This report contains forward-looking statements intended to qualify for the safe harbor from liability established by the Private Securities Litigation Reform Act of 1995. These forward-looking statements can generally be identified as such because the context of the statement will include words such as we "believe," "anticipate," "expect" or words of similar meaning. Similarly, statements that describe our future plans, objectives or goals are also forward-looking statements. Forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those currently anticipated, including: general and local economic conditions; changes in interest rates, deposit flows, loan demand, real estate values and competition; changes in legislation or regulation; changes in accounting principles, policies or guidelines; our ability to manage growth; and other competitive, technological, governmental and regulatory factors affecting our operations, pricing, products, and services.

Management's discussion and analysis is intended to assist readers in the understanding and evaluation of our financial condition and results of operations. You should read this discussion in conjunction with our consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2007.

Overview

We are a commercial bank holding company that was incorporated on June 5, 2002. Effective June 28, 2002, North State Bank became our wholly owned subsidiary. In March 2004, we formed North State Statutory Trust I, in December 2005 we formed North State Statutory Trust II and in November 2007 we established a third subsidiary trust, North State Statutory Trust III, all of which issued trust preferred securities to provide additional capital for general corporate purposes, including expansion of North State Bank. In October 2007, we acquired approximately 5.6% of Beacon Title Agency, LLC, a title insurance agency. Our only business is the ownership and operation of North State Bank, the three subsidiary trusts and our investment in Beacon Title Agency.

North State Bank is a commercial bank that was incorporated under the laws of the State of North Carolina on May 25, 2000 and began operations on June 1, 2000. The Bank is a full service community bank providing banking services through eight locations: its main office in the North Hills section of Raleigh, North Carolina; one office in North Raleigh; one office in West Raleigh; one office in downtown Raleigh; one office in Garner, North Carolina; one office serving the Wake Forest area of North Carolina; one office in Wilmington, North Carolina; and a loan production office in Morehead City, North Carolina. Construction of a new multi-story full-service banking office for our North Raleigh office began in May 2008.

Comparison of Financial Condition at September 30, 2008 and December 31, 2007

Total assets at September 30, 2008 were $633.4 million compared to $547.5 million at December 31, 2007, an increase of $85.8 million or 15.7%, primarily in loans. Although loan growth slowed during the three months ended September 30, 2008, loan production has continued to lead our asset growth during the year, up a total of $70.2 million over December 31, 2007. Our continued loan growth during 2008 has necessitated the broadening of our funding sources to include additional wholesale brokered certificates of deposits, internet deposits and by the issuance of long-term subordinated notes. Total deposits increased $101.2 million over December 31, 2007 of which nearly half was funded through wholesale brokered certificates of deposit, up $50.1 million over December 31, 2007. In May 2008 and July 2008, the Bank issued $9.8 million and $1.2 million, respectively in long-term subordinated notes. The additional subordinated notes and wholesale brokered deposits also contributed to the reduction of our short-term borrowings by $29.0 million from December 31, 2007.

Investments available for sale decreased $10.5 million or 30.1% from $34.8 million at December 31, 2007 as principal repayments and maturing investments were redeployed into the loan portfolio. The investment portfolio increased in fair value $172,000 with a $4,000 loss reclassification recognized in income net of tax during the nine-month period ended September 30, 2008. We have no holdings in Fannie Mae or Freddie Mac preferred stock. At September 30, 2008, our overnight excess funds were invested in our interest-bearing due from account at the Federal Home Loan Bank of Atlanta ("FHLB") resulting in cash and due from banks of $56.7 million. At December 31, 2007, cash and due from banks was $12.6 million and Federal funds sold were $18.2 million.

Loan growth slowed during the three months ended September 30, 2008, increasing $4.9 million to $539.5 million over June 30 2008 as we emphasized our historic niche of mutually-beneficial relationship lending. Loans grew $70.2 million during the first nine months of 2008. The loan growth was primarily in commercial real estate and construction loans throughout all our markets in Wake and New Hanover counties during the nine-month period ended September 30, 2008. We have no direct exposure to sub-prime mortgages.

The allowance for loan losses was $6.0 million at September 30, 2008 or 1.11% of total loans outstanding compared to $5.0 million or 1.07% of loans outstanding at December 31, 2007. The level of the allowance relative to gross loans was increased due to loan growth in general and additional specific reserves for impaired loans. Management considers the level of the allowance for loan losses adequate to provide for probable loan losses based on our assessment of our loan portfolio at September 30, 2008.

Premises and equipment grew to $11.4 million at September 30, 2008 from $10.5 million at December 31, 2007. The $901,000 increase reflects additions for the completion of our new full service office in Wilmington which opened in January 2008, initial costs on construction of our new multi-story building for our North Raleigh office which began in the second quarter of 2008 and the opening in June 2008 of our loan production office in Morehead City. Overall, other assets and accrued interest receivable decreased slightly, by $30,000, at September 30, 2008 over December 31, 2007. During March 2008, we terminated our interest rate floor at $1.9 million, see "Quantitative and Qualitative Disclosures about Market Risk" discussed in Item 3 for additional information.

Loan growth was funded primarily with increased total deposit funds from various sources, up $101.2 million or 22.1% from December 31, 2007. Our core deposits, which represented 63.4% of our total deposits, grew to $354.3 million at September 30, 2008, up $10.3 million from December 31, 2007. Since December 31, 2007, interest-bearing savings, money market and interest checking deposits grew $18.2 million or 9.1% to $217.7 million at September 30, 2008, offsetting a decline in noninterest-bearing deposits of $18.6 million during the same period. The decline in noninterest-bearing demand deposits is in part a result of the North Carolina State Bar requiring deposit accounts of our attorney trust customers to be moved from noninterest-bearing demand deposit accounts and held in interest-bearing deposit accounts by the end of June 30, 2008. Time deposits under $100,000, excluding internet deposits, discussed below, grew $10.7 million or 21.5%

Total time deposits grew $101.7 million or 62.4% with wholesale brokered time deposits contributing $50.1 million of the increase from December 31, 2007 to September 30, 2008. Other time deposits through participation in the CDARs program grew $10.6 million to $23.5 million at September 30, 2008 as increased uncertainty in the financial system encouraged more customers to use these accounts. In addition, time deposits over $100,000 increased $15.6 million or 17.3% to $106.0 million at September 30, 2008. Also, as a new source of funding during the third quarter, certificates of deposit issued by means of an internet subscription service grew to $14.6 million at September 30, 2008. We continue to seek out opportunities to grow core deposits in our markets by expanding and developing our banking relationships with our customers to reduce wholesale brokered deposits in the future as a source of funding. Our efforts to grow core deposits will continue to be a top priority in 2009 as we build banking relationships and push to reduce non-relationship funding.

We also use borrowings to support balance sheet management and growth. Total borrowings were down $18.0 million to $36.2 million at September 30, 2008 from $54.2 million at December 31, 2007. Short-term borrowings decreased $29.0 million due to additional funds available from brokered time deposits. Long-term borrowings increased $11.0 million due to the issuance of $9.8 million of subordinated notes by the Bank in May 2008 and $1.2 million of these notes issued on July 1, 2008, all of which mature in June 2018.

Total shareholders' equity increased $3.3 million or 10.3% from $31.6 million at December 31, 2007 to $34.8 million at September 30, 2008. The increase was provided by net income of $1.9 million and the conversion of 196,664 stock options held by directors and employees into common stock. The exercise of these options contributed $543,000 to our total shareholders' equity with a corresponding tax benefit of $341,000. Stock based compensation added $118,000. Other comprehensive income components increased shareholders' equity at September 30, 2008 by $396,000.

Comparison of Results of Operations for the Three-Month Periods Ended September 30, 2008 and 2007

Net Income. For the three-month period ended September 30, 2008, net income was $586,000 compared to $932,000 for the corresponding three-month period of 2007, representing a 37.1% decrease. On a diluted share basis, earnings were $.08 and $.13 per share, respectively, for the three-month periods ended September 30, 2008 and 2007.

The decrease in earnings is primarily attributable to increased loan loss provision, the impact of a 275 basis point drop in the prime interest rate since September 30, 2007 and the additional operating expenses related to the opening of two new banking offices and a loan production office. As of September 30, 2008, approximately 38.0% of our loan portfolio re-prices with each reduction in the Wall Street Journal prime interest rate and new loans funded during the 2008 period were priced at comparably lower interest rates than the prior year period. Overall, net interest income grew $784,000 in the three-month period ended September 30, 2008 compared to the prior year period, driven by higher average loan volumes. The increase in net interest income was offset by increases in loan loss provision of $522,000 and noninterest expense of $861,000, primarily in personnel costs and occupancy and equipment expense related to staffing the new banking and loan production offices.

Net Interest Income. Interest income for the three-month period ended September 30, 2008 increased $726,000 or 8.6% over the prior year period. The increase in interest income was provided substantially by growth in average earning assets, specifically loans. For the three-month period ended September 30, 2008 compared to the prior year period, average loan volumes increased $141.7 million, providing additional interest income of approximately $2.5 million. Average volumes in investment securities and Federal funds sold decreased almost $20 million as the loan portfolio grew, decreasing interest income by approximately $210,000. The additional interest income provided through higher loan volume was partially offset due to lower rates. The substantially lower rate environment effectively reduced interest income by approximately $1.6 million during the period.

Deposit interest expense decreased $262,000 overall for the three-month period ended September 30, 2008 compared to the prior year period. Although interest-bearing deposits grew $119.0 million for the three months ended September 30, 2008 compared to the prior year period, lower interest rates were the primary factor in the overall decrease in interest expense. Higher average balances in money market and interest checking accounts of $27.9 million increased interest expense approximately $207,000 while higher average balances in time deposits under $100,000 of $72.1 million and time deposits over $100,000 of $19.5 million increased interest expense $782,000 and $237,000, respectively. As a result of the repricing of our interest-bearing deposits to reflect market conditions in a declining rate environment, interest expense was reduced by approximately $1.5 million. Interest expense on average short-term and long-term borrowings increased $204,000 over the prior year period as growth in these funds increased

an average of $19.9 million. Noninterest-bearing demand deposits were down on average $20.8 million during the three months ended September 30, 2008. The decrease in noninterest-bearing demand deposits is primarily due to the North Carolina State Bar requiring deposit accounts of our attorney trust customers to be moved from noninterest-bearing demand deposit accounts to interest-bearing deposit accounts by the end of June 30, 2008.

Overall, net interest income for the three-month period ended September 30, 2008 increased $784,000 or 17.5%. The net interest margin for the three-month period was 3.61% compared to 3.88% for the prior year period.

The following table contains information relating to our average balance sheet and reflects the average yield on assets and cost of liabilities for the periods indicated. Such annualized yields and costs are derived by dividing annualized income or expense by the average balances of assets or liabilities, respectively, for the periods presented.

                                               Three Months Ended                   Three Months Ended
                                               September 30, 2008                   September 30, 2007
                                         Average                 Average      Average                 Average
                                         Balance     Interest     Rate        Balance     Interest     Rate
                                             (Dollars in thousands)               (Dollars in thousands)
Interest-earning assets:
Loans                                   $ 539,882   $    8,760      6.46 %   $ 398,135   $    7,655      7.63 %
Investments available for sale             25,551          279      4.34 %      38,637          451      4.63 %
Fed funds sold                             12,070           60      1.98 %      18,963          249      5.21 %
Other interest-earning assets               2,916           42      5.73 %       2,192           60     10.86 %

Total interest-earning assets             580,419        9,141      6.27 %     457,927        8,415      7.29 %

Other assets                               19,101                               19,888

Total assets                            $ 599,520                            $ 477,815

Interest-bearing liabilities:
Deposits:
NOW & Money Market                      $ 218,984        1,087      1.97 %   $ 191,124        1,888      3.92 %
Savings                                       856            1      0.60 %       1,431            3      0.60 %
Time deposits over $100,000                97,888        1,076      4.37 %      78,355        1,037      5.25 %
Other time deposits                       133,147        1,251      3.74 %      61,013          749      4.87 %
Short-term borrowings                      12,611           53      1.67 %       8,806           51      2.30 %
Long-term debt                             27,319          407      5.93 %      11,182          205      7.27 %

Total interest-bearing liabilities        490,805        3,875      3.14 %     351,911        3,933      4.43 %

Demand deposits                            69,735                               90,500
Other liabilities                           4,078                                5,740
Shareholders' equity                       34,902                               29,664

Total liabilities and shareholders'
equity                                  $ 599,520                            $ 477,815

Net interest income and interest rate
spread                                              $    5,266      3.13 %               $    4,482      2.86 %

Net yield on average interest-earning
assets                                                              3.61 %                               3.88 %

Ratio of average interest-earning
assets to average interest-bearing
liabilities                                                       118.26 %                             130.13 %

Provision for Loan Losses. The provision for loan losses was $777,000 during the three-month period ended September 30, 2008 compared with $255,000 for the same period in 2007. Provisions for loan losses are charged to income to bring the allowance for loan losses to a level considered appropriate by our management. The increase in the provision for the three-month period ended September 30, 2008 is principally in response to probable losses identified in our SFAS 114 evaluation. Net charge-offs were $94,000 for the three-month period ended September 30, 2008 compared to no charge-offs for the prior year period.

Management evaluates the adequacy of our allowance for loan losses on a monthly basis and our directors review management's evaluation of the allowance for loan losses on a quarterly basis. In evaluating the allowance for loan losses, we prepare on a monthly basis an analysis of our current loan

portfolio using historical loss rates, peer statistics and data from our portfolio. We utilize a system of nine possible risk ratings. The risk ratings are established based on perceived probability of loss. All loans risk rated "doubtful" and "loss" are removed from their homogeneous group and individually analyzed for impairment as detailed in SFAS 114. Other groups of loans based on loan size may be selected for impairment review. For loans determined to be impaired, the specific allowance is based on the present value of expected cash flows or the fair value of the collateral or the loan's observable market price. We have identified seven qualitative factors that are considered indicators of changes in the level of risk of loss inherent in our loan portfolio. These factors include and consider the risk of payment performance, overall portfolio quality (utilizing weighted average risk rating), general economic factors such as unemployment, inflation, delinquency and charge-off rates, regulatory examination results, interest rate environment, levels of highly leveraged transactions (as defined in Section 365.2 of the FDIC regulations) and levels of construction, development and non-owner occupied commercial real estate lending. These factors are examined for trends and the risk that they represent to our loan portfolio. Each of these factors is assigned a level of risk and this risk factor is applied to only the SFAS No. 5 "Accounting for Contingencies" ("SFAS 5") pool of loans to calculate the appropriate allowance. Using the data gathered during this monthly evaluation process, the model calculates an estimated reserve amount.

Nonperforming loans increased to $5.3 million or .98% of loans at September 30, 2008 compared to $3.1 million or .66% of period-end loans as of December 31, 2007. There were $141,000 of nonperforming loans as of September 30, 2007. Included in nonperforming loans at September 30, 2008 and December 31, 2007 are $2.1 million and $2.8 million, respectively, in loans attributable to a single-practice physician who died unexpectedly. During the second quarter of 2008, $542,000 attributable to this borrower was charged off and as no additional loss is probable, there is no corresponding impairment reserve as of September 30, 2008. A substantial portion of the increase in nonperforming loans for the three months ended September 30, 2008 is attributable to one residential builder for $1.4 million in real estate construction. The specific loans within this builder relationship have been analyzed for impairment in accordance with SFAS No. 114 and our management concluded no specific impairment reserve allowance is necessary. Our SFAS No. 114 analysis on the remaining $1.8 million nonperforming loans resulted in additional impairment reserves of $289,000 with corresponding outstanding balances of $1.4 million.

Accruing loans 90 days or more past due were $34,000, $492,000, and $580,000, respectively as of September 30, 2008, December 31, 2007 and September 30, 2007. A SFAS No. 114 impairment analysis resulted in impairment reserves of $8,600 with corresponding loan balances of $34,000 at September 30, 2008.

As of September 30, 2008 we also identified and evaluated $2.8 million of potential problem loans primarily as a result of information regarding possible credit problems of the related borrowers. These loans were performing in accordance with the original terms of the loans and not past due as of September 30, 2008. However, after evaluation, management has considered these loans in assessing the adequacy of our allowance for loan losses. Although these loans were represented by nine loans, a single commercial real estate loan of $1.9 million was the largest represented.

The allowance for loan losses was $6.0 million at September 30, 2008, $5.0 million at December 31, 2007, and $4.4 million at September 30, 2007 representing 1.11%, 1.07% and 1.06%, respectively, of loans outstanding at each date. As discussed above, as of September 30, 2008, we analyzed outstanding loan balances of $5.3 million for impairment in accordance with SFAS No. 114. As a result, we provided for probable losses through specific impairment reserve allowances on $1.4 million of these loans. Management has analyzed and determined the collateral on the remaining $3.9 million of loans analyzed for impairment to be adequate and no additional specific reserve allowance is necessary. The allowance for loan losses is maintained at a level management considers adequate to provide for probable loan losses based on our assessment of our loan portfolio at September 30, 2008.

While we believe that our management uses the best information available to determine the allowance for loan losses, unforeseen market conditions could result in adjustments to the allowance for loan losses, and net income could be significantly affected, if circumstances differ substantially from the assumptions used in making the final determination. Because these factors and management's assumptions are subject to change, the allocation is not necessarily indicative of future loan portfolio performance. Also, as an important component of their periodic examination process, regulatory agencies review our allowance for loan losses and may require additional provisions for estimated losses based on judgments that differ from those of management. Additional information regarding our allowance for loan losses and loan loss experience is presented in our 2007 Annual Report on Form 10-K for the year ended December 31, 2007.

Noninterest Income. For the three-month period ended September 30, 2008, non-interest income increased $102,000 to $395,000 from $293,000 for the corresponding period in the prior year. We began efforts at the beginning of 2008 to dissolve our mortgage operations by the end of June 2008, resulting in the decrease of $72,000 in mortgage operation fees from the prior year three-month period. Mortgage operations were terminated as of June 30, 2008. Deposit fees, service charges and other fees increased $142,000 for the three-month period ended September 30, 2008 compared to the prior year period primarily due to an increase in service fees on loans which were up $115,000 over the prior year period. A review of our costs to service loan modifications and renewals resulted in further efforts to increase our fees on such loans. Fees from annuity sales and other fees generated from wealth management services were up $23,000.

Noninterest Expense. Total non-interest expense for the three-month period ended September 30, 2008 was $3.9 million, with salaries and benefits representing the largest expense category at $2.1 million. This compares to total noninterest expense for the three-month period ended September 30, 2007 of $3.0 million with salaries and benefits of $1.8 million. The $310,000 increase in salaries and benefits for the three-month period ended September 30, 2008 is attributable to an overall increase of 13 full time equivalent employees from the prior year period and general increases in employee benefits. We hired six additional staff late in 2007 for our new full service office in Wilmington which opened in January 2008 and five additional staff for our full service office in downtown Raleigh which opened in December 2007. Other management and support staff were also added throughout the Bank.

Occupancy and equipment costs increased $212,000 to $674,000 for the three-month period ended September 30, 2008 compared to the same period last year. These costs include the additional lease expense for our new full-service office in Wilmington which opened in January 2008 and additional lease expense for expansion in our current operations area. Overall, lease expense increased approximately $114,000 over the prior year three-month period. Other non-interest expenses increased $339,000 during the three-month period ended September 30, 2008 over the prior year period in 2007. Directors fees were up $148,000 compared to the prior year period. A decision by our board of directors to waive their equity compensation for fiscal 2007 was approved during September 2007 which resulted in a net credit in directors fees of $66,000 for the three-month period ended September 30, 2007. There were no other significant increases in other noninterest expenses.

Comparison of Results of Operations for the Nine-Month Periods Ended September 30, 2008 and 2007

Net Income. For the nine-month period ended September 30, 2008, net income was $1.9 million compared to $2.5 million for the corresponding nine-month period of 2007, representing a 25.3% decrease. On a diluted share basis, earnings were $.25 and $.34 per share, respectively, for the nine-month period ended September 30, 2008 and 2007.

The decrease in earnings for the nine-month period, as with the three-month period, ended September 30, 2008 is primarily attributable to increased loan loss provision, the impact of a 275 basis point drop in the prime interest rate since September 30, 2007 and the additional operating expenses related to the opening of two new banking offices and a loan production office. Overall, net interest income grew $2.6 million in the nine-month period ended September 30, 2008 compared to the prior year period, driven by higher average loan volumes. The increase in net interest income was offset by increases in loan loss provision of $1.2 million and other noninterest expense of $2.6 million, primarily in personnel costs related to staffing the new banking and loan production offices.

Net Interest Income. Interest income for the nine-month period ended . . .