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 real estate values; changes in interest rates, deposit flows, and loan demand; changes in legislation or regulation including regulatory assessments; our ability to manage growth; changes in accounting principles, policies or guidelines; competition; other competitive, technological, governmental and regulatory factors affecting our operations, pricing, products, and services; and factors set out in our Annual Report on Form 10-K for the year ended December 31, 2008 and our other filings with the Securities and Exchange Commission.

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, 2008.

Recent Market Developments on the Banking Industry

Although recent news indicates the economy may be improving, the economy continues to experience significantly reduced business activity as a result of, among other factors, disruptions in the financial system during the past year. Declines in the real estate market during the past year, due to falling real estate prices, especially home prices, and increased unemployment and foreclosures, have adversely impacted credit markets, consumer confidence and the broader economy.

Our financial performance generally, and in particular the ability of our borrowers to pay interest on and repay principal of outstanding loans and the value of collateral securing those loans, is highly dependent upon the business environment in the markets where we operate in Wake and New Hanover Counties, in North Carolina. In response to the deteriorating economy in our market areas and the resultant impact on our loan portfolio, we significantly increased our allowance for loan losses in the three months ended September 30, 2009, which significantly reduced our earnings for the three and nine months ended September 30, 2009. See the discussions on "Provision for Loan Losses" and "Allowance for Loan Losses and Asset Quality." The business environment in North Carolina and the markets in which we operate may continue to deteriorate for the foreseeable future which could adversely impact our future earnings.

The resulting effects of the recession on the real estate market and economy could adversely affect the credit quality of our loans and our overall results of operations and financial condition for the remainder of 2009 and in the future. Further, the U.S. government's response to the recession and the financial crisis could significantly impact our operations, including the imposition of new laws and regulations.

In February 2009, the FDIC proposed amendments to its restoration plan for the Deposit Insurance Fund. The FDIC base assessment increase in insurance premiums as well as an emergency special assessment of five basis points was levied against all banks in June 2009 and payable on September 30, 2009. The FDIC's interim rule proposed in February 2009 also provides for an additional emergency special assessment of up to 10 basis points if necessary to maintain public confidence in federal deposit insurance coverage for insured banks. On September 29, 2009 the Board of Directors of the FDIC proposed a rule to require insured institutions to prepay their estimated quarterly risk-based insurance deposit premiums for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. The assessment rate would be based on third quarter 2009 and assume a 5% annual growth rate in deposits each year with a three-basis point increase in assessment rates effective on January 1, 2011. If the rule is enacted, the entire assessment would be accounted for as a prepaid expense on our balance sheet, as of December 30,

2009. As of December 31, 2009, and each quarter thereafter, we would charge as an expense to our earnings the portion of the prepaid expense applicable to that quarter. The results of the special assessment and increased regular assessments will continue to have a significant impact on our results of operations for 2009 compared to 2008 as well as in the future.

We generally are unable to control the amount of premiums that we are required to pay for FDIC insurance. If there are additional bank or financial institution failures, we may be required to pay even higher FDIC premiums than the recently increased levels. Additionally, the FDIC may make material changes to the calculation of the prepaid assessment from the current proposal. Any future changes in the calculation or assessment of FDIC insurance premiums may have a material adverse effect to our results of operations and financial condition. Additional discussion regarding increased insurance assessments is presented in Item 1. Business "Supervision and Regulation - Insurance Assessments" in our Annual Report on Form 10-K for the year ended December 31, 2008.

In response to the financial crisis affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions, the U.S. Government adopted the Emergency Economic Stabilization Act and authorized the Department of the Treasury to establish the Troubled Asset Relief Program ("TARP") to purchase equity stakes in a wide variety of banks and thrifts through TARP's Capital Purchase Program ("CPP"). After careful and complete evaluation, our Board of Directors chose not to participate in the CPP. Also, the FDIC adopted the Temporary Liquidity Guarantee Program ("TLGP") as an initiative to counter the system-wide crisis in the nation's financial sector. We elected to participate in the TLGP, in part, through full FDIC insurance coverage of all non-interest bearing deposit transaction accounts regardless of dollar amount, through December 31, 2009. For specific details of the CPP and TLGP plans see "Recent Market Developments" included in "Management's Discussion and Analysis" in our Annual Report on Form 10-K for the year ended December 31, 2008.

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 in North Carolina: its new multi-story main office and corporate headquarters in North Raleigh; one office in the North Hills section of Raleigh; one office in West Raleigh; one office in downtown Raleigh; one office in Garner; one office serving the Wake Forest area; one office in Wilmington; and a loan production office in Morehead City.

Comparison of Financial Condition at September 30, 2009 and December 31, 2008

Total assets at September 30, 2009 were $710.8 million, an increase of $23.2 million or 3.4% over December 31, 2008. The increase in assets is reflected primarily in additional investments in certificates of deposit with other banking institutions, all fully guaranteed by the FDIC. Our loan portfolio of $534.1 million at September 30, 2009 represents our largest earning asset component at 75.1% of total assets, down from 79.5% at December 31, 2008 due to continued slow loan demand and a

renewed focus on making loans only to those customers with whom we also have a corresponding deposit relationship. Our total short-term earning assets, including certificates of deposit with other banking institutions, grew $43.5 million to $120.3 million and our available for sale investment portfolio decreased $11.2 million to $25.2 million at September 30, 2009 compared to December 31, 2008. Our asset growth was funded by growth in deposits, up $20.9 million or 3.4% to $633.6 million at September 30, 2009, compared to total deposits of $612.7 million at December 31, 2008. An increase of $34.2 million in traditional core deposits and slower loan growth during the first nine months of 2009 provided the opportunity to reduce our level of wholesale brokered certificates of deposit during the first nine months of 2009 with a goal to continue to reduce these non-relationship deposits. Our core deposit growth is a result of our efforts to seek opportunities to develop banking relationships with our chosen customers throughout all our markets in general and through the launching of our new property management division "CommunityPLUS." Short-term borrowings, consisting of securities sold under repurchase agreements and Federal funds purchased increased $1.3 million from December 31, 2008 to $9.1 million at September 30, 2009 and long-term borrowings were unchanged. We continue to have no exposure to subprime loans and chose not to participate in the Capital Purchase Plan of the U.S. Government's Troubled Asset Relief Program, or TARP.

Substantially all of our investments are accounted for as available for sale and are presented at their fair market value. Our available for sale investment portfolio decreased $11.2 million to $25.2 million from $36.4 million at December 31, 2008. During January and February 2009, management sold $15.3 million of our U.S. government securities and obligations of U.S. governmental agencies and $1.4 million of our state and municipal securities, respectively, for net gains of $464,000. The decision to sell a substantial part of the securities portfolio was due to concerns over the continued negative downturn in real estate markets and the rising mortgage delinquency and foreclosure rates and the effect of the underlying mortgages on mortgage-backed securities in general. Given the Federal Home Loan Bank, or FHLB, system's large exposure to non-agency mortgage backed securities, management felt it was prudent to reduce our exposure to the FHLB debt instruments. The same general concern about the effect of current and possible future economic events led management to conclude it was prudent to reduce our exposure to municipal debt. We have no holdings in Fannie Mae or Freddie Mac preferred stock and no holdings in non-agency mortgage-backed securities. We own $750,000 in corporate bonds that are accounted for as held to maturity and are carried at book value.

We had no overnight investments in Federal funds sold as of September 30, 2009 compared to $105,000 as of December 31, 2008 as we continue to utilize our Federal Reserve account for our overnight excess funds. Our interest-earning deposits with banks as of September 30, 2009 included $66.4 million in excess overnight funds in our Federal Reserve account compared to $54.0 million as of December 31, 2008. Certificates of deposit with various federally insured banking institutions increased to $53.2 million as of September 30, 2009 compared to $21.8 million as of December 31, 2008. These certificates of deposit are fully insured by the FDIC with an average remaining maturity of less than eight months.

Our loan portfolio decreased $12.3 million or 2.3% during the first nine months of 2009 to $534.1 million as of September 30, 2009 compared to $546.4 million at December 31, 2008. The decline in the loan portfolio reflects loan payoffs and $2.6 million of charge-offs as well as a slow down in new loan demand due to current economic conditions and our continued re-focus on lending only to relationship customers. Commercial real-estate loans decreased approximately $3.6 million and real-estate construction loans decreased approximately $5.7 million from December 31, 2008; however, combined, they remain the largest component of our loan portfolio comprising approximately 76.6% of the loan portfolio at September 30, 2008. Our concentration in commercial real estate exposes us to more credit and regulatory risk than other types of loans.

Real estate values are generally affected by changes in economic conditions, fluctuations in interest rates, the availability of loans to potential purchasers as well as changes in tax and other laws. A

continued downturn in the real estate markets in which we operate, specifically New Hanover and Wake Counties, could have an adverse effect on our business, financial condition and results of operations because loans in these markets are secured by real estate. Borrowers may not be able to make current payments on or repay commercial real estate loans and the value of the collateral securing these loans may decline, which would reduce the security for these loans. Also a concentration in commercial real estate loans has become a focal point of the federal banking regulators. Our concentration in these loans could possibly subject us to adverse comment or action by our federal and state banking regulators, including the FDIC and the Federal Reserve.

The allowance for loan losses was $7.4 million at September 30, 2009 compared to $6.4 million at December 31, 2008, representing 1.38% and 1.17%, respectively, of loans outstanding at each date. The allowance is increased by provisions charged to operations and reduced by loans charged off, net of recoveries. The level of the allowance relative to gross loans was increased primarily due to additional specific reserves for impaired loans as well as overall increases to the general reserve. We established the allowance for loan losses at a level management considers adequate to provide for probable loan losses based on our assessment of our loan portfolio at September 30, 2009. We monitor the allowance regularly.

Our premises and equipment grew $2.6 million during the first nine months of 2009 to $14.9 million. The increase reflects additions for costs on construction and furniture and equipment for our new banking office and corporate headquarters in North Raleigh which we occupied on June 8, 2009. Other real estate owned increased to $4.0 million at September 30, 2009 from $2.3 million at December 31, 2008. Additional discussion regarding other real estate owned is included in the section "Allowance for Loan Losses and Asset Quality."

As a key source of funding, our deposits grew $20.9 million to $633.6 million as of September 30, 2009, from $612.7 million as of December 31, 2008. Slower loan growth and successful building of our core deposits provided the opportunity to begin reducing non-traditional and generally more volatile wholesale brokered certificates of deposit during the first nine months of 2009.

Total time deposits decreased $3.1 million to $302.1 million as of September 30, 2009 compared to $305.3 million as of December 31, 2008. The key reason for the decrease was due to a planned reduction in the level of wholesale brokered time deposits. These brokered deposits were reduced from $75.7 million on December 31, 2008 to $25.2 million at September 30, 2009, to 8.3% of total time deposits as of September 30, 2009, from 24.8% as of December 31, 2008. Non-brokered internet deposits increased $26.0 million over December 31, 2008 to $54.9 million as of September 30, 2009 while other time deposits through participation in the Certificate of Deposit Account Registry Service, or CDARS, program decreased $2.2 million to $26.5 million as of September 30, 2009. The CDARS program provides full FDIC insurance on deposit balances greater than posted FDIC limits by exchanging larger depository relationships with other CDARS members. Time deposits over $100,000, excluding internet deposits, increased $13.5 million to $121.5 million as of September 30, 2009. Traditional core time deposits less than $100,000 grew to $74.2 million, up $10.1 million over December 31, 2008. Total time deposits represented 47.7% of our total deposits outstanding as of September 30, 2009 compared to 49.8% as of December 31, 2008.

Interest-bearing transaction accounts which are savings, money market and interest checking accounts, grew to $244.7 million as of September 30, 2009, an increase of $23.9 million over December 31, 2008. These core deposits increased to 38.6% of total deposits as of September 30, 2009 up from 36.0% of total deposits as of December 31, 2008. Non-interest bearing deposits remained essentially unchanged at $86.8 million as of September 30, 2009. In total, our traditional core deposits, which exclude internet, CDARS, wholesale brokered deposits and time deposits greater than $100,000, grew $34.2 million to $405.7 million, representing 64.0% of total deposits as of September 30, 2009 compared

to 60.6% of total deposits outstanding at December 31, 2008. Deposit funds from our new property management division, "CommunityPLUS," contributed $21.2 million of the increase in core deposits since December 31, 2008. Our ability to maintain and grow our traditional core deposits is a result of our continued efforts to emphasize relationship banking with our customers in which we aim to obtain the customers' borrowing and deposit relationship. Our efforts to grow core deposits will continue to be a top priority during 2009 and beyond as we work to build banking relationships in order to reduce and eventually eliminate non-relationship lending.

Short-term borrowings as of September 30, 2009 were $9.1 million, up from $7.8 million as of December 31, 2008, primarily consisting of securities sold under repurchase agreement. Long-term borrowings remained unchanged at $27.3 million as of September 30, 2009 consisting primarily of $11.0 million of subordinated notes and $15.5 million in junior subordinated debentures.

As of September 30, 2009, shareholders' equity increased $1.1 million to $36.6 million. The increase was provided by net income of $1.5 million and the conversion of 7,245 stock options into common stock. The exercise of these options contributed $45,000 to our total shareholders' equity. Accumulated other comprehensive income components decreased shareholders' equity as of September 30, 2009 by $531,000.

Comparison of Results of Operations for the Three-Month Periods Ended September 30, 2009 and 2008

Net Income. For the three-month period ended September 30, 2009, net income was $161,000 compared to $586,000 for the corresponding three-month period of 2008, representing a decrease of $425,000 or 72.5%. On a diluted share basis, earnings were $.02 and $.08 per share, respectively, for the three-month periods ended September 30, 2009 and 2008.

The decrease in earnings for the period is primarily attributable to higher loan loss provision, up $1.1 million and significantly higher FDIC insurance premiums, up $263,000. These items were partially offset with increased net interest income of $126,000 and reductions of $656,000 in noninterest expenses, excluding FDIC premiums, largely as a result of expense reduction initiatives undertaken early in 2009.

Net Interest Income. Net interest income was $5.4 million for the three-month period ended September 30, 2009 compared to $5.3 million for the prior year period. The overall growth in average interest-earning assets, which helped to offset declines in yields, and the impact of the lower interest rate environment on our funding costs were key factors contributing to the $126,000 increase in net interest income.

Interest income for the three-month period ended September 30, 2009 decreased $757,000 or 8.3% over the prior year period. Interest income is affected by changes in the mix and volume of average interest-earning assets, interest rates and also by the level of loans on nonaccrual status. During the three-month period ended September 30, 2009, The Wall Street Journal prime interest rate averaged 175 basis points lower than in the same period for 2008. The impact of the declines in prime rate on our loan portfolio was minimized to a decrease of 70 basis points in average loan yield during this same period due to several factors. First we had a lower level of variable rate loans, which reprice with each reduction in the Wall Street Journal prime rate and represented approximately 32% of our loan portfolio as of September 30, 2009 compared to approximately 38% as of September 30, 2008. Second, whenever possible, management modifies our loan pricing to include interest rate floors on variable rate loans. A factor contributing to lower loan interest income is a higher level of loans where interest accrual was discontinued, up to $16.2 million as of September 30, 2009 compared to $5.3 million as of September 30, 2008. Overall, lower yields on our interest-earning assets effectively reduced interest income approximately $987,000. The decrease in interest income due to lower rates was partially offset with an

overall higher level of average interest-earning assets over the prior year period. Average interest-earning assets, primarily lower yielding average short-term investments with an average yield of .86%, were up $93.5 million over the prior year period, providing an increase in interest income of approximately $229,000.

Total interest expense decreased $883,000 or 22.8% over the prior year period. As with interest income, deposit pricing to reflect the lower interest rate environment was the primary factor for the overall decrease in interest expense. Lower interest rates paid on our interest-bearing deposits reduced total interest expense by approximately $1.4 million. Growth in average interest-bearing deposits of $82.3 million, primarily time deposits over $100,000, increased total interest expense by approximately $698,000 for the three months ended September 30, 2009 compared to the prior year period. Also contributing to lower deposit interest expense was an average increase of $18.0 million in noninterest-bearing demand deposits for same periods. Interest expense on average short-term and long-term borrowings decreased $44,000 and $152,000, respectively, over the prior year period due to a decrease in interest rates paid on these borrowings as a result of the lower interest rate environment and a decrease of $3.4 million in average short-term borrowings.

Overall, net interest income for the three-month period ended September 30, 2009 increased $126,000 or 2.4%, compared to the same period in 2008. The net interest margin for the three-month period was 3.17% compared to 3.61% 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.

                                           For the Three Months Ended               For the Three Months Ended
                                               September 30, 2009                       September 30, 2008
                                         Average                   Average        Average                   Average
                                         Balance       Interest     Rate          Balance       Interest     Rate
                                             (Dollars in thousands)                   (Dollars in thousands)
Interest-earning assets:
Loans (1)                              $   541,627    $    7,863      5.76 %    $   539,882    $    8,760      6.46 %
Investments available for sale              25,840           284      4.36 %         25,551           279      4.34 %
Investments held to maturity                   750             7      3.70 %            384             7      7.25 %
Fed funds sold                                   -             -         -           12,070            61      2.01 %
Certificates of deposit with banks          44,810           184      1.63 %              -             -         -
Other interest-earning deposits with
banks                                       59,654            40      0.27 %          1,286             5      1.55 %
Other interest-earning assets                1,740             6      1.37 %          1,704            29      6.77 %

Total interest-earning assets              674,421         8,384      4.93 %        580,877         9,141      6.26 %


Other assets                                24,900                                   19,715


Total assets                           $   699,321                              $   600,592


Interest-bearing liabilities:
Deposits:
NOW, money market & savings                225,616           517      0.91 %        219,840         1,088      1.97 %
Time deposits over $100,000                160,851         1,112      2.74 %         97,888         1,076      4.37 %
Other time deposits                        146,681         1,099      2.97 %        133,147         1,251      3.74 %
Short-term borrowings                        9,209             9      0.39 %         12,611            53      1.67 %
Long-term debt                              27,296           255      3.71 %         27,319           407      5.93 %

Total interest-bearing liabilities         569,653         2,992      2.08 %        490,805         3,875      3.14 %


Demand deposits                             87,730                                   69,735
Other liabilities                            4,785                                    5,150
Shareholders' equity                        37,153                                   34,902


Total liabilities and shareholders'
equity                                 $   699,321                              $   600,592


Net interest income and interest
rate spread                                           $    5,392      2.85 %                   $    5,266      3.12 %


Net yield on average
interest-earning assets                                               3.17 %                                   3.61 %


Ratio of average interest-earning
assets to average interest-bearing
liabilities                                                         118.39 %                                 118.35 %

(1) Nonaccrual loans are included in loan amounts.

Provision for Loan Losses. The provision for loan losses increased $1.1 million . . .