FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Both interest income and interest expense fell compared to 2001 levels primarily as the result of the dramatic decrease in interest rates that began in 2001 and continued into 2002. Earning asset yields, on a tax-equivalent basis, declined 77 basis points (0.77%) during 2002 to 6.66% from 7.43% registered in 2001, after decreasing from 7.87% in 2000. The cost of funds for 2002 dropped 117 basis points (1.17%) below 2001 costs of 4.44%, after decreasing 37 basis points (0.37%) from 2000 costs of 4.81%. Average earning assets were $4,294.5 million and average interest-bearing liabilities were $3,746.9 million for 2002, basically flat when compared to 2001 averages in both components. Interest and fees on loans declined $22.3 million for 2002 compared to 2001 levels primarily as yields declined in the lower interest rate environment. Loan yields fell 98 basis points (0.98%) during 2002 to 7.13% from 8.11% for 2001 after a decline of 39 basis points (0.39%) from the 2000 level. Time and demand loan yields fell 149 basis points (1.49%) and the yields on home equity and personal lines of credit declined 163 basis points (1.63%) and 234 basis points (2.34%), respectively compared to the prior year. The increase in average loan volumes was not enough to offset the reduced interest income caused by declining yields. During 2002, the Corporation took advantage of the lower interest rate cycle and continued to change the mix of the loan portfolio. Average mortgage loans declined as consumers refinanced their loans at near record levels. The Corporation continued to offer competitive mortgage loans but generally sold them immediately after origination along with the related servicing rights. Average commercial and municipal loans offset the decline in 1-4 family mortgage loans and grew $159.7 million, primarily in shorter term and variable rate lending. The Corporation has continued to capitalize on lending opportunities with small to mid-sized commercial borrowers, including loans generated through its preferred Small Business Administration (“SBA”) lender status. The Corporation was one of the top small business lenders in Pennsylvania during 2002 and 2001. Interest income on investments declined $10.5 million for 2002 compared to 2001, primarily due to interest rate decreases. Yields on investments for 2002 continued to decline, falling to 5.95% compared to 6.45% for 2001 and 6.88% for 2000. All categories of interest income on investments were negatively impacted by interest rate changes with the largest decline registered in the U.S. Government Agency category, declining $8.3 million or 54 basis points (0.54%) for 2002 compared to 2001. Prepayment speeds of mortgage backed securities (“MBS”) continued to accelerate in 2002 as interest rates continued to decline. Interest rate changes have a direct impact on prepayment speeds. As interest rates increase, prepayments tend to decline and average lives of MBS increase. As interest rates Interest expense on long-term debt increased $294 thousand for 2002 compared to the 2001 period as increases due to volume of $410 thousand were partially offset by decreases due to rate of $116 thousand. Average long-term debt for 2002 rose by $7.2 million compared to 2001 as maturities were extended for short-term borrowings from the Federal Home Loan Bank to take advantage of the lower interest rate environment. Long-term debt includes capital securities borrowings in the amount of $35 million, which were issued during 1999, bearing an interest rate of 9.50% and maturing in thirty years. The proceeds were used by the Corporation in connection with the repurchase of common shares. (See Note 15 to the financial statements for a description of the company obligated mandatorily redeemable capital securities of subsidiary trust.) Interest expense on short-term borrowings decreased $5.2 million during 2002 primarily as a result of rate decreases of $6.7 million offset in part by volume increases of $1.5 million. Average short-term borrowings rose by $39.7 million for 2002 compared to 2001 while the cost of short- term borrowings fell by 197 basis points (1.97%) compared to the prior year. All categories of short-term borrowing costs declined year to year. Interest on deposits dropped $39.6 million for 2002 compared to 2001 primarily due to decreases due to interest rates of $33.7 million. The rate on savings deposits fell 106 basis points (1.06%) resulting in a decrease to interest expense of $7.7 million for 2002 compared to 2001, while the rate on time deposits for 2002 also declined, down 137 basis points (1.37%), compared to 2001 resulting in a decrease to interest expense of $21.8 million. Although average deposits declined compared to 2001, the deposit mix changed as clients registered a preference for savings products which jumped $43.7 million or 6.4% while time deposits dropped $135.5 million or 7.8% due to the continuing economic uncertainties. Average demand deposit balances for 2002 also advanced, up $11.9 million over 2001 balances and represents the highest level in the Corporation’s history. This rise is due principally to the success of the Corporation’s “High Performance Checking” product which was rolled out in 2002 and focuses on growing low cost deposits. decrease, prepayment speeds tend to increase and average lives of MBS decline and accelerates the amount of premium amortization that is realized, further reducing the yields in current periods. Using computer simulation modeling, the Corporation tests the average life and yield volatility of all MBS under various interest rate scenarios on a continuing basis to insure that volatility falls within acceptable limits. The Corporation holds no “high risk” securities nor does the Corporation own any securities of a single issuer exceeding 10% of shareholders’ equity other than U.S. government and agency securities. 43