General

VSB Bancorp, Inc. (referred to using terms such as "we," "us," or the "Company") is the holding company for Victory State Bank (the "Bank"), a New York State chartered commercial bank. Our primary business is owning all of the issued and outstanding stock of the Bank. Victory State Bank is a New York State chartered commercial bank, founded in November 1997. The Bank is supervised by the New York State Banking Department and the Federal Deposit Insurance Corporation ("FDIC"). The Bank gathers deposits from individuals and businesses primarily in Staten Island and makes loans throughout that community. The Bank invests funds that are not used for lending primarily in government securities, mortgage backed securities and collateralized mortgage obligations. Customer deposits are insured, up to the applicable limit, by the FDIC. VSB Bancorp, Inc. common stock is quoted on the NASDAQ Global Market ("NASDAQ GM") under the symbol "VSBN".

Our results of operations are dependent primarily on net interest income, which is the difference between the income we earn on our loan and investment portfolios and our costs of funds, consisting primarily of interest paid on our deposits. Our operating expenses principally consist of employee compensation and benefits, occupancy expenses, professional fees, advertising and marketing expenses and other general and administrative expenses. Our results of operations are significantly affected by general economic and competitive conditions, particularly changes in market interest rates, government policies and actions of regulatory authorities.

We experienced an overall increase in deposits in 2008 due to factors we discuss below. We opened our new main office in 2007. We anticipate that our existing branch network will generate an increase in funds for investment in the future.

In order to support branch expansion and asset growth, we had not paid cash dividends prior to the fourth quarter of 2007. Our Board of Directors approved our first $0.06 cash dividend to stockholders of record on November 29, 2007, payable on January 2, 2008 and we paid quarterly dividends of $0.06 per share with respect to each calendar quarter thereafter through the end of 2008. We paid $443,996 of dividends out of net income of $1,931,774, for a dividend payout ratio of 23%. Thus, we retained the majority of our net income to increase our capital base to support our efforts to expand our franchise in the future.

During 2008, we faced a number of challenges, including reduction in market interest rates that pushed down our yields on assets faster than our cost of funds, due to the downward pressure of deposit rates. The real estate market continued to soften, which reduced loan originations and deposit balances from our attorney customer base. However, the decrease in the prime rate also caused a decrease in yields on our existing prime based loans and originated new loans at lower initial interest rates.

Also important in 2008 was a shift in our deposit mix as we experienced a decline in non-interest bearing demand deposits accounts. This decline resulted from a number of factors including a reduction in real estate activity, which reduced demand deposits held in connection with pending real estate transactions; and a shift in customer preferences towards interest bearing accounts as the yields on those accounts increased to the point where they became desirable alternatives.

Management intends to exert efforts to continue growing our company in the future. However, both internal and external factors could adversely affect our future growth. The recent down turn in the economy has made it more difficult for us to originate new loans that meet our underwriting standards. Not only does that cause us to invest available funds in lower-yielding securities and deposits with other banks, but it also slows the development of non-loan relationships which sometimes flow from cross-selling to loan customers.

A continuation of adverse general economic conditions could make it difficult for us to execute our growth plans. Furthermore, regulatory capital requirements could have a negative effect on our ability to grow if growth outpaces our ability to support that growth with increased capital.

Critical Accounting Policies

We are required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the amounts of revenues and expenses during the reporting period. The allowance for loan losses, prepayment estimates on the mortgage-backed securities and Collateralized Mortgage Obligation portfolios, contingencies and fair values of financial instruments are particularly subject to change and to management's estimates. Actual results can differ from those estimates and may have an impact on our financial statements.

We maintain the interest rate sensitivity of our assets by investing primarily in CMO's and MBS's with short and intermediate average lives to generate cash flows and by originating and retaining primarily loans with interest rates based on the prime rate. As of December 31, 2008, prime based loans totaled $49,880,240, or 79.7% of total loans. Many of these prime based loans are subject to interest rate floors of 7.00% to 8.00%. We anticipate that we will continue to concentrate on originating prime based loans in our principal market areas. We also expect to continue to invest other available funds that we cannot invest in loans in short-term investment grade securities.

Cash Flow Sensitivity Analysis.The matching of assets and liabilities may be analyzed by examining our cash flow sensitivity "gap." An asset or liability is said to be cash flow sensitive within a specific time period if it will mature or reprice within that time period. The cash flow sensitivity gap is defined as the difference between the amount of interest-earning assets maturing within a specific time period and the amount of interest-bearing liabilities maturing within that time period. A gap is considered positive when the amount of interest earning assets exceeds the amount of interest bearing liabilities. A gap is considered negative when the amount of interest bearing liabilities exceeds the amount of interest earning assets.

During a period of falling interest rates, the net income of an institution with a positive gap can be expected to be adversely affected because the yield on its interest-earning assets should reprice downward faster than the decline in its cost of funds. Conversely, during a period of rising interest rates, the net income of an institution with a positive gap position can be expected to increase as it is able to invest in higher yielding interest-earning assets at a more rapid rate than its interest-earning liabilities reprice. A positive gap may not protect an institution with a large portfolio of adjustable rate based loans or mortgage-backed securities from increases in interest rates for extended time periods if such loans or securities have annual and lifetime interest rate caps. The increase in the cost of funds in a rapidly increasing rate environment could exceed the cap on assets yields, negatively impacting net interest income. However, our prime rate based loans and our securities investments generally do not have any annual or lifetime caps.

In the current interest rate environment, we generally have been investing available funds not needed for lending in CMOs and MBSs with estimated average lives of four and one-half years or less. As a result of this strategy, and based upon the assumptions used in the following table at December 31, 2008, our total interest-bearing liabilities maturing within one year exceeded our total interest-earning assets maturing in the same period by $28,841,502, representing a one year cumulative gap ratio of negative 14.53%. In many cases, a negative gap ratio means that in a falling rate environment, the interest that we pay on deposits will reprice downward faster than the rates we earn on assets. However, for a number of important reasons, that is not our recent experience during periods of declining interest rates.

• The gap analysis shown in the table measures repricing during time periods of three months, one year, or longer. However, since most of our loans have interest rates based upon the prime rate and the interest rate adjusts immediately based upon the prime rate, a reduction in the target federal funds rate, which normally presages an immediate reduction in the prime rate, will have an immediate negative effect on our earnings the next business day if the loans do not have or have not reached an interest rate floor. It will take longer for that decline in market interest rates to affect deposit costs.

• The gap table does not measure the magnitude of a change in yields earned or rates paid, but only whether they are expected to change. A 1% decline in the prime rate normally causes a 1% decline in our loan yields, unless the loan is at an interest rate floor. However, a 1% decline in the prime rate would normally result in less than a one percent decline in the rate we pay on deposits because deposit rates are only a fraction of the prime rate. For example, if we offer a deposit for one-half the prime rate, then a 1% decline in the prime rate will result in a 1% decline in a loan yield, but only a 0.5% decline in the rate we offer on deposits. This effect, known as "spread compression," can be especially significant at low market interest rates because the rate on deposits can not be less than zero.

• The gap table does not consider the effects of customer discretion. Thus, a customer may elect to switch a deposit from one category to the other as market rates change, thus changing the cost of that deposit. Our cost of funds on a particular deposit could go up even though market rates are declining if a customer decides to move money from, for example, a low-rate NOW account to a higher-rate time deposit.

• The gap table does not take into account discretion by the Bank in making deposit pricing decisions, which may cause the Bank not to reflect interest rate declines by lowering deposit rates. There are many reasons why the Bank may decide to do so. Examples of reasons include competitive pressures, irrational pricing by other institutions, and the need to maintain customer loyalty.

We closely monitor our interest rate risk as such risk relates to our operational strategies. The Victory State Bank Board of Directors has established an Asset/Liability Committee, responsible for reviewing our asset/liability policies and interest rate risk position, which generally meets quarterly and reports back to the Board on interest rate risk and trends on a quarterly basis. In light of the current interest rate environment, we are attempting to maintain a position in which our assets reprice more quickly than our liabilities. There can be no assurance, however, that we will be able to achieve that result or that we will be able to avoid further spread compression or avoid negative consequences from interest rate fluctuations. Although we have not experienced a material runoff in our core deposits, there can be no assurances that such a runoff will not occur in the future if depositors seek higher yielding investments.

Our substantial level of non-interest-bearing demand deposits also furthers our goal of maintaining a positive gap because the interest cost of those deposits will not increase as market rates increase. However an increase in market interest rates could cause our customers to shift funds from demand deposits into interest earning deposits if interest rates are high enough to justify maintaining multiple accounts. Furthermore, there have been frequent proposals in Congress to permit the payment of interest on commercial demand deposits. The adoption of such legislation could have a significant effect on our net income by forcing us to pay interest on business demand deposits to maintain parity with our competitors.

The following table sets forth the amounts of interest-earning assets and interest-bearing liabilities outstanding at December 31, 2008 which we estimate, based upon certain assumptions, will mature in each of the future time periods shown. Except as stated below, the amount of assets and liabilities shown which mature during a particular period were determined in accordance with the earlier of estimated repayment or runoff or the contractual terms of the asset or liability. There can be no assurance that deposits would reprice to peer bank's historical levels if interest rates were to increase. Certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets may have features which restrict changes in interest rates on a short-term basis and over the life of the asset. For example, if a prime rate loan has a minimum interest rate of 7.5%, an increase in a very low prime rate might not be sufficient to increase the interest rate on the loan to more than the minimum. Further, in the event of a change in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in calculating the table. Finally, the ability of many borrowers to service their prime rate loans may decrease in the event of an interest rate increase.

                                                       At December 31, 2008

                             Three            Four           More than
                            months          to twelve       One year to      More than
                            or less          months         five years       five years         Total

Interest-earning
assets:
Commercial loans (1)     $  58,689,472    $     115,806    $     486,008    $     81,051    $  59,372,337
Consumer loans (1)           4,545,019              452           97,446         162,015        4,804,932
Mortgage-backed
securities                   4,884,270       14,652,810       99,812,207               -      119,349,287
Other
interest-earning
assets                      14,909,325                -                -               -       14,909,325
Investment securities                -                -                -               -                -

Total
interest-earning
assets                      83,028,086       14,769,068      100,395,661         243,066      198,435,881
Less:
Unearned (discount)
and deferred fees(2)           (57,616 )       (172,848 )       (115,717 )             -         (346,181 )

Net interest-earning
assets                      82,970,470       14,596,220      100,279,944         243,066      198,089,700

Interest-bearing
liabilities:
Savings accounts            12,412,561                -                -               -       12,412,561
NOW accounts                17,636,154                -                -               -       17,636,154
Money market accounts       22,829,789                -                -               -       22,829,789
Certificate accounts        51,844,257       21,685,431        2,793,806               -       76,323,494
Subordinated debt                    -                -                -               -                -

Total
interest-bearing
liabilities                104,722,761       21,685,431        2,793,806               -      129,201,998

Interest sensitivity
gap                      $ (21,752,291 )  $  (7,089,211 )  $  97,486,138    $    243,066    $  68,887,702

Cumulative gap           $ (21,752,291 )  $ (28,841,502 )  $  68,644,636    $ 68,887,702    $  68,887,702

Cumulative gap as a
percentage of total
interest-earning
assets                          -10.96 %         -14.53 %          34.59 %         34.72 %          34.72 %
Cumulative net
interest-earning
assets as a
percentage of total
interest-bearing
liabilities                      79.23 %          77.18 %         153.13 %        153.32 %         153.32 %

(1) For purposes of the gap analysis, mortgage and other loans are reduced for non-performing loans but are not reduced for the allowance for possible loan losses.

(2) For purposes of the gap analysis, unearned discount and deferred fees are pro-rated.

Analysis of Net Interest Income

Our profitability is primarily dependent upon net interest income. Net interest income represents the difference between interest income on interest-earning assets and the interest expense on interest-bearing liabilities. Net interest income depends primarily upon the volume of interest-earning assets and interest-bearing liabilities and the interest rates earned or paid on them.

The following table sets forth certain information relating to our consolidated statements of financial condition and the consolidated statements of earnings for the fiscal years ended December 31, 2008, 2007 and 2006 and reflects the average yield on assets and average cost of liabilities for the period indicated. Such yields and costs are derived by dividing income or expense by the average balance of assets or liabilities, respectively, for the periods shown. Average balances are derived from average daily balances. The average balance of loans receivable does not include loans on which we have discontinued accruing interest. The yields and costs include net fees, which are considered adjustments to yields. No tax equivalent adjustments have been made.

                               Year Ended December 31, 2008                   Year Ended December 31, 2007                   Year Ended December 31, 2006

                           Average                         Yield/         Average                         Yield/         Average                         Yield/
                           Balance          Interest        Cost          Balance          Interest        Cost          Balance          Interest        Cost

Assets:
Interest-earning
assets:
Loans receivable        $  64,186,215     $  5,078,576        7.91 %   $  61,107,477     $  5,980,133        9.79 %   $  69,711,760     $  6,985,200       10.02 %
Other interest
earning assets             14,864,864          237,490        1.60        20,652,598          994,334        4.81        18,737,570          887,663        4.74
Investment
securities                119,976,379        5,699,228        4.75       112,178,675        5,303,886        4.73       114,180,350        5,201,089        4.56

Total
interest-earning
assets                    199,027,458       11,015,294        5.53       193,938,750       12,278,353        6.33       202,629,680       13,073,952        6.45

Non-interest earning
assets                     11,105,146                                     14,624,973                                     14,291,015

Total assets            $ 210,132,604                                  $ 208,563,723                                  $ 216,920,695

Liabilities and
equity:
Interest-bearing
liabilities:
Savings accounts        $  12,046,954           76,011        0.63     $  11,942,515           97,900        0.82     $  13,421,670           85,413        0.64
Time accounts              69,562,982        1,615,142        2.32        66,237,498        2,436,688        3.68        70,221,095        2,301,764        3.28
Money market
accounts                   21,092,188          310,714        1.47        21,366,204          439,236        2.06        19,357,106          352,956        1.82
Now accounts               17,607,727          127,066        0.72        19,258,479          131,634        0.68        21,508,418          107,973        0.50
Short Term
Borrowings                          -                -           -                 -                -           -            19,178            1,112        5.80
Subordinated debt           3,098,634          214,685        6.91         5,155,000          356,159        6.91         5,155,000          356,159        6.91

Total
interest-bearing
liabilities               123,408,485        2,343,618        1.90       123,959,696        3,461,617        2.79       129,682,467        3,205,377        2.47

Checking accounts          63,545,525                                     63,596,060                                     68,870,282

Total                     186,954,010                                    187,555,756                                    198,552,749
Other liabilities           1,308,257                                      1,909,693                                      2,529,839

Total liabilities         188,262,267                                    189,465,449                                    201,082,588
Equity                     21,870,337                                     19,098,274                                     15,838,107

Total liabilities
and equity              $ 210,132,604                                  $ 208,563,723                                  $ 216,920,695

Net interest
income/net interest
rate spread                               $  8,671,676        3.63 %                     $  8,816,736        3.54 %                     $  9,868,575        3.98 %

Net interest earning
assets/net interest
margin                  $  75,618,973                         4.36 %   $  69,979,054                         4.55 %   $  72,947,213                         4.87 %

Ratio of
interest-earning
assets to to
interest-bearing
liabilities                      1.61 x                                         1.56 x                                         1.56 x


Return On Average
Assets:                                                       0.92 %                                         0.98 %                                         1.17 %

Return On Average
Equity:                                                       8.83 %                                        10.72 %                                        16.07 %

Equity To Assets:                                            10.91 %                                        10.25 %                                         8.18 %

The following table presents the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected our interest income and interest expense during the periods indicated. Information is provided in each category with respect to (i) changes attributable to changes in volume (changes in volume multiplied by prior rate), (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume), and (iii) the net change. The changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate.

                                 Year Ended December 31, 2008                  Year Ended December 31, 2007                 Year Ended December 31, 2006
                                         Compared to                                    Compared to                                  Compared to
                                      December 31, 2007                              December 31, 2006                            December 31, 2005
                                     Increase/(Decrease)                            Increase/(Decrease)                          Increase/(Decrease)
                                    In Net Interest Income                        In Net Interest Income                       In Net Interest Income

                                   Due to                                         Due to                                        Due to

                           Volume          Rate              Net           Volume          Rate           Net           Volume          Rate            Net


Interest-earning
assets:
Loans receivable         $  301,408    ($  1,202,965 )  ($    901,557 )  ($  862,149 )  ($ 142,918 )  ($ 1,005,067 )  ($  147,482 )  $ 1,304,344    $ 1,156,862
Other interest-earning
assets                     (278,390 )       (478,454 )       (756,844 )       90,772        15,899         106,671         17,438        284,713        302,151
Investment securities,
afs                         368,831           26,511          395,342        (91,276 )     194,073         102,797        (27,019 )      357,473        330,454

Total                       391,850       (1,654,909 )     (1,263,059 )     (862,653 )      67,054        (795,599 )     (157,062 )    1,946,529      1,789,467

Interest-bearing
liabilities:
Savings accounts                856          (22,745 )        (21,889 )       (9,467 )      21,954          12,487        (11,619 )       17,959          6,340
Time accounts               122,378         (943,924 )       (821,546 )     (130,662 )     265,586         134,924        202,996        898,202      1,101,198
Money market accounts        (5,645 )       (122,877 )       (128,522 )       36,566        49,714          86,280        (16,260 )      139,310        123,050
Now accounts                (11,225 )          6,657           (4,568 )      (11,250 )      34,911          23,661        (12,967 )       16,320          3,353
Short term borrowings             -                -                -         (1,112 )           -          (1,112 )        1,112              -          1,112
Subordinated debt          (141,474 )              -         (141,474 )            -             -               -              -              -              -

Total                       (35,110 )     (1,082,889 )     (1,117,999 )     (115,925 )     372,165         256,240        163,262      1,071,792      1,235,053

Net change in net
interest income          $  426,959    ($    572,019 )  ($    145,060 )  ($  746,728 )  ($ 305,110 )  ($ 1,051,839 )  ($  320,324 )  $   874,737    $   554,414

Effect of Adverse Conditions in the Residential Mortgage Market

We do not expect that adverse conditions in the residential mortgage market throughout the United States will have a direct adverse effect on our financial condition or results of operations. We are not a residential mortgage lender. At December 31, 2008, we owned $120.3 million of securities that are either collateralized by residential mortgage loans or that represent shares in pools of such loans. However, 95.0% of those securities are issued or guaranteed by FNMA, GNMA or FHLMC. The remainder of the securities' portfolio are all investment grade fixed-rate securities rated AAA that are at least five years old. None of those securities have experienced ratings downgrades. We do not hold any loans in our portfolio of the type that are commonly known as subprime residential mortgage loans

However, many of our customers, both loan and deposit customers, are involved in the residential construction business in Staten Island. We believe that the . . .