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U.S. SECURITIES AND EXCHANGE COMMISSION

Washington D.C.  20549

FORM 10-K

x      Annual report under Section 13 or 15(d) of the Securities Exchange Act of 1934

(Fee required) for fiscal year ended December 31, 2009

o         Transition report under Section 13 or 15(d) of the Securities Exchange Act of 1934

(No fee required) for the period from             to             

Commission File Number 0-27666

NORTHERN CALIFORNIA BANCORP, INC.

(Exact name of registrant as specified in its Charter)

Incorporated in the State of California

IRS Employer Identification Number 77-0421107

Address:  601 Munras Avenue, Monterey, CA  93940

Telephone: (831) 649-4600

Securities registered under Section 12(g) of the Exchange Act: Common stock

Securities registered under Section 12(b) of the Exchange Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o  No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes o  No x

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 o.

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o  No o

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.  x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.  Yes o  No x

Aggregate market value of Common Stock held by non-affiliates as of the last business day of the registrant’s most recently completed second fiscal quarter ended June 30, 2009 was $3,445,000.

Shares of stock outstanding as of March 1, 2010: 1,783,230.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s proxy statement to be filed with the Securities and Exchange Commission in connection with the registrant’s 2010 annual meeting of shareholders are incorporated by reference into Part III of this Form 10-K.

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FORM 10-K CROSS REFERENCE INDEX

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Statements Regarding Forward-Looking Information

Except for historical information contained herein, the matters discussed or incorporated by reference in this report on Form 10-K contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”), that involve substantial risks and uncertainties.  When used in this report, or in the documents incorporated by reference herein, the words “anticipate,” “believe,” “estimate,” “may,” “intend,” “expect,” and similar expressions identify certain of such forward-looking statements.  Actual results of Northern California Bancorp, Inc. (the “Corporation”) could differ materially from such forward-looking statements contained herein.  Factors that could cause future results to vary from current expectations include, but are not limited to, the following: changes in economic conditions (both generally and more specifically in the markets in which the Corporation operates):  changes in interest rates, deposit flows, loan demand, real estate values and competition; changes in accounting principles, policies or guidelines and in government legislation and regulation (which change from time to time and over which the Corporation has no control); other factors affecting the Corporation’s operations, markets, products and services; and other risks detailed in this Form 10-K (see “Item 1A. Risk Factors”) and in the Corporation’s other reports filed with the Securities and Exchange Commission.  Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s analysis only as of the date hereof.  The Corporation undertakes no obligation to publicly revise these forward-looking statements to reflect events or circumstances that arise after the date thereof.

PART I

ITEM 1.                                                     BUSINESS

GENERAL

Northern California Bancorp, Inc. was incorporated on August 29, 1995, as a for-profit corporation under California corporate laws for the principal purpose of engaging in banking and non-banking activities as allowed for a bank holding company.  At December 31, 2009, on a consolidated basis the Corporation had total assets of $273,295,000, total loans of $166,742,000 and total deposits of $202,422,000.  The Corporation owns 100% of the stock of Monterey County Bank (the “Bank”).   The Corporation’s sources of revenues at this time are dividends on investments, gains on securities transactions and potential dividends, management fees and tax equalization payments, if any, from the Bank.

The Corporation, as a bank holding company, engages in commercial banking through the Bank.  The Corporation may also engage in certain non-banking activities closely related to banking and own certain other business companies that are not banks, subject to applicable laws and regulations, although it has no current plans to do so.

BANK SUBSIDIARY

Monterey County Bank, an independent, California chartered commercial banking corporation, was chartered by the State of California on July 30, 1976.  The Bank’s customer base includes individuals, small and medium-sized businesses and a variety of government agencies with residences, offices or other relationships located in or about the city and county of Monterey, California, including the cities of Carmel by the Sea, Pacific Grove and Salinas.  The Bank offers its

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customers a wide variety of the normal personal, consumer and commercial services expected of a locally owned, independently operated bank.  The Bank’s deposits are insured by the Federal Deposit Insurance Corporation (the “FDIC”), and, as such, the Bank is subject to regulations by that federal agency and to periodic audits of its operations and documentary compliance by FDIC personnel.  As a state chartered bank, which is not a member of the Federal Reserve System, it is also regulated and periodically examined by the California Department of Financial Institutions (DFI).

The Bank’s activities are conducted at its principal branch offices, 601 Munras Ave., Monterey, California and at its four branch offices in Carmel-By-The-Sea, Carmel Valley, Pacific Grove and Salinas, California and a loan production office in Monterey, California.  At December 31, 2009, the Bank had total assets, loans and deposits of approximately $272,154,000, $166,742,000 and $202,671,000, respectively.

The Bank provides a range of competitive retail and commercial banking services.  The deposit services offered include various types of personal and business checking accounts, savings accounts, money market investment accounts, certificates of deposit, and retirement accounts.  Lending services include consumer loans, various types of mortgage loans for residential and commercial real estate, personal lines of credit, home equity loans, real estate construction, accounts receivable financing and commercial loans to small and medium-sized businesses and professionals.  The Bank also provides drive-through facilities, at its Monterey and Carmel offices, and night depository facilities for customer convenience.  The Bank offers safe deposit box facilities, cashiers’ checks, travelers’ checks, U.S. Savings Bonds, and wire transfers.  The Bank does not provide trust services.

While the Bank has the authority to engage in a wide range of banking activities, and offers most of the types of banking services of a commercial bank, over the past three years it has derived much of its profitability and differentiated itself from its competitors through (i) commercial and real estate loans guaranteed by the Small Business Administration (“SBA”), (ii) sponsorship of credit card and debit card programs and (iii) credit card depository services for merchants.

The primary issue that affected the Corporation in 2009 was the depressed economic conditions and related stress in real estate markets. The Corporation focused much of its efforts on managing the deterioration of asset quality resulting from the effect that deteriorating economic conditions had on loans made primarily to residential real estate development projects. The increase in the Corporation’s provision for loan losses ($3,368,000 in 2009 compared to $1,132,000 in 2008) was largely due to asset quality issues related to this market segment.

Management’s efforts focused on identifying potentially weak credits as early as possible, which enabled a proactive and aggressive approach to managing these credits and the development of workout strategies as appropriate.  Nonetheless, loans 30 days past due increased from $6,925,000 (4.1% of total loans) at December 31, 2008 to $8,190,000 (4.9% of total loans) at December 31, 2009.  Past due loans increased during this period by $1,265,000 or 18.3%.  During the same period, non-performing loans (non-accrual loans and troubled debt restructurings) increased from $7,091,000 (4.8% of total loans) to $8,884,000 (5.3% of total loans) at December 31, 2009. Of the non-performing loans outstanding at December 31, 2009, $5,137,000 or 57.8% were secured by real estate (net of any charge-offs previously taken).  Total past due loans and non-performing loans are net of the guaranteed portion of SBA loans totaling $1,636,000 and $1,421,000, respectively.  Management believes the presence of real estate collateral mitigates the level of expected loss though the level of mitigation is uncertain due to the difficulty ascertaining

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real estate values at this time.

Management utilized a pricing discipline and other strategies to offset pressure on the Corporation’s net yield on earning assets created by declining interest rates and an increase in non-performing loans.  To combat this and other adverse factors, Management’s efforts to improve its net yield on earning assets included the development of a loan pricing model, establishing floors on variable rate loan products, increased investment in tax free municipal securities, increased efforts to attract lower cost checking accounts and increased use of competitively priced out-of-area deposits and Federal Reserve Bank borrowings.  The Corporation’s tax-equivalent net yield on earning assets increased to 3.1% for 2009 compared to 2.9% for 2008.  The tax-equivalent net yield on earning assets was affected in 2008 by the increase in loans being placed on non-accrual during the year. Non-accrual loans totaled $8,884,000 at year-end 2009 compared to $7,091,000 at year-end 2008, an increase of $1,793,000 or 25.3%.  The increase in non-accrual loans resulted from slowing economic activity and a depressed real estate market.

The Bank has provided sponsorship of third party credit card and debit card programs since August 2002.  The Bank gave notice in June 2008 to the third-party card vendors that it will reduce its sponsorship of credit card and stored value card programs, terminating sponsorship agreements on all programs except a drug manufactures’ rebate card program.  The characteristics of the drug manufactures’ rebate card program significantly reduces the level of required monitoring.  The Bank decided to continue its sponsorship of a debit card program which issues payroll cards.  The Bank decided to continue its sponsorship of one credit card program in order to preserve the third party’s indemnification of the Bank against potential expenses and/or liabilities.  The Bank also decided to grant extensions of its sponsorship of one credit card program to allow time for the final resolution of issues raised by the FDIC as further discussed under “Regulatory Enforcement Powers”.  Extension of the program sponsorship is considered quarterly with the third party paying an extension fee each time an extension is granted.  The Bank’s sponsorship of the terminated programs ended in 2009.    The Bank has been named as a defendant in a lawsuit brought by one of the third-party credit card companies, seeking to compel the Bank to continue its sponsorship for a period of time.  (See “Item 3. Legal Proceedings” for further discussion.)

The Bank’s revenues, consisting of a monthly fee per card or a minimum monthly fee, from the credit card programs were $1,075,000, $514,000 and $684,000 in 2009, 2008 and 2007, respectively.  The 2007 revenues included $204,000 in transfer fees received as a result of a card portfolio being transferred to another financial institution.  The Bank’s revenues from the credit card programs in 2009 increased due to the collection of quarterly extension fees paid by one of the programs.   The Bank’s revenues, consisting of a monthly fee per card or a minimum monthly fee, from the debit card programs were $81,000, $155,000 and $293,000 in 2009, 2008 and 2007, respectively.

Northern California Bancorp, Inc. Trust I

On March 27, 2003, Northern California Bancorp, Inc. Trust I, a Delaware statutory business trust and a wholly owned subsidiary of the Corporation (“Trust I”), issued an aggregate of $3.0 million of principal amount of Floating Rate TRUPSâ (Capital Trust Pass-through Securities of the Trust) (the “Trust Preferred Securities”).  The securities issued by Trust I are fully guaranteed by the Corporation with respect to distributions and amounts payable upon liquidation, redemption or repayment.  The entire proceeds to Trust I from the sale of the Trust Preferred Securities were used by Trust I in order to purchase $3.0 million in principal amount of the Floating Rate Junior Subordinated Deferrable Interest Debentures due 2033 issued by the Corporation (the

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“Subordinated Debt Securities”).

Pursuant to Financial Accounting Standards Board (FASB) issued ASC 810-10 (formerly interpretation FIN 46(R)) entitled “Consolidation of Variable Interest Entities,” Trust I is not reflected on a consolidated basis in our consolidated financial statements.

The Subordinated Debt Securities bear a variable interest rate equal to the three-month London Interbank Offered Rate (“LIBOR”) plus 3.25%.  The effective rate at December 31, 2009 was 3.53%.  Total broker and legal costs associated with the issuance of $115,000 are being amortized over a 30 year period.

The Corporation exercised its rights in accordance with Section 2.11 Extension of Interest Payment Period of the Indentures dated March 27, 2003 for Northern California Bancorp, Inc. Trust I to defer interest payments for an undetermined period of time, not to exceed twenty (20) consecutive quarterly payments.  The deferral of interest payments on Northern California Bancorp, Inc. Trust I was effective with the October 7, 2009 interest payment.  At December 31, 2009 accrued and unpaid interest totaled $60,000.

Northern California Bancorp, Inc. Trust II

On November 13, 2003, Northern California Bancorp, Inc. Trust II, a Delaware statutory business trust and a wholly owned subsidiary of the Corporation (“Trust II”), issued an aggregate of $5.0 million of principal amount of Floating Rate TRUPSâ (the “Trust Preferred Securities-II”).   The securities issued by Trust II are fully guaranteed by the Corporation with respect to distributions and amounts payable upon liquidation, redemption or repayment.  The entire proceeds to Trust II from the sale of the Trust Preferred Securities were used by Trust II in order to purchase $5.0 million in principal amount of the Floating Rate Junior Subordinated Deferrable Interest Debentures due 2033 issued by the Corporation (the “Subordinated Debt Securities-II”).

Pursuant to Financial Accounting Standards Board (FASB) issued ASC 810-10 (formerly interpretation FIN 46(R)) entitled “Consolidation of Variable Interest Entities,” Trust II is not reflected on a consolidated basis in our consolidated financial statements.

The Subordinated Debt Securities-II bear a variable interest rate equal to the three-month LIBOR plus 2.85%.  The effective rate at December 31, 2009 was 3.13%. Total broker and legal costs associated with the issuance of $54,000 are being amortized over a 30 year period.

The Corporation has exercised its rights in accordance with Section 2.11 Extension of Interest Payment Period of the Indentures dated November 13, 2003 for Northern California Bancorp, Inc. Trust II to defer interest payments for an undetermined period of time, not to exceed twenty (20) consecutive quarterly payments.  The deferral of interest payments on Northern California Bancorp, Inc. Trust II was effective with the November 8, 2009 interest payment.  At December 31, 2009 accrued and unpaid interest totaled $65,000.

EMPLOYEES

At December 31, 2009, the Corporation and the Bank employed a total of 56 full-time equivalent persons.  Our employees are not represented by any union or other collective bargaining agreement and we consider our relations with our employees to be excellent.

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COMPETITION

All phases of the Bank’s business have been, since inception, and will continue to be subject to significant competitive forces.  Although the Bank has increasing recognition in its primary service area of Monterey County as a whole, it nevertheless has to compete with other independent local banking institutions, including commercial banks and savings and loan associations, as well as branch offices of regional and national commercial banks, which have assets, capital and lending limits substantially larger than the Bank, as well as wider geographic markets, more support services and larger media advertising capabilities.  The Bank competes with respect to its lending activities, as well as in attracting demand deposits, with savings banks, savings and loan associations, insurance companies, regulated small loan companies and credit unions, as well as securities brokerage offices which can issue commercial paper and other securities (such as shares in money market funds).

Among the advantages such institutions have over the Bank are their ability to finance wide ranging advertising campaigns and to allocate their investment assets to regions of highest yields and demand.  Many institutions offer certain services, such as trust services and international banking, which the Bank does not currently offer or plan to offer.  By virtue of their greater total capital, such institutions have substantially higher lending limits than the Bank (legal lending limits to an individual customer being limited to a percentage of a bank’s total capital accounts).  These competitors may intensify their advertising and marketing activities to counter any efforts by the Bank to further attract new business as a commercial bank.  In addition, as a result of legislation enacted earlier in the decade, there is increased competition between banks, savings and loan associations and credit unions for the deposit and loan business of individuals.  These activities may hinder the Bank’s ability to capture a significant market share.

To compete with the financial institutions in its primary service area, the Bank intends to use the flexibility which its independent status permits.  Its activities in this regard include an ability and intention to respond quickly to changes in the interest rates paid on time and savings deposits and charged on loans, and to charges imposed on depository accounts, so as to remain competitive in the market place.  It also will continue to emphasize specialized services for the small business person and professional and personal contacts by the Bank’s officers, directors and employees.  If there are customers whose loan demands exceed the Bank’s lending limits, the Bank has the ability to arrange for such loans on a participation basis with other financial institutions.  No assurance can be given, however, that the Bank’s efforts to compete with other financial institutions in its primary service area will be successful.

The Bank’s earnings depend largely on rate differentials.  In general, the difference between the interest rate paid by the Bank on its deposits and its other borrowings, and the interest rate received by the Bank on loans extended to its customers and securities held in the Bank’s portfolio, comprise the major portion of the Bank’s earnings.  These rates are highly sensitive to many factors that are beyond the control of the Bank.  Accordingly, the earnings and growth of the Bank are subject to the influence of domestic and foreign economic conditions, including inflation, recession and unemployment.

Monetary and fiscal policies of the federal government and the policies of regulatory agencies, particularly the Federal Reserve Board, also impact on the Bank’s business.  The Federal Reserve Board implements national monetary policies (with objectives such as curbing inflation and combating recession) by its open-market operations in U.S. Government securities, by adjusting the required level of reserves for financial intermediaries subject to its reserve requirements and by varying the discount rates applicable to borrowings by depository institutions.  The actions of the

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Federal Reserve Board in these areas influence the growth of bank loans, investments and deposits and also affect interest rates charged on loans and paid on deposits.  The nature and impact of any future changes in monetary policies cannot be predicted.

SUPERVISION AND REGULATION

The Corporation

On December 29, 1995, after receipt of appropriate approvals, the Corporation acquired the Bank through a reverse triangular merger (the “Merger”).  As a result, by operation of law, each outstanding share of common stock of the Bank prior to the Merger was converted into a share of common stock of the Corporation, while the Corporation became the sole owner of the newly issued shares of common stock of the Bank.

The Bank Holding Company Act of 1956, as amended, places the Corporation under the supervision of the Board of Governors of the Federal Reserve System (the “FRB”). The Corporation must generally obtain the approval of the FRB before acquiring all or substantially all of the assets of any bank, or ownership or control of any voting securities of any bank if, after giving effect to such acquisition, the Corporation would own or control more than 5% of the voting shares of such bank.

A bank holding company is generally prohibited from engaging in, or acquiring direct or indirect control of more than 5% of the voting shares of any company engaged in non-banking activities unless the FRB, by order or regulation, has found such activities to be so closely related to banking, managing or controlling banks as to be a proper incident thereto. In making such determinations, the FRB considers whether the performance of such activities by a bank holding company would offer advantages to the public, which outweigh possible adverse effects.

The FRB’s Regulation “Y” sets out the non-banking activities that are permissible for bank holding companies under the law, subject to the FRB’s approval in individual cases.  Most of these activities are now permitted for California banks that are well-capitalized.   The Corporation and its subsidiaries are also subject to certain restrictions with respect to engaging in the underwriting, public sale and distribution of securities.  The Gramm-Leach-Bliley Act did three fundamental things: 1) it repealed key provisions of the Glass Steagal Act to permit commercial banks to affiliate with investment banks, 2) it substantially modified the Bank Holding Company Act of 1956 to permit companies that own commercial banks to engage in any type of financial activity, and 3) it allowed subsidiaries of banks to engage in a broad range of financial activities that are not permitted by banks.  Management believes the Act has resulted in increased competition for financial services.

The Corporation is required to file reports with the FRB and provide such additional information as the FRB may require. The FRB also has the authority to examine the Corporation and each of its subsidiaries with the cost thereof borne by the Corporation.  Under California banking law, the Corporation and its subsidiaries are also subject to examination by, and may be required to file reports with, the Commissioner of the Department of Financial Institutions.

The Corporation and any subsidiaries which it may acquire or organize will be deemed affiliates of the Bank within the meaning of the Federal Reserve Act.  Pursuant thereto, loans by the Bank to affiliates, investments by the Bank in affiliates’ stock, and taking affiliates’ stock by the Bank as collateral for loans to any borrower is limited to 10% of the Bank’s capital, in the case of

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any one affiliate, and is limited to 20% of the Bank’s capital, in the case of all affiliates.  Federal and State law place other limitations on transactions between the Bank and its affiliates designed to ensure that the Bank receives treatment in such transactions comparable to that available from unaffiliated third parties.

The Corporation and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, sale or lease of property or furnishing of services.  For example, with certain exceptions, the Bank may not condition an extension of credit on a customer’s obtaining other services provided by it, the Corporation or any other subsidiary, or on a promise from its customer not to obtain other services from a competitor.

Future offers or sales of the stock of the Corporation will be subject to the registration requirements of the Securities Act of 1933, and qualification under the California Corporate Securities Act of 1968, and possibly other state Blue Sky laws (unless an exemption is available).

Recent Regulatory Developments

In light of current conditions in the global financial markets and the global economy, legislators and banking regulators have increased their focus on the financial services industry. Proposals for legislation that could substantially intensify the regulation of the financial services industry are expected to be introduced in the U.S. Congress and in state legislatures. The agencies regulating the financial services industry also adopt changes to their regulations. Substantial regulatory and legislative initiatives, including a comprehensive overhaul of the regulatory system in the U.S., are possible in the months or years ahead. Any such action could have a materially adverse effect on our business, financial condition and results of operations.

Recent months have already seen an unprecedented number of government initiatives designed to respond to the stresses experienced in financial markets.  In response to the financial crises affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions, the Emergency Economic Stabilization Act of 2008 (“EESA”) was signed into law on October 3, 2008.  Pursuant to EESA, the U.S. Treasury was given the authority to, among other things, purchase up to $700 billion of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets. Pursuant to EESA, the U.S. Treasury established the Troubled Asset Relief Program (“TARP”) and has since injected capital into many financial institutions under the TARP Capital Purchase Program (“TARP CPP”).  Neither the Corporation nor the Bank has participated in TARP CPP.

On February 10, 2009, the U.S. Treasury announced the Financial Stability Plan (“FSP”) which, among other things, established a new Capital Assistance Program (“CAP”) through which eligible banking institutions will have access to U.S. Treasury capital as a bridge to private capital until market conditions normalize, and extended the Debt Guarantee Program  of the FDIC’s Temporary Liquidity Guarantee Program (“TLGP”) to October 31, 2009 pursuant to which the FDIC fully guaranteed certain newly issued senior unsecured debt and provided full FDIC deposit insurance coverage for certain accounts, including noninterest-bearing transaction deposit accounts. The FSP also extended the Transaction Account Guarantee Program of the TLGP to June 30, 2010.   As a complement to CAP, a new Public-Private Investment Fund on an initial scale of up to $500 billion, with the potential to expand up to $1 trillion, was announced to catalyze the removal of legacy assets from the balance sheets of financial institutions. This proposed fund will combine public and private capital with government financing to help free up capital to support new lending. In addition, the existing Term Asset-Backed Securities Lending Facility (“TALF”) would be

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expanded (up to $1 trillion) in order to reduce credit spreads and restart the securitized credit markets that in recent years supported a substantial portion of lending to households, students, small businesses, and others. Furthermore, the FSP proposed a new framework of governance and oversight to help ensure that banks receiving funds are held responsible for appropriate use of those funds through stronger conditions on lending, dividends and executive compensation along with enhanced reporting to the public. The Bank participates in the Transaction Account Guarantee Program under the TLGP.

On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (“ARRA”) was signed into law.  ARRA is intended to provide tax breaks for individuals and businesses, direct aid to distressed states and individuals, and provide infrastructure spending.  In addition, ARRA imposes new executive compensation and expenditure limits on all previous and future TARP CPP recipients and expands the class of employees to whom the limits and restrictions apply.  ARRA also provides the opportunity for additional repayment flexibility for existing TARP CPP recipients.  Among other things, ARRA prohibits the payment of bonuses, other incentive compensation and severance to certain highly paid employees (except in the form of restricted stock subject to specified limitations and conditions), and requires each TARP CPP recipient to comply with certain other executive compensation related requirements.  These provisions modify the executive compensation provisions that were included in EESA, and in most instances apply retroactively for so long as any obligation arising from financial assistance provided to the recipient under TARP remains outstanding.  On June 10, 2009, the U.S. Treasury issued final regulations that implement and clarify the provisions of ARRA relating to corporate governance and executive compensation limitations.

In addition, ARRA directs the Secretary of the U.S. Treasury to review previously-paid bonuses, retention awards and other compensation paid to the senior executive officers and certain other highly-compensated employees of each TARP CPP recipient to determine whether any such payments were excessive, inconsistent with the purposes of ARRA or the TARP, or otherwise contrary to the public interest. If the Secretary determines that any such payments have been made by a TARP CPP recipient, the Secretary will seek to negotiate with the TARP CPP recipient and the subject employee for appropriate reimbursements to the U.S. government (not the TARP CPP recipient) with respect to any such compensation or bonuses. ARRA also permits the Secretary, subject to consultation with the appropriate federal banking agency, to allow a TARP CPP recipient to repay any assistance previously provided to such TARP CPP recipient under the TARP, without regard to whether the TARP CPP recipient has replaced such funds from any source, and without regard to any waiting period. Any TARP CPP recipient that repays its TARP assistance pursuant to this provision would no longer be subject to the executive compensation provisions under ARRA.

On February 18, 2009, the U.S. Treasury announced the Homeowner Affordability and Stability Plan (“HASP”), which proposes to provide refinancing for certain homeowners, to support low mortgage rates by strengthening confidence in Fannie Mae and Freddie Mac, and to establish a Homeowner Stability Initiative to reach at-risk homeowners. Among other things, the Homeowner Stability Initiative would offer monetary incentive to mortgage servicers and mortgage holders for certain modifications of at-risk loans, and would establish an insurance fund designed to reduce foreclosures.

It is not clear at this time what impact EESA, the CPP, the TLGP, the FSP, ARRA, HASP, or other liquidity and funding initiatives will have on the financial markets and the other difficulties described above, including the high levels of volatility and limited credit availability currently being experienced, or on the U.S. banking and financial industries and the broader U.S. and global economies. Failure of these programs to address the issues noted above could have an adverse effect

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on the Bank and its business.

Moreover, in light of current conditions in the global financial markets and the global economy, legislators and banking regulators have increased their focus on the financial services industry. Proposals for legislation that could substantially intensify the regulation of the financial services industry are expected to be introduced in the U.S. Congress and in state legislatures. The agencies regulating the financial services industry also adopt changes to their regulations. Substantial regulatory and legislative initiatives, including a comprehensive overhaul of the regulatory system in the U.S., are possible in the months or years ahead. Any such action could have a materially adverse effect on the business, financial condition and results of operations of the Bank.

Sarbanes-Oxley Act of 2002

The Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”) was enacted to increase corporate responsibility, provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies, and protect investors by improving the accuracy and reliability of disclosures pursuant to the securities laws. Sarbanes-Oxley includes important new requirements for public companies in the areas of financial disclosure, corporate governance, and the independence, composition and responsibilities of audit committees. Among other things, Sarbanes-Oxley mandates chief executive and chief financial officer certifications of periodic financial reports, additional financial disclosures concerning off-balance sheet items, and speedier transaction reporting requirements for executive officers, directors and 10% shareholders. In addition, penalties for non-compliance with the Exchange Act were heightened. SEC rules promulgated pursuant to Sarbanes-Oxley impose obligations and restrictions on auditors and audit committees intended to enhance their independence from management, and include extensive additional disclosure, corporate governance and other related rules. Sarbanes-Oxley represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a Board of Directors and management and between a Board of Directors and its committees.

The Corporation has not experienced any significant difficulties in complying with Sarbanes-Oxley. However, the Corporation has incurred and expects to continue to incur significant costs in the future in connection with compliance with Section 404 of Sarbanes-Oxley, which starting with the year ended December 31, 2007, requires management to undertake an assessment of the adequacy and effectiveness of our internal controls over financial reporting and will require our auditors to attest to, and report on, management’s assessment and the operating effectiveness of these controls. The SEC has extended the compliance date for the auditor attestation requirements so that the Corporation will not be required to comply until its fiscal year ending December 31, 2010.

Monterey County Bank

Both federal and state laws provide extensive regulation of the banking business.  State and federal statutes and regulations apply to many aspects of the Bank’s operations, including minimum capital requirements, reserves against deposits, interest rates payable on deposits, loans, investments, mergers and acquisitions, borrowings, dividends and locations of branch offices. The DFI and the FDIC provide primary supervision, periodic examination and regulation of the Bank.

The FDIC, through its Deposit Insurance Fund (the “DIF”), insures the Bank’s deposits.  Previously, the maximum deposit insurance coverage was $100,000 per depositor, except that individual retirement accounts were insured up to a maximum of $250,000 per depositor.  Effective

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November 21, 2008 and until December 31, 2013, the FDIC expanded deposit insurance limits under the FDIC’s TLGP to $250,000 per depositor for certain accounts and unlimited coverage for noninterest-bearing transaction accounts held at financial institutions which have not opted out of the Program. On January 1, 2014, these increased limits on deposit insurance coverage will return to $100,000 for all deposit categories except individual retirement accounts and certain other retirement accounts, which will continue to be insured up to $250,000 per depositor.  For this protection, the Bank, like all insured banks, pays a quarterly statutory assessment and is subject to the rules and regulations of the FDIC.  Although the Bank is not a member of the Federal Reserve System, certain regulations of the Federal Reserve Board also apply to its operations.

California law restricts the amount available for cash dividends by state-chartered banks to the lesser of retained earnings or the bank’s net income for its last three fiscal years (less any distributions to shareholders made during such period).  Cash dividends may also be paid in an amount not exceeding the net income for such bank’s last preceding fiscal year after obtaining the prior approval of the Commissioner.  The FDIC also has authority to prohibit the Bank from engaging in unsafe or unsound practices.  The FDIC can use this power, under certain circumstances, to restrict or prohibit a bank from paying dividends.

Federal law imposes restrictions on banks with regard to transactions with affiliates, including any extensions of credit to, or the issuance of a guarantee or letter of credit on behalf of, its affiliates, as well as the purchase of or investments in stock or other securities thereof, or the taking of such securities as collateral for loans, and the purchase of assets from affiliates.  These restrictions have the effect of preventing affiliates (such as the Corporation) from borrowing from the Bank unless the loans are secured by marketable obligations of designated amounts.  Secured loans and investments by the Bank are limited to 10% of the Bank’s capital and surplus (as defined by federal regulations) in the case of any one affiliate, and 20% thereof in the case of all affiliates.  California law also imposes certain restrictions with respect to transactions involving other controlling persons of the Bank.

From time to time, legislation is enacted which has the effect of increasing the cost of doing business, limiting or expanding permissible activities or affecting the competitive balance between banks and other financial intermediaries.  Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies and other financial intermediaries are frequently made in Congress, in the California legislature and before various bank regulatory and other professional agencies. The Bank cannot predict what, if any legislation or regulations will be enacted, or the impact thereof on its business and profitability.

Capital Adequacy Standards

Government agencies have traditionally regulated bank capital through explicit and implicit guidelines and rules.  State law requires “adequate” capital, without objective definition.  Federal law and regulations require minimum levels of risk-based and so-called “Leverage” capital.

FDIC guidelines implement the risk-based capital requirements. The guidelines establish a systematic analytical framework that makes regulatory capital requirements more sensitive to differences in risk profiles (using the rough measures set forth therein) among banking organizations, take certain off-balance sheet items into account in assessing capital adequacy and minimize disincentives to holding liquid, low-risk assets. Under these guidelines, assets and credit equivalent amounts of off-balance sheet items, such as letters of credit and outstanding loan

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commitments, are assigned to one of several risk categories, which range from 0% for risk-free assets, such as cash and certain U.S. government securities, to 100% for relatively high-risk assets, such as loans and investments in fixed assets, premises and other real estate owned. The aggregate dollar amount of each category is then multiplied by the risk-weight associated with that category. The resulting weighted values from each of the risk categories are then added together to determine the total risk-weighted assets.

A banking organization’s risk-based capital ratios are obtained by dividing its qualifying capital by its total risk adjusted assets, including dollar equivalents for certain off-balance sheet assets.

The guidelines require a minimum ratio of qualifying total capital to risk-weighted assets of 8%, of which at least 4% must consist of Tier I capital.  Higher risk-based ratios are required to be considered “well capitalized” under prompt corrective action provisions.

A banking organization’s qualifying total capital consists of two components: Tier 1 capital (core capital) and Tier 2 capital (supplementary capital).  Tier 1 capital consists primarily of common stock, related surplus and retained earnings, qualifying noncumulative perpetual preferred stock and minority interests in the equity accounts of consolidated subsidiaries. Trust preferred securities qualify as Tier 1 capital up to a maximum of 25% of capital for holding companies only.  Any additional portion will qualify as Tier 2 capital for holding companies only.  Intangibles, such as goodwill, are generally deducted from Tier 1 capital; however, purchased mortgage servicing rights and purchased credit card relationships may be included, subject to certain limitations. At least 50% of the banking organization’s total regulatory capital must consist of Tier 1 capital.

Tier 2 capital may consist of (i) the allowance for loan and lease losses in an amount up to 1.25% of risk-weighted assets; (ii) cumulative perpetual preferred stock and long-term preferred stock and related surplus; (iii) hybrid capital instruments (instruments with characteristics of both debt and equity), perpetual debt and mandatory convertible debt securities; and (iv) eligible term subordinated debt and intermediate-term preferred stock with an original maturity of five years or more, including related surplus, in an amount up to 50% of Tier 1 capital. The inclusion of the foregoing elements of Tier 2 capital is subject to certain requirements and limitations of the federal banking agencies.

The FDIC imposes a minimum leverage ratio of Tier I capital to average total assets of 3% for the highest rated banks, and 4% for all other banks.  Institutions experiencing or anticipating significant growth or those with other than minimum risk profiles are expected to maintain capital at least 100-200 basis points above the minimum level.

In addition, the FRB and the FDIC have issued or proposed rules to take account of interest rate risk, concentration of credit risk and the risks of nontraditional activities in calculating risk-based capital.

For capital adequacy purposes, deferred tax assets that can be realized from taxes paid in prior carry-back years, and from the future reversal of temporary differences, are generally unlimited.  However, deferred tax assets that can only be realized through future taxable earnings, including the implementation of a tax planning strategy, count toward regulatory capital purposes only up to the lesser of (i) the amount that can be realized within one year of the quarter-end report date or (ii) 10% of Tier I capital.  The amount of deferred taxes in excess of this limit, if any, would be deducted from Tier I capital and total assets in regulatory capital calculations.

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Effective January 17, 1995, the federal banking agencies issued a final rule relating to capital standards and the risks arising from the concentration of credit and nontraditional activities.  Institutions which have significant amounts of their assets concentrated in high risk loans or nontraditional banking activities and who fail to adequately manage these risks, will be required to set aside capital in excess of the regulatory minimums.  The federal banking agencies have not imposed any quantitative assessment for determining when these risks are significant, but have identified these issues as important factors they will review in assessing an individual bank’s capital adequacy.  Management of the Corporation does not believe that the Bank’s assets and activities, as currently structured, would lead the FDIC to require additional capital under this rule.

Future changes in regulations or practices could further reduce the amount of capital recognized for purposes of capital adequacy.  Such a change could affect the ability of the Bank to grow and could restrict the amount of profits, if any, available for the payment of dividends.

Prompt Corrective Action and Other Enforcement Mechanisms

Under Section 38 of the Federal Deposit Insurance Act (“FDIA”), as added by the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), each federal banking agency is required to implement a system of prompt corrective action for institutions which it regulates.  The federal banking agencies have promulgated substantially similar regulations to implement this system of prompt corrective action.  Under the regulations, an institution shall generally be deemed to be: (i) “well capitalized” if it has a total risk-based capital ratio of 10.0% or more, has a Tier I risk-based capital ratio of 6.0% or more, has a Tier I leverage capital ratio of 5.0% or more and is not subject to specified requirements to meet and maintain a specific capital level for any capital measure; (ii) “adequately capitalized” if it has a total risk-based capital ratio of 8.0% or more, a Tier I risk-based capital ratio of 4.0% or more and a Tier I leverage capital ratio of 4.0% or more (3.0% under certain circumstances) and does not meet the definition of “well capitalized;” (iii) “undercapitalized” if it has a total risk-based capital ratio that is less than 8.0%, a Tier I risk-based capital ratio that is less than 4.0% or a Tier I leverage capital ratio that is less than 4.0% (3.0% under certain circumstances); (iv) “significantly undercapitalized” if it has a total risk-based capital ratio that is less than 6.0%, a Tier I risk-based capital ratio that is less than 3.0% or a Tier I leverage capital ratio that is less than 3.0%; and (v) “critically undercapitalized” if it has a ratio of tangible equity to total assets that is equal to or less than 2.0%.

Section 38 of the FDIA and the implementing regulations also provide that a federal banking agency may, after notice and an opportunity for a hearing, reclassify a well capitalized institution as adequately capitalized and may require an adequately capitalized institution or an undercapitalized institution to comply with supervisory actions as if it were in the next lower category if the institution is in an unsafe or unsound condition or engaging in an unsafe or unsound practice.  (The FDIC may not, however, reclassify a significantly undercapitalized institution as critically undercapitalized.)

An institution generally must file a written capital restoration plan which meets specified requirements, as well as a performance guaranty by each company that controls the institution, with the appropriate federal banking agency within 45 days of the date that the institution receives notice or is deemed to have notice that it is undercapitalized, significantly undercapitalized or critically undercapitalized.  Immediately upon becoming undercapitalized, an institution shall become subject to the provisions of Section 38 of the FDIA, which sets forth various mandatory and discretionary restrictions on its operations.

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At December 31, 2009, the Bank met the tests to be categorized as “well capitalized” under the prompt corrective action regulations of the FDIC.

Safety and Soundness Standards

Federal law requires the federal banking regulatory agencies to prescribe, by regulation, standards for all insured depository institutions relating to: (i) internal controls, information systems and internal audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) interest rate risk exposure; (v) asset growth; and (vi) compensation, fees and benefits.  The federal banking agencies recently adopted final regulations and Interagency Guidelines Prescribing Standards for Safety and Soundness (the “Guidelines”) to implement safety and soundness standards required by the FDIA.  The Guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired.  The agencies also proposed asset quality and earnings standards which, if adopted in final, would be added to the Guidelines.  Under the final regulations, if the FDIC determines that the Bank fails to meet any standard prescribed by the Guidelines, the agency may require the Bank to submit to the agency an acceptable plan to achieve compliance with the standard, as required by the FDIA.  The final regulations establish deadlines for the submission and review of such safety and soundness compliance plans.

FDIC Insurance and Insurance Assessments

Banks and thrifts have historically paid varying amounts of premiums on deposits for federal deposit insurance depending upon a risk-based system which evaluated the institution’s regulatory and capital adequacy ratings.  The FDIC operated two separate insurance funds, the Bank Insurance Fund (“BIF”) and the Savings Association Insurance Fund (“SAIF”).

As a result of the Federal Deposit Insurance Reform Act of 2006 and regulations adopted by the FDIC effective as of November 2, 2007: (i) the BIF and the SAIF have been merged into the Deposit Insurance Fund (the “DIF”); (ii) the $100,000 insurance level has been indexed to reflect inflation (the first adjustment for inflation will be effective January 1, 2011 and thereafter adjustments will occur every 5 years); (iii) deposit insurance coverage for retirement accounts has been increased to $250,000, and will also be subject to adjustment every five years; (iv) banks that historically have capitalized the BIF are entitled to a one-time credit which can be used to off-set premiums otherwise due (this addresses the fact that institutions that have grown rapidly have not had to pay deposit premiums); (v) a cap on the level of the DIF has been imposed and dividends will be paid when the DIF grows beyond a specified threshold; and (vi) the previous risk-based system for assessing premiums has been revised.

Effective January 1, 2007, the FDIC utilized a risk-based assessment system to set semi-annual insurance premium assessments which categorizes banks into four risk categories based on capital levels and supervisory “CAMELS” ratings and named them Risk Categories I, II, III and IV.  The “CAMELS” rating system is based upon an evaluation of the five critical elements of an institution’s operations: Capital adequacy, Asset quality, Management, Earnings, Liquidity, and Sensitivity to risk.  This rating system is designed to take into account and reflect all significant financial and operational factors financial institution examiners assess in their evaluation of an institution’s performance.  The following table sets forth these four Risk Categories:

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Within Risk Category I, the assessment system combines supervisory ratings with other risk measures to differentiate risk.  For most institutions, the assessment system combines CAMELS component ratings with financial ratios to determine an institution’s assessment rate.  For large institutions that have long-term debt issuer ratings, the new assessment system differentiates risk by combining CAMELS component ratings with those ratings.  For large institutions within Risk Category I, initial assessment rate determinations may be modified within limits upon review of additional relevant information.  The new assessment system assess those within Risk Category I that pose the least risk a minimum assessment rate and those that pose the greatest risk a maximum assessment rate that is two basis points higher.  An institution that poses an intermediate risk within Risk Category I will be charged a rate between the minimum and maximum that will vary incrementally by institution.

On February 27, 2009, the FDIC adopted final rules modifying the risk-based assessment system and setting initial base assessment rates that began on April 1, 2009.  Under these new rules, risk assessments for small Risk Category I institutions and large Risk Category I institutions with no long-term debt rating will include a consideration of such institution’s adjusted brokered deposit ratio. The adjusted brokered deposit ratio affects institutions whose brokered deposits are more than 10% of domestic deposits and whose total assets are more than 40% greater than they were four years previously. The adjusted brokered deposit ratio excludes certain reciprocal deposits for institutions in Risk Category I. Brokered deposits that consist of balances swept into an insured institution are included in the adjusted brokered deposit ratio for all institutions.

Further, the new rules revised the method for calculating the assessment rate for a large Risk Category I institution with a long-term debt issuer rating so that it equally weights the institution’s weighted average CAMELS component ratings, its long-term debt issuer ratings and the financial ratios method assessment rate. The final rule updates the uniform amount and the pricing multipliers for the weighted average CAMELS component ratings and financial ratios method. It also increases the maximum possible large bank adjustment from 0.5 basis point to 1.0 basis point.

These new rules set forth three possible adjustments to an institution’s initial base assessment rate: (i) a decrease of up to five basis points for long-term unsecured debt, including senior unsecured debt (other than debt guaranteed under the Temporary Liquidity Guarantee Program) and subordinated debt and, for small institutions, a portion of Tier 1 capital; (ii) an increase not to exceed 50% of an institution’s assessment rate before the increase for secured liabilities in excess of 25% of domestic deposits; and (ii) for non-Risk Category I institutions, an increase not to exceed 10 basis points for brokered deposits in excess of 10% of domestic deposits.

Under these new rules, the FDIC adopted new initial base assessment rates as of April 1, 2009, as follows, expressed in terms of cents per $100 in insured deposits:

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Initial Base Assessment Rates

*Initial base rates that were not the minimum or maximum rate will vary between these rates.

After applying all possible adjustments, minimum and maximum total base assessment rates for each Risk Category are as follows:

Total Base Assessment Rates

* All amounts for all risk categories are in basis points annually. Total base rates that are not the minimum or maximum rate will vary between these rates.

In addition, on February 27, 2009, the FDIC adopted an interim rule that imposed a 20 basis point emergency special assessment on all insured depository institutions on June 30, 2009. The special assessment was collected on September 30, 2009, at the same time that the risk-based assessments for the second quarter of 2009 were collected. The interim rule also permits the FDIC to impose an emergency special assessment of up to 10 basis points on all insured depository institutions whenever, after June 30, 2009, the FDIC estimates that the DIF reserve ratio will fall to a level that the FDIC believes would adversely affect public confidence or to a level close to zero or negative at the end of a calendar quarter.

Effective November 21, 2008 and until December 31, 2009, the FDIC expanded deposit insurance limits for certain accounts under the FDIC’s TLGP.  Provided an institution has not opted out of the Temporary Liquidity Guarantee Program, the FDIC may (i) guarantee, through the earlier of maturity or June 30, 2012, certain newly issued senior unsecured debt issued by participating institutions on or after October 14, 2008 and before June 30, 2009 and (ii) provide full FDIC deposit insurance coverage for noninterest-bearing transaction deposit accounts, Negotiable Order of Withdrawal (“NOW”) accounts paying less than 0.5% interest per annum and Interest on Lawyers Trust Accounts (IOLTAs) held at participating FDIC-insured institutions through December 31, 2009. On May 20, 2009, the Helping Families Save Their Homes Act extended the temporary increase in the standard maximum deposit insurance amount to $250,000 per depositor through December 31, 2013. The standard maximum deposit insurance amount will return to $100,000 on January 1, 2014. The fee assessment for coverage of senior unsecured debt ranges from 50 basis points to 100 basis points per annum, depending on the initial maturity of the debt. The fee assessment for deposit insurance coverage is 10 basis points per quarter on amounts in covered accounts exceeding $250,000.  On February 10, 2009, the U.S. Treasury extended the TLGP to October 31, 2009 pursuant to the Financial Stability Plan - Capital Assistance Program.  On August 26, 2009, the FDIC extended the TAGP portion of the TLGP for an additional six months, through June 30, 2010.  The Bank has not opted out of the TLGP.

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Effective November 17, 2009 the FDIC amended its regulations requiring insured institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009, and for all of 2010, 2011, and 2012.  The prepaid assessment for these periods were collected on December 30, 2009, along with each institution’s regular quarterly risk-based deposit insurance assessment for the third quarter of 2009.  For purposes of estimating an institution’s assessments for the fourth quarter of 2009, and for all of 2010, 2011, and 2012, and calculating the amount that an institution will prepay on December 30, 2009, the institution’s assessment rate was its total base assessment rate in effect on September 30, 2009.  On September 29, 2009, the FDIC increased annual assessment rates uniformly by 3 basis points beginning in 2011.  As a result, an institution’s total base assessment rate for purposes of estimating an institution’s assessment for 2011 and 2012 will be increased by an annualized 3 basis points beginning in 2011.  Again for purposes of calculating the amount that an institution prepaid on December 30, 2009, an institution’s third quarter 2009 assessment base was increased quarterly at a 5% annual growth rate through the end of 2012.  The FDIC will begin to draw down an institution’s prepaid assessments on March 30, 2010, representing payment for the regular quarterly risk-based assessment for the fourth quarter of 2009.  The Bank’s prepaid assessment totaled $1,816,000 and was paid on December 31, 2009.

The FDIC may terminate its insurance of deposits if it finds that the Bank has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC.

The Financing Corporation (“FICO”), established by the Competitive Equality Banking Act of 1987, is a mixed-ownership government corporation whose sole purpose was to function as the financing vehicle for the Federal Savings and Loan Insurance Corporation.  Effective December 12, 1991, as provided by the Resolution Trust Corporation Refinancing, Restructuring and Improvement Act of 1991, FICO’s ability to issue new debt was terminated.  Outstanding FICO bonds, which are 30-year non-callable bonds with a principal amount of approximately $8.1 billion, mature in 2017 through 2019.

FICO has assessment authority, separate from the FDIC’s authority to assess risk-based premiums for deposit insurance, to collect funds from FDIC-insured institutions sufficient to pay interest on FICO bonds.  The FDIC acts as collection agent for FICO.  The FICO assessment rate is adjusted quarterly to reflect changes in the assessment basis of the respective funds based on the quarterly Call Report and the Thrift Financial Report submissions.  The FICO rates are expressed as basis points per $100 of deposits.  The FICO quarterly rates for 2009 were 0.285, 0.26, 0.26 and 0.255.  The FICO quarterly rate for the first and second quarters of 2010 is 0.265 and 0.26, respectively.

Interstate Banking and Branching

On September 29, 1994, the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the “Interstate Act”) was signed into law.  Under the Interstate Act, beginning one year after the date of enactment, a bank holding company that is adequately capitalized and managed may obtain regulatory approval to acquire an existing bank located in another state without regard to state law.  A bank holding company would not be permitted to make such an acquisition if, upon consummation, it would control (a) more than 10% of the total amount of deposits of insured depository institutions in the United States or (b) 30% or more of the deposits in the state in which the bank is located.  A state may limit the percentage of total deposits that may be held in that state by any one bank or bank holding company if application of such limitation does not discriminate against out-of-state banks.  An out-of-state bank holding company may not acquire a state bank in

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existence for less than a minimum length of time that may be prescribed by state law except that a state may not impose more than a five year existence requirement.

The Interstate Act also permitted, effective June 1, 1997, mergers of insured banks located in different states and conversion of the branches of the acquired bank into branches of the resulting bank.  Each state may adopt legislation to prohibit interstate mergers after June 1, 1997 in that state or in other states by that state’s banks.  The same concentration limits discussed in the preceding paragraph apply.  The Interstate Act also permits a national or state bank to establish branches in a state other than its home state if permitted by the laws of that state, subject to the same requirement and conditions as for a merger transaction.

The Interstate Act has increased competition in the Bank’s market areas, especially from larger financial institutions and their holding companies.

On October 2, 1995, the “California Interstate Banking and Branching Act of 1995” (the “1995 Act”) became effective.  The 1995 Act generally allows out-of-state banks to enter California by merging with, or purchasing, a California bank or industrial loan company which is at least five years old.

Community Reinvestment Act and Fair Lending Developments

The Bank is subject to certain fair lending requirements, reporting obligations involving home mortgage lending operations and Community Reinvestment Act (the “CRA”).  The CRA generally requires the federal banking agencies to evaluate the record of financial institutions in meeting the credit needs of their local community, including low and moderate income neighborhoods.  In addition to substantial penalties and corrective measures that may be required for a violation of certain fair lending laws, the federal banking agencies may take compliance with such laws and CRA into account when regulating and supervising other activities.

In May, 1995, the federal banking agencies issued final regulations which change the manner in which they measure a bank’s compliance with its CRA obligations.  The final regulations adopt a performance-based evaluation system which bases CRA ratings on an institution’s actual lending service and investment performance rather than the extent to which the institution conducts needs assessments, documents community outreach or complies with other procedural requirements.  In March 1994, the Federal Interagency Task Force on Fair Lending issued a policy statement on discrimination in lending.  The policy statement describes the three methods that federal agencies will use to prove discrimination: overt evidence of discrimination, evidence of disparate treatment and evidence of disparate impact.  Following the Bank’s most recent CRA examination, the Bank’s rating was “needs to improve.”  The rating is due primarily to issues related to the Bank’s third party vendor programs.

Other Regulations and Policies

The federal regulatory agencies have adopted regulations that implement Section 304 of FDICIA which requires federal banking agencies to adopt uniform regulations prescribing standards for real estate lending.  Each insured depository institution must adopt and maintain a comprehensive written real estate lending policy, developed in conformance with prescribed guidelines, and each agency has specified loan-to-value limits in guidelines concerning various categories of real estate loans.

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Section 24 of the FDIA, as amended by the FDICIA, generally limits the activities and equity investments of FDIC-insured, state-chartered banks to those that are permissible for national banks.  Under regulations dealing with equity investments, an insured state bank generally may not directly or indirectly acquire or retain any equity investment of a type, or in an amount, that is not permissible for a national bank.  An insured state bank is not prohibited from, among other things, (i) acquiring or retaining a majority interest in a subsidiary, (ii) investing as a limited partner in a partnership the sole purpose of which is direct or indirect investment in the acquisition, rehabilitation or new construction of a qualified housing project, provided that such limited partnership investments may not exceed 2% of the bank’s total assets, (iii) acquiring up to 10% of the voting stock of a company that solely provides or reinsures directors’, trustees’ and officers’ liability insurance coverage or bankers’ blanket bond group insurance coverage for insured depository institutions, and (iv) acquiring or retaining the voting shares of a depository institution if certain requirements are met.

FDIC regulations implementing Section 24 of the FDIA provide that an insured state-chartered bank may not, directly, or indirectly through a subsidiary, engage as “principal” in any activity that is not permissible for a national bank unless the FDIC has determined that such activities would pose no risk to the insurance fund of which it is a member and the bank is in compliance with applicable regulatory capital requirements.  Any insured state-chartered bank directly or indirectly engaged in any activity that is not permitted for a national bank must cease the impermissible activity.

Effect of Governmental Monetary Policies

The Corporation’s earnings are affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies.  The Federal Reserve’s monetary policies have had, and are likely to continue to have, an important impact on the operating results of commercial banks through the Federal Reserve’s statutory power to implement national monetary policy in order, among other things, to curb inflation or combat a recession.  The Federal Reserve, through its monetary and fiscal policies, affects the levels of the Bank’s loans, investments and deposits through its control over the issuance of United States government securities, its regulation of the discount rate applicable to member banks and its influence over reserve requirements to which member banks are subject.  We cannot predict the nature or impact of future changes in monetary and fiscal policies.

The actions of the FRB in these areas influence the growth of bank loans, investments, and deposits and also affect market interest rates.  From January 2001 to June 2003, the FRB decreased interest rates numerous times, reducing the overnight “Federal Funds” rate from 6.50% to 1.00%, the lowest level in four decades.  From June 2004 to June 2006, the FRB reversed direction and increased rates 17 times to 5.25%.  From September 2007 through December 2008, the FRB reduced rates ten times to their current level of 0.00%.  The nature and timing of any future changes in such policies and their impact on the Corporation cannot be predicted.  However, depending on the degree to which the Bank’s interest-earning assets and interest-bearing liabilities are rate sensitive, increases in rates would have a temporary effect of increasing the Bank’s net interest margin, while decreases in interest rates would have the opposite effect.  In addition, adverse economic conditions, including a downturn in the local or regional economy and rising energy prices, have made a higher provision for loan losses a prudent course and have caused higher loan charge-offs, thus adversely affecting the Corporation’s net income or other operating costs.

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Financial Modernization Act

Effective March 11, 2000, the Gramm-Leach-Bliley Act eliminated most barriers to affiliations among banks and securities firms, insurance companies, and other financial service providers, and enabled full affiliations to occur between such entities.  This legislation permits bank holding companies to become “financial holding companies” and thereby acquire securities firms and insurance companies and engage in other activities that are financial in nature.  A bank holding company may become a financial holding company if each of its subsidiary banks is well capitalized under the prompt corrective action provisions discussed above, is well managed, and has at least a satisfactory rating under the CRA by filing a declaration that the bank holding company wishes to become a financial holding company.  No regulatory approval will be required for a financial holding company to acquire a company, other than a bank or savings association, engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the FRB.  The Corporation has no current intention of becoming a financial holding company, does not currently qualify to do so, but may do so at some point in the future if deemed appropriate in view of opportunities or circumstances at the time.

The Gramm-Leach-Bliley Act defines “financial in nature” to include securities underwriting, dealing and market making; sponsoring mutual funds and investment companies; insurance underwriting and agencies; merchant banking activities; and activities that the FRB has determined to be closely related to banking.  A national bank (and therefore, a state bank as well) may also engage, subject to limitations on investment, in activities that are financial in nature, other than insurance underwriting, insurance company portfolio investment, real estate development and real estate investment, through a financial subsidiary of the bank, if the bank is well capitalized, well managed and has at least a satisfactory CRA rating.  Subsidiary banks of a financial holding company or national banks with financial subsidiaries must continue to be well capitalized and well managed in order to continue to engage in activities that are financial in nature without regulatory actions or restrictions, which could include divestiture of the financial in nature subsidiary or subsidiaries.  In addition, a financial holding company or a bank may not acquire a company that is engaged in activities that are financial in nature unless each of the subsidiary banks of the financial holding company or the bank has a CRA rating of satisfactory or better.

The Gramm-Leach-Bliley Act also imposed significant new requirements on financial institutions with respect to the privacy of customer information, and modified other laws, including those related to community reinvestment.

USA Patriot Act of 2001

The USA Patriot Act of 2001, enacted in response to the terrorist attacks in New York, Pennsylvania and Washington, D.C. on September 11, 2001, is intended to strengthen U.S. law enforcement’s and the intelligence communities’ ability to work cohesively to combat terrorism on a variety of fronts.  The impact of the USA Patriot Act on financial institutions of all kinds has been significant and wide ranging.  The USA Patriot Act contains sweeping anti-money laundering and financial transparency laws and requires various regulations applicable to financial institutions, including:

·                                          due diligence requirements for financial institutions that administer, maintain, or manage private bank accounts or correspondent accounts for non-U.S. persons;

·                                          standards for verifying customer identification at account opening; and

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·                                          rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.

The Bank implemented the requirements under the USA Patriot Act during 2001 and 2002.  Compliance with such requirements has all been accomplished with existing staff, so the financial impact on the Bank has been negligible.

Regulatory Enforcement Powers

Commercial banking organizations, such as the Bank, may be subject to enforcement actions by the FDIC and the DFI for engaging in unsafe or unsound practices in the conduct of their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency.  Enforcement actions may include the imposition of a conservator or receiver, the issuance of a cease-and-desist order that can be judicially enforced, the termination of insurance of deposits, the imposition of civil money penalties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the issuance of removal and prohibition orders against institution-affiliated parties and the imposition of restrictions and sanctions under the prompt corrective action provisions of the FDICIA.

The FDIC requested the Bank consent to a regulatory order resulting from its 2008 Consumer Compliance Examination, which was completed in 2009.  The Bank disputes various provisions in the proposed order and is consulting with legal counsel regarding the issues at dispute.  As a result of the Bank’s refusal to sign the order in accord with the FDIC’s time frame, the FDIC has indicated to the Bank that it will proceed with the Administrative Hearing process to issue the order. The FDIC is asserting that three credit and debit card programs operated by third-party vendors violated certain provisions of Federal law, which the Bank disputes, and the FDIC is demanding that the Bank make restitution to affected customers and be subjected to a civil money penalty as a result of the alleged violations.  The Bank also believes that restitution and civil money penalty are inappropriate under the circumstances.  The FDIC is presently investigating the Bank’s involvement in the subject card programs utilizing its subpoena powers pursuant to statutory authority.  The financial and non-financial impact of this matter is not known as of the balance sheet date and as of the issuance date of this report.

California and Federal Change in Bank Control Laws

The Federal Change in Bank Control Act of 1978 prohibits a person or group of persons “acting in concert” from acquiring “control” of a bank or holding company unless the appropriate federal regulatory agency has been given 60 days’ prior written notice of such proposed acquisition and, within that time period, has not issued a notice disapproving the proposed acquisition or extending for up to another 30 days the period during which such a disapproval may be issued. An acquisition may be made prior to the expiration of the disapproval period if the agency issues written notice of its intent not to disapprove the action.  The acquisition of more than 10% of a class of voting stock of a bank (or holding company) with a class of securities registered under Section 12 of the Securities Exchange Act of 1934, as amended (such as the Common stock), is generally presumed, subject to rebuttal, to constitute the acquisition of control.

Under the California Financial Code, no person shall, directly or indirectly, acquire control of a California licensed bank or a bank holding company unless the DFI has approved such acquisition of control.  A person would be deemed to have acquired control of the Corporation

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under this state law if such person, directly or indirectly, has the power (i) to vote 25% or more of the voting power of the Corporation or (ii) to direct or cause the direction of the management and policies of the Corporation.  For purposes of this law, a person who directly or indirectly owns or controls 10% or more of the Common stock would be presumed to control the Corporation, subject to rebuttal.

In addition, any “company” would be required to obtain the approval of the Federal Reserve under the Bank Holding Company Act of 1956, as amended (the “BHC Act”), before acquiring 25% (5% in the case of an acquirer that is, or is deemed to be, a bank holding company) or more of the outstanding Common stock of, or such lesser number of shares as constitute control over, the Bank or the Corporation.

RESEARCH

Neither the Corporation nor the Bank makes any material expenditures for research and development.

DEPENDENCE UPON A SINGLE CUSTOMER

Neither the Corporation nor the Bank is dependent upon a single customer or very few customers.  The Bank’s business is concentrated in, and largely dependent upon the strength of the local economy in, the Monterey Peninsula area of Northern California.  The local economy is affected by both national trends and by local factors.  Tourism and the activities at the former Fort Ord military base are among the major contributors to the local economy.

ITEM 1A.  RISK FACTORS

DIFFICULT CONDITIONS IN THE CAPITAL MARKETS AND THE ECONOMY GENERALLY MAY MATERIALLY ADVERSELY AFFECT OUR BUSINESS AND RESULTS OF OPERATIONS.

Our results of operations are materially affected by conditions in the capital markets and the economy generally. The capital and credit markets have been experiencing extreme volatility and disruption for more than twelve months at unprecedented levels. In many cases, these markets have produced downward pressure on stock prices of, and credit availability to, certain companies without regard to those companies’ underlying financial strength.

Recently, concerns over inflation, energy costs, geopolitical issues, the availability and cost of credit, the U.S. mortgage market and a declining U.S. real estate market have contributed to increased volatility and diminished expectations for the economy and the capital and credit markets going forward.  These factors, combined with volatile oil prices, declining business and consumer confidence and increased unemployment, have precipitated an economic slowdown and national recession.  In addition, the fixed-income markets are experiencing a period of extreme volatility which has negatively impacted market liquidity conditions.  Initially, the concerns on the part of market participants were focused on the subprime segment of the mortgage-backed securities market.  However, these concerns have since expanded to include a broad range of mortgage-and asset-backed and other fixed income securities, including those rated investment grade, the U.S. and international credit and interbank money markets generally, and a wide range of financial institutions and markets, asset classes and sectors.

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Factors such as consumer spending, business investment, government spending, the volatility and strength of the capital markets, and inflation all affect the business and economic environment and, ultimately, the amount and profitability of our business. In an economic downturn characterized by higher unemployment, lower family income, lower corporate earnings, lower business investment and lower consumer spending, the demand for our financial products could be adversely affected. Adverse changes in the economy could affect earnings negatively and could have a material adverse effect on our business, results of operations and financial condition.  The current mortgage crisis and economic slowdown has also raised the possibility of future legislative and regulatory actions in addition to the enactment of EESA that could further impact our business. We cannot predict whether or when such actions may occur, or what impact, if any; such actions could have on our business, results of operations and financial condition.

THERE CAN BE NO ASSURANCE THAT ACTIONS OF THE U.S. GOVERNMENT, FEDERAL RESERVE AND OTHER GOVERNMENTAL AND REGULATORY BODIES FOR THE PURPOSE OF STABILIZING THE FINANCIAL MARKETS WILL ACHIEVE THE INTENDED EFFECT.

In response to the financial crises affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions, on October 3, 2008, President Bush signed EESA into law.  Pursuant to EESA, the U.S. Treasury has the authority to utilize up to $700 billion to purchase distressed assets from financial institutions or infuse capital into financial institutions for the purpose of stabilizing the financial markets.  The U.S. Treasury announced the Capital Purchase Program under EESA pursuant to which it has purchased and will continue to purchase senior preferred stock in participating financial institutions such as the Corporation.  There can be no assurance, however, as to the actual impact that EESA, including the Capital Purchase Program and the Treasury’s Troubled Asset Repurchase Program, will have on the financial markets or on us.  The failure of these programs to help stabilize the financial markets and a continuation or worsening of current financial market conditions could materially and adversely affect our business, financial condition, results of operations, access to credit or the trading price of our common stock.

The federal government, Federal Reserve and other governmental and regulatory bodies have taken or are considering taking other actions to address the financial crisis.  There can be no assurance as to what impact such actions will have on the financial markets, including the extreme levels of volatility currently being experienced.  Such continued volatility could materially and adversely affect our business, financial condition and results of operations, or the trading price of our common stock.

WE WILL BE REQUIRED TO PAY SIGNIFICANTLY HIGHER FEDERAL DEPOSIT INSURANCE CORPORATION PREMIUMS IN THE FUTURE.

Recent insured institution failures, as well as deterioration in banking and economic conditions, have significantly increased FDIC loss provisions, resulting in a decline in the designated reserve ratio to historical lows.  The FDIC expects a higher rate of insured institution failures in the next few years compared to recent years; thus, the reserve ratio may continue to decline.  In addition, EESA temporarily increased the limit on FDIC coverage to $250,000 through December 31, 2013.  These developments have caused the premiums assessed to us by the FDIC to increase.

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On December 16, 2008, the FDIC Board of Directors determined deposit insurance assessment rates for the first quarter of 2009 at 12 to 14 basis points per $100 of deposits.  Beginning April 1, 2009, the rates increased to 12 to 16 basis points per $100 of deposits. Additionally, on February 27, 2009, the FDIC announced an interim rule imposing a 20 basis point special emergency assessment on June 30, 2009, payable September 30, 2009.  The special assessment for the Bank was $134,000. The interim rule also allows the FDIC to impose a special emergency assessment after June 30, 2009, of up to 10 basis points if necessary to maintain public confidence in FDIC insurance. These higher FDIC assessment rates and special assessments could have an adverse impact on our results of operations.

RECENT NEGATIVE DEVELOPMENTS IN THE FINANCIAL INDUSTRY AND THE CREDIT MARKETS MAY SUBJECT US TO ADDITIONAL REGULATION.

As a result of the recent global financial crisis, the potential exists for new federal or state laws and regulations regarding lending and funding practices and liquidity standards to be promulgated, and bank regulatory agencies are expected to be active in responding to concerns and trends identified in examinations, including the expected issuance of many formal enforcement orders.  Negative developments in the financial industry and the domestic and international credit markets, and the impact of new legislation in response to those developments, may negatively impact our operations by restricting our business operations, including our ability to originate or sell loans, and may adversely impact our financial performance.

THE GEOGRAPHIC CONCENTRATION OF OUR MARKETS MAKES OUR BUSINESS HIGHLY SUSCEPTIBLE TO LOCAL ECONOMIC CONDITIONS.

Unlike larger banking organizations that are more geographically diversified, our operations are currently concentrated in the Monterey Peninsula and Salinas, California markets. As a result of this geographic concentration, our financial results depend largely upon economic conditions in these market areas.  Deterioration in economic conditions in one or all of these markets could result in an increase in loan delinquencies, an increase in problem assets and foreclosures, a decrease in the demand for our products and services or a decrease in the value of collateral for loans, especially real estate, in turn reducing customers’ borrowing power, the value of assets associated with problem loans and collateral coverage.

FUTURE GROWTH OR OPERATING RESULTS MAY REQUIRE THE CORPORATION TO RAISE ADDITIONAL CAPITAL BUT THAT CAPITAL MAY NOT BE AVAILABLE OR IT MAY BE DILUTIVE.

The Corporation is required by federal and state regulatory authorities to maintain adequate levels of capital to support its operations.  To the extent the Corporation’s future operating results erode capital or the Corporation elects to expand through loan growth or acquisition it may be required to raise capital.  The Corporation’s ability to raise capital will depend on conditions in the capital markets, which are outside of its control, and on the Corporation’s financial performance. Accordingly, the Corporation cannot be assured of its ability to raise capital when needed or on favorable terms. If the Corporation cannot raise additional capital when needed, it will be subject to increased regulatory supervision and the imposition of restrictions on its growth and business.  These could negatively impact the Corporation’s ability to operate or further expand its operations through acquisitions or the establishment of additional branches and may result in increases in operating expenses and reductions in revenues that could have a material adverse effect on its financial condition and results of operations.

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THE CORPORATION’S ALLOWANCE FOR POSSIBLE LOAN LOSSES MAY BE INSUFFICIENT.

The Corporation maintains an allowance for possible loan losses, which is a reserve established through a provision for possible loan losses charged to expense that represents management’s best estimate of probable losses within the existing portfolio of loans.  The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio.   The level of the allowance reflects management’s continuing evaluation of industry concentrations; specific credit risks; loan loss experience; current loan portfolio quality; present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio.  The determination of the appropriate level of the allowance for possible loan losses inherently involves a high degree of subjectivity and requires management to make significant estimates of current credit risks and future trends, all of which may undergo material changes.  In addition, bank regulatory agencies periodically review the Corporation’s allowance for loan losses and may require an increase in the provision for possible loan losses or the recognition of further loan charge-offs, based on judgments different than those of management.  If charge-offs in future periods exceed the allowance for possible loan losses, the Corporation will need additional provisions to increase the allowance for possible loan losses.  Any increases in the allowance for possible loan losses will result in a decrease in net income and, possibly, capital, and may have a material adverse effect on the Corporation’s financial condition and results of operations.

THE CORPORATION IS SUBJECT TO INTEREST RATE RISK.

The Corporation’s earnings and cash flows are largely dependent upon its net interest income.  Net interest income is the difference between interest income earned on interest-earning assets such as loans and securities and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds.  Interest rates are highly sensitive to many factors that are beyond the Corporation’s control, including general economic conditions and policies of various governmental and regulatory agencies.  Changes in monetary policy, including changes in interest rates, could influence not only the interest the Corporation receives on loans and securities and the amount of interest it pays on deposits and borrowings, but such changes could also affect the Corporation’s ability to originate loans and obtain deposits and the fair value of the Corporation’s financial assets and liabilities.  If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, the Corporation’s net interest income, and earnings, could be adversely affected.  Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings.

THE CORPORATION IS SUBJECT TO ENVIRONMENTAL LIABILITY RISK ASSOCIATED WITH LENDING ACTIVITIES.

A significant portion of the Corporation’s loan portfolio is secured by real property.  During the ordinary course of business, the Corporation may foreclose on and take title to properties securing certain loans.  In doing so, there is a risk that hazardous or toxic substances could be found on these properties.  If hazardous or toxic substances are found, the Corporation may be liable for remediation costs, as well as for personal injury and property damage.  Environmental laws may require the Corporation to incur substantial expenses and may materially reduce the affected property’s value or limit the Corporation’s ability to use or sell the affected property.  In addition,

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future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase the Corporation’s exposure to environmental liability.  The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on the Corporation’s financial condition and results of operations.

THE CORPORATION IS SUBJECT TO EXTENSIVE GOVERNMENT REGULATION AND SUPERVISION.

The Corporation, primarily through the Bank, is subject to extensive federal and state regulation and supervision. Banking regulations are primarily intended to protect depositors’ funds, federal deposit insurance funds and the banking system as a whole, not shareholders. These regulations affect the Corporation’s lending practices, capital structure, investment practices, dividend policy and growth, among other things. Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes.  Changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect the Corporation in substantial and unpredictable ways.  Such changes could subject the Corporation to additional costs, limit the types of financial services and products the Corporation may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things.  Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on the Corporation’s business, financial condition and results of operations.

THE CORPORATION’S CONTROLS AND PROCEDURES MAY FAIL OR BE CIRCUMVENTED.

Management regularly reviews and updates the Corporation’s internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met.  Any failure or circumvention of the Corporation’s controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on the Corporation’s business, results of operations and financial condition.

THE CORPORATION’S INFORMATION SYSTEMS MAY EXPERIENCE AN INTERRUPTION OR BREACH IN SECURITY.

The Corporation relies heavily on communications and information systems to conduct its business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in the Corporation’s customer relationship management, general ledger, deposit, loan and other systems.  While the Corporation has policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of its information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed.  The occurrence of any failures, interruptions or security breaches of the Corporation’s information systems could damage the Corporation’s reputation, result in a loss of customer business, subject the Corporation to additional regulatory scrutiny, or expose the Corporation to civil litigation and possible financial liability, any of which could have a material adverse effect on the Corporation’s financial condition and results of operations.

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CHANGES IN TECHNOLOGY COULD BE COSTLY.

The banking industry is undergoing technological innovation.  In order to maintain its competitive position, the Corporation must react to these innovations and evaluate the technologies to enable it to compete on a cost-effective basis.  The cost of such technology, including personnel, may be high in both absolute and relative terms.  There can be no assurance, given the fast pace of change and innovation, that the Corporation’s technology will meet or continue to meet its needs.

THE TRADING VOLUME IN THE CORPORATION’S COMMON STOCK IS LESS THAN THAT OF OTHER LARGER FINANCIAL SERVICES COMPANIES.

Although the Corporation’s common stock is listed for trading on the Over The Counter Bulletin Board (OTCBB), the trading volume in its common stock is less than that of other larger financial services companies.  A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of willing buyers and sellers of the Corporation’s common stock at any given time.  This presence depends on the individual decisions of investors and general economic and market conditions over which the Corporation has no control.  Given the lower trading volume of the Corporation’s common stock, significant sales of the Corporation’s common stock, or the expectation of these sales, could cause the Corporation’s stock price to fall.

WE MAY NOT BE ABLE TO PAY DIVIDENDS IN THE FUTURE IN ACCORDANCE WITH PAST PRACTICES.

The Corporation may not be able to pay dividends in accordance with past practice.  The Corporation traditionally pays an annual dividend to shareholders.  The payment of dividends is subject to legal and regulatory restrictions and, therefore, any payment of dividends in the future will depend in large part on the Corporation’s earnings, capital requirements, financial conditions, liquid resources (including the ability to receive dividends from the Bank), and other factors considered relevant by the Corporation’s Board of Directors.

The Corporation has deferred interest payments on its subordinated debt securities, therefore it may not pay any dividends or distribution on its capital stock until the total deferred interest is paid.  Additionally the Corporation, prior to paying any dividend or distribution, must request the prior approval of the Federal Reserve Bank.

The Bank must request the prior approval of the FDIC and the DFI before paying any dividends to the Corporation.

ITEM 1B.                                       UNRESOLVED STAFF COMMENTS.

None.

ITEM 2.                                                PROPERTIES

The main branch office of the Bank, which also serves as the principal office of the Corporation, is located at 601 Munras Ave., Monterey, California 93940.  This facility contains a lobby, executive and customer service offices, teller stations, safe deposit boxes and related non-vault area, vault, operations area, lounge and miscellaneous areas.  A drive-through facility and adequate paved parking are also on the premises.  Both the land and all improvements thereto are

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owned by the Bank.

The Bank also owns a building located at 556 Abrego St., Monterey, California 93940, which houses a loan production office and additional office space.  The Bank currently operates four branch offices in Carmel-By-The-Sea, Carmel Valley, Pacific Grove and Salinas, California, all within approximately 20 miles from the Bank’s main office.  The land and improvements dedicated to the Carmel-By-The-Sea, Carmel Valley, Pacific Grove and Salinas branch offices are leased.  See Footnote 13 to the Corporation’s financial statements included herewith.

Generally, neither the Bank nor the Corporation may invest in equity interests in real estate, except for the direct use of the Bank or the Corporation in their business.  The Bank makes and/or purchases loans secured by real estate, subject to normal banking practices, its own policies and the restrictions described above under Item 1.

For a discussion of legal proceedings see Note 13, “Commitments and Contingencies” in the Consolidated Financial Statements.

Although the amount of any ultimate liability with respect to such proceedings cannot be determined, in the opinion of management, any such liability will not have a material effect on the consolidated financial position of the Corporation or the Bank.

PART II

The Corporation’s stock is traded on the OTCBB) a quotation service for securities not listed or traded on NASDAQ or a national securities exchange, under the stock symbol “NRLB.”  The Corporation also has knowledge of a limited number of transactions conducted between individual shareholders.

The Corporation currently has one company which makes a market for its common stock, Howe Barnes Hoeffer & Arnett.

At December 31, 2009, there were 530 record holders of common stock of the Corporation. This does not reflect the number of persons or entities who hold their stock in nominee or street name through various brokerage firms.

The Corporation repurchased 20,678 and 46,010 shares of common stock in 2009 and 2008, respectively, at an average price of $4.10 and $7.41 per share in 2009 and 2008, respectively; no shares were repurchased in 2007.

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The information in the following table indicates the high and low bid information and volume of trading for our Common Stock for each quarterly period since January 1, 2007, and is based upon information provided by the OTCBB.  The information does not include transactions for which no public records are available.  The OTCBB market quotations reflect inter-dealer prices, without retail mark-up, mark-down or commissions and may not necessarily represent actual transactions.

The principal source of cash flow of the Corporation, including cash flow to pay dividends on its stock or principal and interest on debt, is from interest and dividends on investments and tax benefit payments and dividends from the Bank.  There are statutory and regulatory limitations on the payment of dividends by the Bank to the Corporation, as well as by the Corporation to its shareholders.

If in the opinion of the applicable federal and/or state regulatory authority, a depository institution or holding company is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the depository institution or holding company, could include the payment of dividends), such authority may require, after notice and hearing (except in the case of an emergency proceeding where there is in no notice or hearing), that such institution or holding company cease and desist from such practice.  Moreover, the Federal Reserve and the FDIC have issued policy statements which provide that bank holding companies and insured depository institutions generally should only pay dividends out of current operating earnings.

Under the FDICIA, an FDIC insured depository institution may not pay any dividend if payment would cause it to become undercapitalized or once it is undercapitalized.

The Bank’s payment of dividends, as a California chartered commercial banking corporation, is also regulated by the California Financial Code.  Under the California Financial Code, funds available for cash dividend payments by the Bank are restricted to the lessor of: (i) retained earnings; or (ii) the Bank’s net income for its last three fiscal years (less any distributions

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to the shareholders made during such period).  As of December 31, 2009 the Bank had $16,347,000 in retained earnings.  The Bank’s net income for the last three fiscal years less distributions to shareholders was $6,577,000.

The Corporation did not pay a cash dividend in 2009.  In December 2008 and 2007 the Corporation paid cash dividends of $0.25 per share.  The Bank paid cash dividends totaling $500,000 and $800,000 to the Corporation during 2009 and 2007, respectively; no dividends were paid by the Bank in 2008.

The Corporation has deferred interest payments on its subordinated debt securities, therefore it may not pay any dividends or distribution on its capital stock until the total deferred interest is paid.  Additionally the Corporation, prior to paying any dividend or distribution, must request the prior approval of the Federal Reserve Bank.

The Bank must request the prior approval of the Federal Deposit Insurance Corporation and the California Department of Financial Institutions before paying any dividends to the Corporation.

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ITEM 6.                SELECTED FINANCIAL DATA

(1)         Basic earnings per share amounts were computed on the basis of the weighted average number of shares of common stock during the year.  The weighted average number of shares used for this computation was 1,791,218

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for 2009, 1,823,965 for 2008, 1,785,812 for 2007, 1,658,675 for 2006 and 1,614,196 for 2005.

(2)         Fully diluted earnings per share amounts were computed on the basis of the weighted average number of shares of common stock and common stock equivalents outstanding during the year.  Common stock equivalents include employee stock options.  The weighted average number of shares used for this computation was 1,795,764, 1,848,173, 1,881,004, 1,831,892 and 1,923,532 in 2009, 2008, 2007, 2006 and 2005, respectively.

(3)   Weighted average common shares.

(4)   Includes loans being held for sale.

(5)         Averages are of daily balances.

OVERVIEW

General

The following discussion reviews and analyzes the operating results and financial condition of the Corporation, focusing on the Bank.  It should be read in conjunction with the consolidated financial statements and the other financial data presented elsewhere herein.

Net income for each of the last three years was $1,611,000 in 2009, $1,462,000 in 2008, and $1,929,000 in 2007.  The net income per share for each of the last three years was $0.90, $0.80, and $1.08 respectively.  The diluted net income per share for the same time periods was $.90, $0.79 and $1.03, respectively.  Return on average shareholders’ equity was 9.98%, 10.67%, and 14.09% in 2009, 2008 and 2007, respectively.  Return on average assets was 0.55%, 0.54%, and 0.91% in 2009, 2008 and 2007, respectively.

The increase in earnings in 2009 compared to 2008 was due to an increase in noninterest income of $5,089,000 and a decrease of $940,000 in income tax expense, partially offset by a decrease of $1,804,000 in net interest income after provision for loan losses and an increase of $4,077,000 in noninterest expense.

The decrease in earnings in 2008 compared to 2007 was due to a decrease of $2,455,000 in net interest income after provision for loan losses, partially offset by an increase in noninterest income of $695,000, and decreases of $98,000 in noninterest expense and $1,195,000 in income tax expense.

Critical Accounting Policies

The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in the Corporation’s financial statements and accompanying notes.  Management believes that the judgments, estimates and assumptions used in preparation of the Corporation’s financial statements are appropriate given the factual circumstances as of December 31, 2009.

Various elements of the Corporation’s accounting policies, by their nature, are inherently subject to estimation techniques, valuation assumptions and other subjective assessments.  Critical accounting policies are those that involve the most complex and subjective decisions and

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assessments and have the greatest potential impact of the Corporation’s results of operations.  In particular, management has identified one accounting policy that, due to judgments, estimates and assumptions inherent in this policy, and the sensitivity of the Corporation’s consolidated financial statements to those judgments, estimates and assumptions, are critical to an understanding of the Corporation’s consolidated financial statements.  This policy relates to the methodology that determines the allowance for loan and lease losses.  Management has discussed the development and selection of this critical accounting policy with the Audit Committee of the Board of Directors.  Although Management believes the level of the allowance at December 31, 2009 is adequate to absorb losses inherent in the loan portfolio, a decline in the regional economy may result in increasing losses that cannot reasonably be predicted at this time.  For further information regarding the allowance for loan losses see “Provision and Allowance for Loan and Lease Losses,” and Note 6 to the Corporation’s audited consolidated financial statements included elsewhere herein.

Recently Issued Accounting Standards

Refer to Note 1 to the Financial Statements — “Summary of Significant Accounting Policies” for discussion of the recently issued accounting standards.

NET INTEREST INCOME

Net interest income, the difference between (a) interest and fees earned on interest-earning assets and (b) interest paid on interest-bearing liabilities, is the most significant component of the Bank’s earnings.  Changes in net interest income from period to period result from increases or decreases in the average balances of interest-earning assets portfolio, the availability of particular sources of funds and changes in prevailing interest rates.

The following table summarizes the Corporation’s net interest income.

Net interest income increased $433,000 or 6.40% from 2008 to 2009.  Average interest-earning assets increased 6.75%, while the average rate earned decreased 66 basis points, resulting in a decrease of $1,238,000 in total interest income.  Interest expense decreased $1,670,000, the result of a 7.04% increase in average interest-bearing liabilities, while the average rate paid decreased 98 basis points.

Net interest income decreased $2,188,000 or 24.5% from 2007 to 2008.  Average interest-earning assets increased 28.19%, while the average rate earned decreased 202 basis points, resulting in a decrease of $441,000 in total interest income.  Interest expense increased $1,747,000, the result of a 33.04% increase in average interest-bearing liabilities, while the average rate paid decreased 40 basis points.

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Average Balances, Interest Income and Expense, Rates and Yields

The following table shows the components of net interest income, setting forth, for each of the three years ended December 31, 2009, 2008 and 2007 (i) average assets, liabilities and investments, (ii) interest income earned on interest-earning assets and interest expense paid on interest-bearing liabilities, (iii) average yields earned on interest-earning assets and average rates paid on interest-bearing liabilities, (iv) the net interest spread (i.e., the average yield earned on interest-earning assets less the average rate paid on interest-bearing liabilities) and (v) the net interest yield on average interest-earning assets (i.e., net interest income divided by average interest-earning assets).  Yields are computed on a tax-equivalent basis, resulting in adjustments to interest earned on non-taxable securities of $1,026,000, $378,000 and $148,000 in 2009, 2008 and 2007, respectively.  Non-accrual loans and overdrafts are included in average loan balances.  Average loans are presented net of unearned income.

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Rate and Volume Analysis

The following tables show the increase or decrease in interest income, interest expense and net interest income, resulting from changes in rates and volumes, for the year ended December 31, 2009 compared with the same period in 2008 and for the year ended December 31, 2008 compared with the same period in 2007: