital ratio that is less than eight percent, a Tier 1 risk-based
capital ratio less than four percent or a leverage ratio less than four percent
(or a leverage ratio less than three percent if the institution is rated
composite one in its most recent report of examination, subject to appropriate
Federal banking agency guidelines); significantly undercapitalized if the
institution has a total risk-based capital ratio less than six percent, a Tier 1
risk-based capital ratio less than three percent, or a leverage ratio less than
three percent; and critically undercapitalized if the institution has a ratio of
tangible equity to total assets equal to or less than two percent.

At December 31, 2001, Frost Bank, Cullen/Frost's only insured depository
institution subsidiary was considered "well capitalized".

FDICIA generally prohibits a depository institution from making any capital
distributions (including payment of a dividend) or paying any management fee to
its holding company if the depository institution would thereafter be
undercapitalized. Undercapitalized institutions are subject to growth
limitations and are required to submit a capital restoration plan. The agencies
may not accept such a plan without determining, among other things, that the
plan is based on realistic assumptions and is likely to succeed in restoring the
depository institution's capital. In addition, for a capital restoration plan to
be acceptable, the depository institution's parent holding company must
guarantee that the institution will comply with such capital restoration plan.
The aggregate liability of the parent holding company is limited to the lesser
of (i) an amount equal to five percent of the depository institution's total
assets at the time it became undercapitalized and (ii) the amount which is
necessary (or would have been necessary) to bring the institution into
compliance with all capital standards applicable with respect to such
institution as of the time it fails to comply with the plan. If a depository
institution fails to submit an acceptable plan, it is treated as if it is
significantly undercapitalized.

"Significantly undercapitalized" depository institutions may be subject to
a number of requirements and restrictions, including orders to sell sufficient
voting stock to become "adequately capitalized," requirements to reduce total
assets, and cessation of receipt of deposits from correspondent banks.
"Critically undercapitalized" institutions are subject to the appointment of a
receiver or conservator.

DEPOSIT INSURANCE
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Frost Bank is subject to Federal Deposit Insurance Corporation ("FDIC")
deposit insurance assessments and to certain other statutory and regulatory
provisions applicable to FDIC-insured depository institutions. The risk-based
assessment system imposes insurance premiums based upon a matrix that takes into
account a bank's capital level and supervisory rating. Over the last several
years many banks, including Frost Bank, have paid no deposit insurance premiums.
It is possible that in the near term the FDIC could impose assessment rates on
institutions such as Frost Bank in connection with declines in the insurance
funds or increases in the amount of insurance coverage.

A depository institution insured by the FDIC can be held liable for any
loss incurred by, or reasonably expected to be incurred by, the FDIC in
connection with (i) the default of a commonly controlled FDIC-insured depository
institution or (ii) any assistance provided by the FDIC to a commonly
controlled, FDIC-insured depository institution in danger of default. "Default"
is defined generally as the appointment of a conservator or receiver, and "in
danger of default" is defined generally as the existence of certain conditions
indicating that a "default" is likely to occur in the absence of regulatory
assistance.

DEPOSITOR PREFERENCE
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Deposits and certain claims for administrative expenses and employee
compensation against an insured depository institution are afforded priority
over other general unsecured claims against such an institution, including
federal funds and letters of credit, in the "liquidation or other resolution" of
such an institution by any receiver.

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ACQUISITIONS
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The BHC Act generally limits acquisitions by bank holding companies that
are not financial holding companies to commercial banks and companies engaged in
activities that the Federal Reserve Board has determined to be so closely
related to banking as to be a proper incident thereto and requires the prior
approval of the Federal Reserve Board to consummate such acquisitions. Financial
holding companies may acquire non-banking entities under the Modernization Act
by providing a notice to the Federal Reserve Board after consummation of such an
acquisition.

The BHC Act, the Federal Bank Merger Act, and the Texas Banking Code
regulate the acquisitions of commercial banks. The BHC Act requires the prior
approval of the Federal Reserve Board for the direct or indirect acquisition of
more than five percent of the voting shares of a commercial bank or bank holding
company. With respect to Frost Bank, the approval of the Comptroller of the
Currency is required for branching, purchasing the assets or assuming deposits
of other banks and bank mergers in which the continuing bank is a national bank.

In reviewing bank acquisition and merger applications, the bank regulatory
authorities will consider, among other things, the competitive effect and public
benefits of the transactions, the capital position of the combined organization,
and the applicant's record under the Community Reinvestment Act and fair housing
laws.

Cullen/Frost regularly evaluates acquisition opportunities and conducts due
diligence activities in connection with possible acquisitions. As a result,
acquisition discussions and, in some cases, negotiations may take place and
future acquisitions involving cash, debt or equity securities may occur.
Acquisitions typically involve the payment of a premium over book and market
values, and, therefore, some dilution of the Corporation's book value and net
income per common share may occur in connection with any future transactions.

INTERSTATE BANKING AND BRANCHING LEGISLATION
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The Riegle-Neal Interstate Branching Efficiency Act ("IBBEA"), authorizes
interstate acquisitions of banks and bank holding companies without geographic
limitation. IBBEA also authorizes a bank to merge with a bank in another state
as long as neither of the states has opted out of interstate branching. A bank
may establish a de novo branch in a state in which the bank does not maintain a
branch if the state expressly permits de novo branching. Once a bank has
established branches in a state through an interstate merger transaction, the
bank may establish and acquire additional branches at any location in the state
where any bank involved in the merger transaction could have established or
acquired branches under applicable federal or state law. A bank that has
established a branch in a state through de novo branching may establish and
acquire additional branches in such state in the same manner and to the same
extent as a bank having a branch in such state as a result of an interstate
merger. If a state opts out of interstate branching within the specified time
period, no bank in any other state may establish a branch in the opting out
state, whether through an acquisition or de novo. On August 28, 1995, Texas
enacted legislation opting out of interstate branching; however, in the second
quarter of 1998, the OCC approved a series of merger transactions requested by a
non-Texas based institution that ultimately resulted in the merger of its Texas
based bank into the non-Texas based institution. Although challenged in the
courts, the final legal ruling allowed the merger to proceed. In addition, on
May 13, 1998, the Texas Banking Commissioner began accepting applications filed
by state banks to engage in interstate mergers and branching.

REGULATORY ECONOMIC POLICIES
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The earnings of Cullen/Frost are affected not only by general economic
conditions but also by the policies of various governmental regulatory
authorities. The Federal Reserve Board regulates the supply of credit in order
to influence general economic conditions, primarily through open market
operations in United States government obligations, as well as varying the
discount rate on financial institution borrowings and
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varying reserve requirements against financial institution deposits and by
restricting certain borrowings by such financial institutions and their
subsidiaries. The deregulation of interest rates has had, and is expected to
continue to have, an impact on the competitive environment in which Frost Bank
operates.

Governmental policies have had a significant effect on the operating
results of commercial banks in the past and are expected to continue to do so in
the future. However, Cullen/Frost cannot accurately predict the nature or extent
of any effect such policies may have on its future business and earnings.

EMPLOYEES
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At December 31, 2001, Cullen/Frost employed 3,387 full-time equivalent
employees. Employees of Cullen/Frost enjoy a variety of employee benefit
programs, including a deferred profit sharing plan, 401(k) stock purchase plans,
various comprehensive medical, accident and group life insurance plans and paid
vacations. Cullen/Frost considers its employee relations to be good.

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EXECUTIVE OFFICERS OF THE REGISTRANT
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The names, ages, recent business experience and positions or offices held
by each of the executive officers of Cullen/Frost during 2001 are as follows:

Stan McCormick, age 56, has been an officer of Frost Bank since 1994 and
Secretary of Cullen/Frost from June 1999 to present.

There are no arrangements or understandings between any executive officer
of Cullen/Frost and any other person pursuant to which such executive officer
was or is to be selected as an officer.

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ITEM 2. PROPERTIES
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The executive offices of Cullen/Frost, as well as the principal banking
headquarters of Frost Bank, are housed in both a 21-story office tower and a
nine-story office building located on approximately 3.5 acres of land in
downtown San Antonio. Cullen/Frost and Frost Bank lease approximately 50 percent
of the office tower. The nine-story office building was purchased in April 1994.
Frost Bank also leases space in a seven-story parking garage adjacent to the
banking headquarters. In June 1987, Frost Bank consummated the sale of its
office tower and leased back a portion of the premises under a 13-year primary
lease term with options allowing for occupancy up to 50 years. The Bank also
sold its adjacent parking garage facility and leased back space in that
structure under a 12-year primary lease term with options allowing for occupancy
up to 50 years. Both leases allow for purchase of the related asset under
specific terms. Frost Bank has agreed to repurchase both the office tower and
the adjacent parking garage facility. Closing of the purchase agreement on the
properties is expected to take place in the second quarter of 2002, with the
purchase price of the office tower and the adjacent parking garage being
approximately $25.7 million and $15.0 million, respectively.

ITEM 3. LEGAL PROCEEDINGS
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Certain subsidiaries of Cullen/Frost are defendants in various matters of
litigation which have arisen in the normal course of conducting a commercial
banking business. In the opinion of management, the disposition of such pending
litigation will not have a material effect on Cullen/Frost's consolidated
financial position.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
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None.

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PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER
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MATTERS
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Common Stock Market Prices and Dividends

The tables below set forth for each quarter the high and low sales prices
for Cullen/Frost's common stock and the dividends per share paid for each
quarter. The Company's common stock is traded on The New York Stock Exchange
("NYSE") under the symbol "CFR". High and low sales prices are as reported by
the NYSE. The closing price on March 15, 2002 was $35.71.

The number of record holders of common stock at February 22, 2002 was
2,172.

The Corporation's management is committed to continuing to pay regular cash
dividends; however, there is no assurance as to future dividends because they
are dependent on future earnings, capital requirements and financial conditions.
See "Capital and Liquidity" section on page 38 in Item 7 for further discussion
and Note K "Dividends" on page 57.

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ITEM 6. SELECTED FINANCIAL DATA
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CONSOLIDATED STATEMENTS OF OPERATIONS
(dollars in thousands, except per share amounts)

Historical amounts have been restated for stock splits and to reflect the
pooling-of-interests merger with Overton Bancshares, Inc., in 1998.

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SELECTED FINANCIAL DATA
(dollars in thousands, except per share amounts)

* 2001 basic and diluted earnings per share before the after-tax restructuring
charges were $1.82 and $1.76, respectively.

1998 basic and diluted earnings per share before the after-tax merger related
charge were $1.60 and $1.56, respectively.

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

Discussed below are the operating results for Cullen/Frost Bankers, Inc.
and Subsidiaries ("Cullen/ Frost" or the "Corporation") for the years 1999
through 2001. All of the acquisitions during this period were accounted for as
purchase transactions, and as such, their related results of operations are
included from the date of acquisition.

All balance sheet amounts presented in the following financial review are
averages unless otherwise indicated. Certain reclassifications have been made to
make prior periods comparable. Taxable-equivalent adjustments are the result of
increasing income from tax-free loans and investments by an amount equal to the
taxes that would be paid if the income were fully taxable assuming a 35 percent
federal tax rate, thus making tax-exempt yields comparable to taxable asset
yields. Dollar amounts in tables are stated in thousands, except for per share
amounts.

FORWARD-LOOKING STATEMENTS
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Certain statements contained in this Annual Report on Form 10-K that are
not statements of historical fact constitute forward-looking statements within
the meaning of the Private Securities Litigation Reform Act of 1995 (the "Act"),
even though they are not specifically identified as such. In addition, certain
statements in future filings by Cullen/Frost with the Securities and Exchange
Commission, in press releases, and in oral and written statements made by or
with the approval of the Corporation which are not statements of historical fact
constitute forward-looking statements within the meaning of the Act. Examples of
forward-looking statements include, but are not limited to: (i) projections of
revenues, income or loss, earnings or loss per share, the payment or nonpayment
of dividends, capital structure and other financial items; (ii) statements of
plans and objectives of Cullen/Frost or its management or Board of Directors,
including those relating to products or services; (iii) statements of future
economic performance; and (iv) statements of assumptions underlying such
statements. Words such as "believes", "anticipates", "expects", "intends",
"targeted" and similar expressions are intended to identify forward-looking
statements but are not the exclusive means of identifying such statements.

Forward-looking statements involve risks and uncertainties that may cause
actual results to differ materially from those in such statements. Factors that
could cause actual results to differ from those discussed in the forward-looking
statements include, but are not limited to: (i) local, regional and
international economic conditions and the impact they may have on Cullen/Frost
and its customers; (ii) the effects of and changes in trade, monetary and fiscal
policies and laws, including interest rate policies of the Federal Reserve
Board; (iii) inflation, interest rate, market and monetary fluctuations; (iv)
political instability; (v) acts of war or terrorism; (vi) the timely development
and acceptance of new products and services and perceived overall value of these
products and services by users; (vii) changes in consumer spending, borrowings
and savings habits; (viii) technology changes; (ix) acquisitions and integration
of acquired businesses; (x) the ability to increase market share and control
expenses; (xi) changes in the competitive environment among financial holding
companies; (xii) the effect of changes in laws and regulations (including laws
and regulations concerning taxes, banking, securities and insurance) with which
Cullen/Frost and its subsidiaries must comply; (xiii) the effect of changes in
accounting policies and practices, as may be adopted by the regulatory agencies
as well as the Financial Accounting Standards Board; (xiv) changes in the
Corporation's organization, compensation and benefit plans; (xv) the costs and
effects of litigation and of unexpected or adverse outcomes in such litigation;
(xvi) costs or difficulties related to the integration of the businesses of
Cullen/ Frost being greater than expected; and (xvii) the Corporation's success
at managing the risks involved in the foregoing.

Such forward-looking statements speak only as of the date on which such
statements are made. Cullen/ Frost undertakes no obligation to update any
forward-looking statement to reflect events or circumstances after the date on
which such statement is made, or to reflect the occurrence of unanticipated
events.

15

ACQUISITIONS
- ---------------------

Cullen/Frost regularly evaluates acquisition opportunities and conducts due
diligence activities in connection with possible acquisitions. As a result,
acquisition discussions and, in some cases, negotiations, may take place and
future acquisitions involving cash, debt or equity securities may occur.
Acquisitions typically involve the payment of a premium over book and market
values, and, therefore, some dilution of the Corporation's book value and net
income per common share may occur in connection with any future transaction. All
of the acquisitions during the period 1999 through 2001 were accounted for as
purchase transactions, and as such, their related results of operations are
included from the date of acquisition. None of the acquisitions had a material
impact on Cullen/Frost's results of operations.

Bank Acquisitions

On May 20, 1999, Cullen/Frost paid approximately $42.3 million to acquire
Commerce Financial Corporation and its four-location subsidiary, Bank of
Commerce, in Fort Worth, Texas. The Corporation acquired loans of approximately
$76 million and deposits of approximately $164 million.

On January 15, 1999, Cullen/Frost paid approximately $18.7 million to
acquire Keller State Bank which had three locations in Tarrant County, Texas.
The Corporation acquired loans of approximately $38 million and deposits of
approximately $62 million.

Insurance Acquisitions

On August 1, 2001, Frost Insurance Agency ("FIA"), a subsidiary of The
Frost National Bank, completed its acquisition of AIS Insurance & Risk
Management ("AIS"), an independent insurance agency based in Fort Worth. AIS
offered a broad range of commercial insurance for small to mid-size businesses,
including property and casualty, employee benefits (health, life and retirement
plans), business succession planning and risk management services.

On July 1, 2000 FIA acquired Nieman Hanks Puryear Partners and Nieman Hanks
Puryear Benefits ("Nieman Hanks"), an Austin-based independent insurance agency.
Nieman Hanks offered property and casualty insurance, professional and umbrella
liability, homeowner and auto insurance, group health, life and disability
policies and 401(k) retirement plans and executive planning.

On April 1, 2000, FIA acquired Wayland Hancock Insurance Agency, Inc.
("Wayland Hancock"), a Houston-based independent insurance agency. Wayland
Hancock offered a full range of property and casualty, life and health insurance
products, as well as retirement and financial planning, to individuals and
businesses.

On May 1, 1999, FIA acquired Professional Insurance Agents, Inc. ("PIA"), a
mid-sized independent insurance agency based in Victoria, Texas, with additional
locations in San Antonio, New Braunfels and Refugio. PIA offered as agent,
corporate and personal property and casualty insurance as well as group health
and life insurance products to individuals and businesses. PIA was the newly
formed FIA's first insurance agency acquisition.

Investment Banking Subsidiary

On August 2, 1999 Cullen/Frost began operations of its investment banking
subsidiary in Dallas, Texas. Frost Securities, Inc. ("FSI") is a full-service
investment bank offering financial advisory services, mergers and acquisitions
support, equity research, and institutional equity sales and trading. The firm
provides institutional investors with in-depth research coverage in energy and
communications technology.

16

RESULTS OF OPERATIONS
- ---------------------

For the year ended December 31, 2001, the Corporation reported net income
of $80.9 million or $1.52 per diluted common share, compared to $108.8 million
or $2.03 per diluted common share and $97.6 million or $1.78 per diluted common
share for 2000 and 1999, respectively. Operating earnings for 2001 were $93.8
million or $1.76 per diluted common share. Operating earnings exclude $19.9
million of pre-tax restructuring charges that are discussed in detail on page
23. Operating earnings for 2001 were lower than the net income reported in 2000,
primarily due to higher provision for possible loan losses and lower net
interest income.

* Operating basic and diluted earnings per share for 2001 were $1.82 and $1.76,
respectively. Operating ROA and ROE for 2001 were 1.20 percent and 15.28
percent, respectively.

The provision for possible loan losses increased to $40.0 million for 2001,
up from the $14.1 million recorded in 2000. This level of increase was
considered necessary in light of credit deterioration in two large credits and
continued uncertainty in the current economic environment. Loan loss reserves at
the end of 2001 were built to $72.9 million or 1.61 percent of period-end loans.

The operating results for 2001 were also impacted by an unprecedented
decline in short term interest rates throughout the year, which resulted in
lower net interest income, down two percent from 2000. With core deposits,
especially demand deposits, being the predominant source of the Corporation's
funding, the falling

17

interest rate environment caused margin compression due mainly to earning assets
repricing faster than interest-bearing liabilities. More detail is available in
the Net Interest Income section below.

Also included in the 2001 results was a pre-tax gain of $5.7 million
related to the sale of an interest rate floor, which was purchased as a hedge
against falling interest rates. Of the total gain, $1.1 million was included in
other non-interest income, with the remainder included, net of tax, as a $3.0
million cumulative effect of adopting Statement of Financial Accounting Standard
("SFAS") No. 133, which went into effect January 1, 2001. See the Interest Rate
Swaps/Floor section on page 39 for further details.

Given the impact of the higher provision for possible loan losses, lower
net interest income, and $19.9 million in restructuring charges, return on
average assets for 2001 was 1.03 percent, compared with 1.52 percent in 2000,
while return on average equity was 13.18 percent in 2001, compared with 20.41
percent in 2000. Operating earnings return on average assets and return on
average equity were 1.20 percent and 15.28 percent, respectively, for the year
2001.

NET INTEREST INCOME
- -------------------

Net interest income, which accounted for 62 percent of Cullen/Frost's 2001
total revenue, is the Company's largest source of revenue. Net interest income
is the difference between interest income on earning assets, such as loans and
investment securities, and interest expense on liabilities, such as deposits and
borrowings, which are used to fund those assets. The level of interest rates and
the volume and mix of earning assets and interest-bearing liabilities impact net
interest income. Net interest margin is the taxable-equivalent net interest
income as a percentage of average earning assets for the period. This measure is
followed closely by the analyst community.

Net interest income on a tax equivalent basis for 2001 was $321.0 million,
a two percent decrease from $327.3 million recorded in 2000 and up from the
$301.5 million for 1999. The net interest margin was 4.89 percent for the year
ended December 31, 2001, compared to 5.32 percent and 5.15 percent for the years
2000 and 1999, respectively. The decrease in the net interest income and net
interest margin from a year ago is reflective of the impact of sharply reduced
interest rates on the Corporation's asset-sensitive balance sheet (the company's
earning assets are repricing faster than its interest-bearing liabilities). The
federal funds rate (generally one-day loans of excess reserves from one bank to
another) declined eleven times for a total of 4.75 percent during 2001. The
Corporation is funded primarily by core deposits with demand deposits
historically being a strong source of funds. This low cost funding base has
historically been a positive to net interest income and margin. However, in a
falling rate environment the Corporation suffers margin compression as (i) its
earning assets are repricing quicker than its interest-bearing liabilities and
(ii) its low cost funding base results in its inability to cut these rates
proportionately with decreases in market rates. For 2001, the Corporation's
ratio of average demand deposits to total average deposits was 33.4 percent,
which was well above peer levels. See "Consolidated Average Balance Sheets" on
pages 76 and 77 and "Rate Volume Analysis" on page 78.

Net interest spread, which represents the difference between the rate
earned on earning assets and the rates paid out on funds, decreased 18 basis
points for 2001 to 4.15 percent. This compares to 4.33 percent and 4.34 percent
for 2000 and 1999, respectively. The net interest spread as well as the net
interest margin will be impacted by future changes in short-term and long-term
interest rate levels, as well as the impact from the competitive environment. A
discussion on the effects of changing interest rates on net interest income is
included in the Market Risk Disclosure -- Interest Sensitivity section on page
39.

The Corporation uses interest rate swaps and interest rate floors, commonly
referred to as derivatives, to manage exposure to interest rates. Information on
these swaps and floors is included in the Interest Rate Swaps/Floor section on
page 39 and Notes A on page 47 and S on page 69 to the Consolidated Financial
Statements.

18

NON-INTEREST INCOME
- -------------------

Non-interest income was $192.9 million for 2001, up $22 million or 12.9
percent when compared with $170.9 million for 2000, and up from $151.3 million
for 1999. The $22 million increase from last year is primarily related to an
increase in service charges on deposit accounts for both commercial and consumer
accounts, an increase in insurance commissions, and higher revenues associated
with FSI. The increase in non-interest income for 2000 compared to 1999 was
broad based as all categories of fee income increased. The increase from 1999 to
2000 came from core growth and was also driven, in part, by the positive impact
of the insurance agency acquisitions made during 2000 and FSI's first full year
of operations. In addition to core growth, non-interest income was favorably
impacted in 1999 by the first quarter acquisition of Keller State Bank and the
second quarter acquisitions of Commerce Financial Corporation and PIA.

Trust fees declined one percent compared to a year ago due to lower
investment fees, which account for approximately 75 percent of trust fees.
Investment fees are based on the market value of assets within a trust account.
The market value of trust assets and the related investment fees were negatively
impacted by the unfavorable equity market conditions during the year. The
decline in investment fees ($1.6 million) was partially offset by higher fees on
accounts with oil and gas properties ($1.2 million). These accounts are charged
based on energy prices, which were higher during 2001 relative to 2000. In 2000,
trust fees were up $2.9 million or 6.2 percent from 1999, mainly due to
increases in investment fees and oil and gas fees, which partially offset
decreases in management fees associated with small cap value funds.

The market value of trust assets at the end of 2001 was $13.3 billion, up
$400 million when compared to $12.9 billion at the end of 2000, with growth
occurring in both managed and custody assets. Most of this growth occurred at
the end of the year having little impact on investment fees in 2001. Trust
assets were comprised of managed assets of $6.0 billion and custody assets of
$7.3 billion at year-end 2001 compared to $5.7 billion and $7.2 billion,
respectively, last year.

Service charges on deposits increased $9.9 million or 16.3 percent from
2000. This increase can be attributed to higher revenues associated with both
commercial and individual accounts and higher overdraft fees partially offset by
lower non-sufficient funds charges. The increase associated with commercial
accounts resulted primarily from higher treasury management services. Due in
part to a lower earnings credit rate, the Corporation received more payment for
services through fees than through the use of balances. The increase in revenues
from individual accounts continues to result from the simplification of deposit
account offerings in 1999. This simplification process resulted in fewer product
offerings while enhancing the remaining available products ultimately resulting
in a better value for the customer. In 2000, deposit service charges increased
$1.8 million or 3.1 percent from 1999. This increase was due to higher overdraft
charges and higher revenues associated with individual accounts. The previously
discussed simplification of deposit account offerings, which began in 1999, was
the primary reason for the increase in individual account revenues.

19

Insurance commissions increased $7.1 million or 68.6 percent from a year
ago. Excluding the impact of the acquisition of AIS in the third quarter of
2001, insurance commissions would have increased 56.8 percent. This increase was
the combined result of the impact of continued selling efforts and the effect of
higher insurance premiums on commission revenues, as the insurance market has
started to tighten the availability of certain products. Insurance commissions
increased $6.4 million to $10.3 million in 2000 compared to $3.9 million in
1999. The increase in insurance commission income was positively impacted by the
two agency acquisitions during 2000.

Other service charges and fees increased $4.9 million or 24.1 percent when
compared to 2000. The primary contributor to this increase was growth in equity
sales commission revenue at FSI. Other service charges and fees increased $6.4
million or 46.2 percent from 1999 to 2000. Primary contributors to this growth
were revenues from FSI, as it completed its first full year of operation.

Other non-interest income increased $579 thousand or 1.9 percent to $31.1
million in 2001 compared to $30.5 million in 2000. The increase is related to
the 2001 purchase of bank owned life insurance on certain employees where the
Corporation is the beneficiary. The increase in cash surrender value on these
insurance policies during 2001 was $3.4 million and was recorded in other
non-interest income. This revenue and higher revenues received from larger
balances held by the provider of the Corporation's official checks program were
the primary reasons for the increase from a year ago. Additionally, a $1.1
million gain was recognized from the sale of an interest rate floor. These
increases were offset somewhat by the $2 million non-recurring pre-tax gain from
the sale of the mortgage servicing rights in 2000 and lower gain on the sale of
student loans. Other non-interest income increased $2.0 million or 7.1 percent
to $30.5 million in 2000 compared to $28.5 million in 1999. The increase in 2000
from 1999 resulted from higher income primarily related to increased usage of
the Visa check card and annuity sales income and the previously mentioned $2
million gain from the sale of the mortgage servicing rights in 2000. These
increases were partially offset by fewer mortgage loan origination fees, which
resulted from the Corporation's outsourcing mortgage loans through the
co-branding arrangement with GMAC Mortgage, and lower gains on the sale of
student loans.

NON-INTEREST EXPENSE
- --------------------

Non-interest expense was $352.6 million for 2001, an increase of $39.3
million or 12.6 percent compared with $313.3 million for 2000 and $287.2 million
for 1999. Non-interest expense would have been $332.7 million, an increase of
$19.5 million or 6.2 percent from 2000 excluding the restructuring charges
included in the table and discussed below. Excluding the restructuring charge,
approximately 65 percent of the increase from 2000 related to salaries and
benefits. The increase in non-interest expense for 2000 was impacted by the
insurance agency acquisitions made during 2000. In addition, the increase was
impacted by a full years cost associated with Frost Securities and Commerce
Financial Corporation. The acquisitions of Keller State Bank, Commerce Financial
Corporation, and PIA, as well as the formation of FSI, impacted the growth in
expenses in 1999.

20

Salaries and wages increased by $6.1 million or 4.4 percent in 2001 and
$16.5 million or 13.5 percent in 2000. Salaries and wages in both years have
experienced increases related to FSI, the Corporation's investment banking
subsidiary which began operations in August of 1999, and acquisitions made by
FIA as well as normal market and merit increases based on performance in 2000.
Offsetting part of the increase from the year 2000 was a decrease from the
elimination of management bonuses for 2001. Also, included in 2000 were
approximately $600 thousand in severance costs related to the outsourcing of
mortgage loans.

Pension and other employee benefits increased by $6.3 million or 21.7
percent during 2001 as a result of higher retirement plan expense, higher
payroll taxes and higher medical expenses. For the year 2000 compared to 1999,
pension and other employee benefits increased 11.8 percent as a result of two
insurance acquisitions and the first full year of operations for FSI, as well
as, higher medical expenses throughout the Corporation.

Net occupancy increased $1.7 million or 6.2 percent during 2001 primarily
reflecting higher general building maintenance and utility expenses and higher
property tax expense related to a full year of operations for the two insurance
acquisitions made in 2000 and five months of operations for the August 2001
acquisition. In 2000, net occupancy expense increased $756 thousand or 2.8
percent due to higher building lease expense and general building maintenance
and utility expenses affected by de novo branches opened in 2000 and the second
and third quarter 2000 insurance acquisitions. De novo branches are branches
originally established by the bank and not acquired from another institution by
purchase or merger. These increases were offset somewhat by lower property tax
expense.

Furniture and equipment costs increased $2.4 million or 11.3 percent in
2001 primarily due to higher software maintenance and amortization primarily
related to the Corporation's e-commerce efforts and enhanced web site introduced
in November of 2000. In 2000, furniture and equipment costs increased $1.5
million or 7.7 percent, which was also primarily due to higher amortized
software and software maintenance.

Intangible amortization for 2001 includes $8.0 million of goodwill
amortization and $7.1 million of other intangible amortization, primarily
related to core deposit intangibles. Intangible amortization for 2000 includes
$7.9 million of goodwill amortization and $7.7 million of other intangible
amortization, primarily related to core deposit intangibles. The increase in
amortized goodwill was due to goodwill associated with acquisitions by FIA.
Other intangible amortization decreased due to the run-off of core deposit
intangibles associated with bank acquisitions in earlier years. See the
discussion in the Cash Earnings section on page 24 for a discussion of SFAS No.
142, which will impact intangible amortization expense effective in 2002.

The restructuring charges recorded in 2001 included separation and benefit
charges of $11.5 million related to a voluntary early retirement program
effective as of December 31, 2001, which was accepted by about four percent of
the staff. The $11.5 million charge consisted of approximately $6.0 million
related to additional pension benefits, $1.4 million associated with future
medical benefits, with the remainder due to cash payments based on length of
service. The restructuring charges also included $6.7 million due to the
freezing of the Corporation's defined benefit pension plan (replaced by a
deferred profit sharing plan). The remaining $1.7 million related to severance
and outplacement services for a two percent reduction in workforce. Anticipated
savings from the reduction in workforce and the voluntary early retirement
program ("ERW") are expected to be approximately $13.2 million in 2002. The
freeze of the defined benefit plan and its replacement by a deferred profit
sharing plan should reduce the volatility in retirement plan expense going
forward. However, the Corporation still has funding obligations related to the
defined benefit plan and could recognize retirement expense related to this plan
in future years, which would be dependent on the return earned on plan assets,
the level of interest rates and employee turnover.

Other non-interest expense increased $3.3 million or 4.1 percent during
2001 primarily due to higher professional, advertising, and travel expenses
related to the Corporation's fee business expansion efforts. Federal Reserve
service charges were also up from last year due to the lower rate environment,
as the Corporation paid more for services through fees than through the use of
balances held at the Federal Reserve. Somewhat offsetting this increase in
expenses was lower educational and telephone expense. Other non-interest expense
increased $3.6 million or 4.6 percent during 2000 and was broad-based throughout
several operational accounts including professional expenses, business
development and travel expenses.

21

RESULTS OF SEGMENT OPERATIONS
- -----------------------------

The Corporation's operations are managed along three Operating Segments:
Banking, the Financial Management Group ("FMG") and FSI, which began operations
in August of 1999. A description of each business and the methodologies used to
measure financial performance are described in Note U to the Consolidated
Financial Statements on page 71. The following table summarizes operating
earnings by Operating Segment for each of the last three years:

Banking

Operating earnings were $91.6 million for 2001, down 13.2 percent from
$105.6 million for 2000 and down from $93.4 million for 1999. The decrease in
operating earnings in 2001 versus 2000 reflects the impact of a $26.0 million
increase in the provision for possible loan losses, mainly related to a
deterioration of two large credits and continued uncertainty in the current
economic environment. The loan loss reserve was built to $72.9 million or 1.61
percent of period-end loans. Net interest income was lower due to the decline in
short-term interest rates, from 6.50 percent at the beginning of the year to
1.75 percent by year-end. The bank is primarily funded by non-interest bearing
demand deposits representing 33.3 percent of total deposits at year-end 2001.
This high level of demand deposits has been a positive for the bank's net
interest income in the past. In a falling rate environment, however, margin
compression can occur more rapidly as rates on this funding source cannot go any
lower.

Partially offsetting the adverse impacts of higher provision for loan
losses and lower net interest income were higher service charges on deposits,
increased insurance commissions, and the pre-tax gain of $5.7 million related to
the sale of an interest rate floor. The $9.9 million increase in service charges
on deposits, up 16.4 percent, over 2000 can be attributed to higher revenues
associated with both commercial and individual accounts and higher overdraft
fees partially offset by lower non-sufficient funds charges.

FIA, which is included in the banking operating segment, had gross revenues
of $18.8 million during 2001 as compared with $11.1 million in 2000. Insurance
commissions were the largest component of these revenues. The $7.1 million or
68.6 percent increase over 2000 reflects the acquisition on August 1, 2001 of
AIS and the full year impact of the acquisitions made in the third and second
quarters of 2000. It also reflects the impact of tightening insurance markets
for some products, as well as continued selling efforts. Referrals made by
employees across the organization, including commercial banking, are expected to
be an important source of growth for FIA. During 2001, FIA was successful on
about 60 percent of their proposals made to qualified referrals provided by
other employees of the bank.

There were no bank acquisitions during 2001 or 2000. Results for the year
2000 reflect the full year impact of the acquisition in May 1999 of PIA and the
two bank acquisitions made in the first and second quarters of 1999.

Financial Management Group

Operating earnings for 2001 were $11.4 million, compared to $16.2 million
for 2000 and $15.3 million for 1999. Net interest income was down $2.7 million
compared to the previous year as the lower rate environment has reduced the
funds transfer price paid on FMG's securities sold under repurchase agreements.
Total non-interest income was up $1.0 million from 2000. The leading component
of FMG non-interest income, trust

22

fees, were down slightly due to equity market conditions and the resulting
impact to investment fees, which represent approximately 75 percent of trust
fees. Other fees, not included in trust fees, such as brokerage commissions from
the sale of mutual funds, money markets and annuities, account for most of the
increase year over year. This was slightly offset by a decrease in brokerage
commissions from less sales of equities.

Operating expenses were up $3.0 million from last year. Most of the
increase was due to salaries and benefits, as well as litigation expenses and
sundry losses. Salaries and benefits were up, in part, to support business
initiatives within FMG through expansion of the brokerage sales force,
securities lending and fixed income management. Comparing 2000 to 1999, the
increase in operating earnings can be attributed to growth in investment fees
and oil and gas fees. While oil and gas fees were influenced by the higher
market prices of oil and gas, investment fees were positively impacted by a
larger fee base due to growth in the number of trust accounts combined with
increased market values associated with managed assets.

Frost Securities Inc.

FSI's operating loss of $3.7 million for 2001 increased from a $3.4 million
loss for 2000, and from a $2.4 million loss for less than a half year of
operations in 1999. Investment banking fees have been adversely impacted by
market conditions in the energy and technology sectors. Both years were further
impacted by expenses as the company continued to expand this business segment
during its startup phase. Total revenues were up $4.1 million or 63.9 percent
over 2000 driven primarily by equities sales commissions, which represented
about 90 percent of FSI's 2001 revenue. FSI revenues represented approximately
six percent of the Corporation's non-interest income during 2001.

Non-interest expenses for 2001 were up $4.5 million or 39.4 percent to $16
million. Approximately one half of the increase was in salaries and benefits
associated with an increase in overall average headcount of 23 percent
year-over-year. Also impacting higher salaries were increases in sales
commissions related to higher revenue from equity sales. Business development
expenses were up due to an increase in institutional sales marketing activity.
Clearing fees were higher as a result of increased commission revenue.
Additional market data and trading floor communication systems and recruiting
expenses also added to the increase in non-interest expenses. Staffing levels at
the end of 2001 included 46 employees compared to 43 at the end of 2000 and 28
at the end of 1999. As of year-end 2001 there were 39 energy and 24 technology
stocks under coverage.

Non-Banks

The reduction in operating loss for non-banks in 2001 was due to a decrease
in expenses relating to elimination of management bonuses. The increased loss in
2000 compared with 1999 was due to increased incentive compensation and fees for
professional services.

Restructuring Charges

The restructuring charges, after tax, recorded in 2001 included separation
and benefit charges of $7.5 million after tax related to a voluntary early
retirement program effective as of December 31, 2001, which was accepted by
about four percent of the staff. The $7.5 million after tax charge consisted of
approximately $3.9 million after tax related to additional pension benefits,
$900 thousand after tax associated with future medical benefits, with the
remainder due to cash payments based on length of service. The restructuring
charges also included $4.3 million after tax due to the freezing of the
Corporation's defined benefit pension plan (replaced by a deferred profit
sharing plan). The remaining $1.1 million after tax related to severance and
outplacement services for a two percent reduction in workforce.

23

INCOME TAXES
- ------------

Cullen/Frost recognized income tax expense of $40.2 million in 2001,
compared to $57.4 million in 2000, and $51.0 million in 1999. The effective tax
rate in 2001 was 33.18 percent compared to 34.54 percent in 2000 and 34.30
percent in 1999. The lower effective tax rate in 2001 compared to 2000 was
mainly due to an increase in tax exempt income resulting from the purchase of
bank owned life insurance during 2001. For a detailed analysis of the
Corporation's income taxes see Note O "Income Taxes" on page 65.

CASH EARNINGS
- -------------

Historically, excluding the merger with Overton Bancshares, Inc. in 1998,
the Corporation's acquisitions have been accounted for using the purchase method
of accounting, which results in the creation of intangible assets. These
intangible assets are deducted from capital in the determination of regulatory
capital. Thus, "cash" or "tangible" earnings represents the regulatory capital
generated during the year and can be viewed as net income excluding intangible
amortization, net of tax. While the definition of "cash" or "tangible" earnings
may vary by company, the Corporation believes this definition is appropriate as
it measures the per share growth of regulatory capital, which impacts the amount
available for dividends, acquisitions, and growth.

Statement of Financial Accounting Standards ("SFAS") No. 142, issued in
July 2001, replaces the practice of amortizing goodwill and indefinite lived
intangible assets with an annual review for impairment. See Note A "Accounting
Changes" section on page 49 for further discussion on this statement.

The following table reconciles reported earnings to net income excluding
intangible amortization ("cash" earnings) for each of the three most recent year
periods:

* Calculated as A/B
** Calculated as A/C
- ---------------------

24

SOURCES AND USES OF FUNDS
- -------------------------

Average assets for 2001 of $7.8 billion increased by 9.6 percent from 2000
levels and increased 4.0 percent between 1999 and 2000. Deposits remain the
primary source of funding for Cullen/Frost. Funding sources in 2001 reflected an
increase in demand deposits and other liabilities offsetting a decrease in time
deposits. In addition, borrowed funds increased due to the third quarter 2001
issuance by Frost Bank of $150 million of its 6 7/8 percent Subordinated Bank
Notes due 2011.

Demand deposits in particular have shown an improving trend over the three
year period, which has been a key factor in the Corporation's ability to
maintain a low cost of funds while funding loan growth. For 2001, average demand
deposits were 33.4 percent of total average deposits compared with 31.3 percent
during 2000, and 30.6 percent during 1999.

Loans continue to be the largest component of the earning assets mix.
However, non-earning assets increased 2.3 percent from levels a year ago because
of float associated with higher demand deposit balances. Non-earning assets
include cash, due from banks, banking premises, accrued interest and other
assets.

25

LOANS
- -----

Total period-end loans for 2001 were $4.5 billion, which were flat compared
to 2000. However, excluding shared national credits purchased ("SNCs"), 1-4
family residential mortgages and the indirect lending portfolio, loans increased
by 5.3 percent over 2000. The Corporation withdrew from the mortgage origination
business, as well as the indirect lending business during 2000, and these
portfolios continue to decrease through payoffs and refinancings. The SNCs
portfolio has decreased steadily over the past year. See NPA section on page 30
for further discussion. The mortgage and indirect portfolios are also discussed
in more detail later in this section.

At December 31, 2001, the majority of the loan portfolio was comprised of
real estate loans totaling $2.1 billion or 45.9 percent of total loans and the
commercial and industrial loan portfolio totaling $2.0 billion or 43.9 percent
of total loans. The real estate total includes both commercial and consumer
balances. At December 31, 2001 and 2000, the Corporation had no concentration,
by Standard Industrial Classification code ("SIC"), in any single industry that
exceeded 10 percent of total loans. The SIC code is a federally designed
standard numbering system identifying companies by industry. Cullen/Frost uses
the SIC code to categorize loans by the recipient's type of business. The
largest single concentration by SIC code at year-end

26

2001 was in energy at 6.5 percent of total loans. The following table
categorizes loan portfolio concentrations by SIC code, illustrating the
diversity in the Corporation's total loan portfolio:

The majority of the 5.3 percent growth in total loans over 2000 (excluding
SNCs, mortgage loans and indirect lending) was in the commercial and industrial
loan portfolio, which increased to $2.0 billion at year-end 2001. The
Corporation's commercial and industrial loans are a diverse group of loans to
small, medium and large businesses. The purpose of these loans varies from
supporting seasonal working capital needs to term financing of equipment. While
some short term loans may be made on an unsecured basis, most are secured by the
assets being financed with appropriate collateral margins. The commercial and
industrial loan portfolio also includes the commercial lease portfolio and asset
based lending. At December 31, 2001, the commercial lease portfolio totaled
$41.0 million and asset based loans totaled $48.6 million. These totals are both
increases from December 31, 2000 balances of $40.0 million and $31.0 million,
respectively. In addition, at December 31, 2001, over 97 percent of the
outstanding balance of SNCs were included in the commercial and industrial
portfolio, with the remainder included in the real estate categories.

The Corporation had a total SNCs portfolio of approximately $237 million
outstanding at year-end 2001, which is down from $316 million at the previous
year end. Of the outstanding total at year-end 2001, approximately 35 percent
were energy related with the remainder diversified throughout various
industries. These participations are done in the normal course of business to
meet the needs of the Corporation's customers. General corporate policy towards
participations is to lend to companies either headquartered in or having
significant operations within our markets. In addition, the Corporation must
have an existing banking relationship or the expectation of broadening the
relationship with other bank products.

Total real estate loans at December 31, 2001 were $2.1 billion, down 2.9
percent from year-end 2000. However, excluding the decline in the 1-4 family
residential mortgage portfolio, which is discussed below, total real estate
loans remained relatively flat with year-end 2000. The commercial real estate
portfolio, which totals $1.5 billion, represents over 72 percent of the total
real estate loans at year-end 2001. The majority of this portfolio is commercial
real estate mortgages, which includes both permanent and intermediate term
loans. The diversity in the commercial real estate portfolio allows the
Corporation to reduce the impact of a

27

decline in any single industry. The following table reflects the concentration
by industry in the commercial real estate portfolio:

The primary focus of the commercial real estate portfolio has been the
growth of loans secured by owner-occupied properties. These loans are viewed
primarily as cash flow loans and secondarily as loans secured by real estate.
Consequently, these loans must undergo the analysis and underwriting process of
a commercial and industrial loan, as well as a commercial real estate loan. At
December 31, 2001, approximately 49 percent of the Corporation's commercial real
estate loans were secured by owner-occupied properties.

The consumer loan portfolio, including all consumer real estate, at
December 31, 2001 totaled $987 million, down 11.2 percent from year-end 2000.
However, excluding the decrease in the 1-4 family residential mortgage and the
indirect lending portfolios, total consumer loans increased by 2.1 percent. As
the following table illustrates, the consumer loan portfolio has four distinct
segments -- consumer real estate, consumer non-real estate, indirect consumer
loans and 1-4 family residential mortgages.

The majority of the 2.1 percent growth in consumer loans, excluding
mortgage and indirect lending, has occurred in the consumer real estate
portfolio, which primarily consists of home equity, home improvement and
residential lot loans. This segment has increased to $331 million at year-end
2001 from $321 million at the previous year-end. The Corporation offers home
equity loans up to 80 percent of the estimated value of the personal residence
of the borrower, less the value of existing mortgages and home improvement
loans. Home equity loans, which were allowed in the state of Texas beginning
January 1, 1998, account for almost half of the consumer real estate total at
year-end 2001.

The consumer non-real estate loan segment has grown to $346 million at
year-end 2001 from $342 million at year-end 2000. Loans in this segment include
automobile loans, unsecured revolving credit products, personal loans secured by
cash and cash equivalents, and other similar types of credit facilities.

The indirect consumer loan segment has continued to decrease by about $18
million per quarter since the Corporation's decision to discontinue originating
these types of loans during 2000. At December 31, 2001, the majority of the
portfolio was comprised of new and used automobile loans (60.1 percent of
total), as well as purchased home improvement and home equity loans (37.4
percent of total). The portfolio is not expected to

28

completely pay off by year-end 2002 due to the longer life of the non-auto loans
in this portfolio. However, the portfolio is expected to be substantially
reduced by that time.

The Corporation also discontinued originating 1-4 family residential
mortgage loans in 2000. These types of loans are now offered through the
Corporation's co-branding arrangement with GMAC Mortgage. At December 31, 2001,
the 1-4 family residential loan segment totaled $245 million down from $311
million at year-end 2000. Although this portfolio will continue to decline due
to the decision to withdraw from the mortgage origination business, the high
level of mortgage refinancings during 2001's falling interest rate environment
drove the substantial decrease during 2001.

The following table details the Corporation's total loan portfolio by a
regional breakout at year-end 2001 and 2000. The "Other portfolios" category
includes indirect lending, 1-4 family residential mortgages, SNCs and student
loans. The decreases in the major components of this category have been
previously discussed.