Financial Condition at September 30, 2008

Total assets were $206,907,050 at September 30, 2008, an increase of $3,113,481 or, 1.5%, from December 31, 2007. The increase resulted from the investment of funds available to us as the result of an increase in deposits. The deposit increase was caused generally by our efforts to grow our franchise and specifically by the deposit increases at our branch offices. We invested these funds primarily in investment securities available for sale. The net increase in assets can be summarized as follows:

† A $2,929,072 net increase in investment securities available for sale and

† A $2,536,553 net increase in net loans receivable, partially offset by

† A $2,087,659 net decrease in cash and cash equivalents.

In addition, we also experienced changes in other asset categories due to normal fluctuations in operations.

Our deposits (including escrow deposits) were $183,273,417 at September 30, 2008, an increase of $6,938,974 or 3.9%, from December 31, 2007. The increase in deposits resulted from increases of $6,172,292 in time deposits, $1,779,352 in savings accounts and $1,030,746 in NOW accounts, partially offset by a decrease of $1,496,449 in non-interest demand deposits and $546,967 in money market accounts.

Total stockholders' equity was $22,175,831 at September 30, 2008, an increase of $1,292,026 from December 31, 2007. The increase reflected (i) net income of $1,330,924 for the nine months ended September 30, 2008, (ii) an increase of additional paid in capital of $164,857 due to the exercise by management and directors of 23,375 options, (iii) a reduction in the net unrealized loss on securities available for sale of $66,009 and (iv) a reduction of $126,808 in Unearned ESOP shares reflecting the gradual payment of the loan we made to fund the ESOP's purchase of our stock. These increases were partially offset by $343,982 of dividends paid, representing the three $0.06 per share quarterly cash dividends in 2008.

The unrealized loss on securities available for sale is excluded from the calculation of regulatory capital. Management does not anticipate selling securities in this portfolio, but changes in market interest rates or in the demand for funds may change management's plans with respect to the securities portfolio. If there is a material increase in interest rates, the market value of the available for sale portfolio may decline. Management believes that the principal and interest payments on this portfolio, combined with the existing liquidity, will be sufficient to fund loan growth and potential deposit outflow.

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. We do not hold any loans in our portfolio of the type that are commonly known as subprime residential mortgage loans. At September 30, 2008, we owned $120.7 million of securities that are either collateralized by residential mortgage loans or that represent shares in pools of such loans. However, 94.8% of those securities are issued or guaranteed by FNMA (Fannie Mae), GNMA (Ginnie Mae) or FHLMC (Freddie Mac). The remainder of the securities portfolio is all investment grade fixed-rate securities rated AAA that are at least five years old. None of those securities have experienced ratings downgrades. Those securities issued or guaranteed by Fannie Mae or Freddie Mac are entirely securities in which we have a relatively senior position in the cash flow received on the underlying mortgages and there is at least one significant class in each security with a lower cash flow priority. As a result, we anticipate that even if here are defaults on the underlying mortgages and even if Fannie Mae or Freddie Mac suffers from economic difficulties, the ultimate recovery of the entire amount owed of the securities we have purchased is reasonably certain.

Many of our customers, both loan and deposit customers, are involved in the residential construction business in Staten Island. We believe that the turmoil in the national housing and residential mortgage markets has had an adverse effect on some of our customers. An apparent slow down in the local housing market and a noticeable reduction in the availability of residential mortgage loans seems to have had an adverse effect on our customers and reduced their business activity. We believe that this, in turn, has caused a reduction in their demand for loans from us, such as construction loans to build new homes. It also appears to have adversely affected the level of deposits they maintain.

The Effect of Declining Market Interest Rates.

Market interest rates, especially short term market interest rates, declined substantially from September 2007 to April 2008 as the Federal Reserve reduced the target federal funds rate, which resulted in an immediate and equal reduction in the prime lending rate. The prime rate and the target overnight federal funds rate both declined by 325 basis points during that period, with the most dramatic decline being a 200 basis point decline in the two months from January 22, 2008 through March 18, 2008. As a result, our loan yields (usually based on the prime rate) and our overnight investment yields (based upon the target federal funds rate) declined as market interest rates declined.

The decline in loan yields and earnings on overnight investments was more rapid than the decline in our cost of funds for a number of reasons. Approximately one-third of our deposits are interest-free checking accounts and the rates on those accounts (already at zero) do not decline as market rates decline. The rates we pay on interest-bearing deposits, because of their lower starting point, cannot be reduced by as much as the basis point decline in market rates because of the need to maintain customer relationships, competitive pressures and the simple fact that if we price our time deposit rate at, hypothetically, 50% of the prime rate, then if the prime rate declines 100 basis points, then deposit rate only declines 50 basis points. In addition, customers have the ability to exercise discretion in moving funds between different types of deposits to maximize their interest earnings.

We have some flexibility in allocating our investment choices between the three categories of earning assets - loans, investment securities and other investments (principally overnight investments). As interest rates declined, we elected to invest more of our available liquid assets into investment securities instead of overnight investments. This shift in the mix of our investments allowed us to reduce the effect of declining interest rates because investment securities tend to have higher yields that overnight investments. We were also able to reinvest the payments we received on existing investment securities in securities with rates comparable to the rates we were earning on the securities being repaid because many of the securities being repaid were purchased a number of years ago before market interest rates reached their recent peak towards the end of 2006.

FDIC Temporary Liquidity Program and Capital Purchase Program

The FDIC has recently instituted the Temporary Liquidity Program in which the FDIC will guarantee, with certain limitations, all senior unsecured debt of eligible financial institutions. The FDIC has also recently increased insurance coverage on non-interest bearing demand accounts to an unlimited amount, but with the payment of an additional assessment fee. The United States Department of the Treasury recently announced a Capital Purchase Program ("CPP") in which the Treasury will purchase preferred stock from approved institutions, with certain limitations and restrictions. These three programs are all entirely voluntary. VSB Bancorp, Inc. and Victory State Bank, have strong capital (Tier 1 Capital ratio in excess of 10% and Total Risk Based Capital ratio in excess of 25%). We have reported positive and increased quarterly earnings in 2008 and we did not originate or invest in subprime mortgages nor in FNMA and FHLMC preferred stock. Although all of the details of the Treasury and FDIC programs have not yet been announced, we do not currently anticipate that we will participate in any of these programs.

Results of Operations for the Three Months Ended September 30, 2008 and September 30, 2007

Our results of operations depend primarily on net interest income, which is the difference between the income we earn on our loan and investment portfolios and our cost of funds, consisting primarily of interest we pay on customer 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.

General. We had net income of $542,704 for the quarter ended September 30, 2008, compared to net income of $496,279 for the comparable quarter in 2007. The principal categories which make up the 2008 net income are:

† Interest income of $2,798,701

† Reduced by interest expense of $517,528

† Reduced by a provision for loan losses of $40,000

† Increased by non-interest income of $603,965

† Reduced by non-interest expense of $1,835,730

† Reduced by $466,704 in income tax expense

Interest Income. Interest income was $2,798,701 for the quarter ended September 30, 2008, compared to $3,117,919 for the quarter ended September 30, 2007, a decrease of $319,218, or 10.2%. The principal reason for this decrease was a 224 basis point decrease in the yield on our loan portfolio due to lower market interest rates. The effect of the decline in yields was partially mitigated by a $4,704,165 increase in the average balance of loans, our highest yielding asset category. We also used liquid assets, such as overnight investments, to purchase investment securities as we reduced the average balance of overnight investments by $13,519,866 and reallocated the funds to increase the average balance of higher yielding investment securities.

The 3 basis point increase in the average yield on our investment securities portfolio, from 4.72% to 4.75%, was due to the purchase of new investment securities at higher market rates than the yields on the principal paydowns we received. The yield on investment securities did not decrease as the other interest-earning assets because most of the bonds and notes in our investment portfolio have either fixed interest rates or interest rates that react more slowly to changes in market interest rate conditions. The average balance of our investment portfolio increased by $12,360,237, or 11.13%, between the periods. The increase in volume and the increase in yield resulted in an overall $153,571 increase in interest income from investment securities. The investment securities portfolio represented 92.0% of average non-loan interest earning assets in the 2008 period compared to 82.1% in the 2007 period.

Interest Expense. Interest expense was $517,528 for the quarter ended September 30, 2008, compared to $909,227 for the quarter ended September 30, 2007, a decrease of 43.1%. The decrease was primarily the result of the repayment of the subordinated debt in August 2008 coupled with a decrease in the rates we paid on deposits, specifically time deposits (166 basis point decrease) and money market accounts (93 basis point decrease). Our average cost of funds, excluding the effect of interest-free demand deposits, decreased to 1.68% from 2.84% between the periods due to the decline in market interest rates.

Net Interest Income Before Provision for Loan Losses. Net interest income before the provision for loan losses was $2,281,173 for the quarter ended September 30, 2008, an increase of $72,481, or 3.3% over the $2,208,692 in the comparable 2007 quarter. Our net interest spread increased to 3.84% in the third quarter of 2008 from 3.46% in the third quarter of 2007. We were able to main the spread due to the reallocation of overnight investments into investment securities and our net interest margin increased to 4.48% in the third quarter of 2008 from 4.45% in the third quarter of 2007.

Provision for Loan Losses. We took a provision for loan losses of $40,000 for the quarter ended September 30, 2008 compared to a credit provision for loan losses of $15,000 for the quarter ended September 30, 2007. The increase in the provision was the result of an increase in loan delinquencies. The provision for loan losses in any period depends upon the amount necessary to bring the allowance for loan losses to the level management believes is appropriate, after taking into account charge offs and recoveries. Our allowance for loan losses is based on management's evaluation of the risks inherent in our loan portfolio and the general economy. Management periodically evaluates both broad categories of performing loans and problem loans individually to assess the appropriate level of the allowance.

Although management uses available information to assess the appropriateness of the allowance on a quarterly basis in consultation with outside advisors and the board of directors, changes in national or local economic conditions, the circumstances of individual borrowers, or other factors, may change, increasing the level of problem loans and requiring an increase in the level of the allowance. The allowance for loan losses represented 1.45% of total loans at September 30, 2008, but there can be no assurance that a higher level, or a higher provision for loan losses, will not be necessary in the future.

Non-interest Expense. Non-interest expense was $1,835,730 for the quarter ended September 30, 2008, compared to $1,834,361 for the quarter ended September 30, 2007. The shifts in the individual categories were:

† $24,402 increase in occupancy expenses due to higher utility bills;

† $15,555 increase in legal expenses primarily due to increased collection costs

† $24,703 increase in other expenses due to an increase in advertising expenses in connection with the Bank's new advertising campaign

† $70,259 decrease in salaries and benefits expense, due in part to the retirement of the former president and reduced incentive and ESOP compensation expense.

Income Tax Expense. Income tax expense was $466,704 for the quarter ended September 30, 2008, compared to income tax expense of $432,689 for the quarter ended September 30, 2007. The increase in income tax expense was due to the $80,440 increase in income before income taxes in the 2008 quarter. Our effective tax rate for the quarter ended September 30, 2008 was 46.2% and for the quarter ended September 30, 2007 was 46.6%.

Results of Operations for the Nine Months Ended September 30, 2008 and September 30, 2007

Our results of operations depend primarily on net interest income, which is the difference between the income we earn on our loan and investment portfolios and our cost of funds, consisting primarily of interest we pay on customer 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.

General. We had net income of $1,330,924 for the nine months ended September 30, 2008, compared to net income of $1,534,071 for the comparable period in 2007. The principal categories which make up the 2008 net income are:

† Interest income of $8,208,613

† Reduced by interest expense of $1,866,141

† Reduced by a provision for loan losses of $125,000

† Increased by non-interest income of $1,794,101

† Reduced by non-interest expense of $5,536,057

† Reduced by $1,144,592 in income tax expense

We discuss each of these categories individually and the reasons for the differences between the nine months ended September 30, 2008 and 2007 in the following paragraphs. In general, the principal reasons for the decline in net income when comparing the first nine months of 2008 with the same period in 2007 were (i) a reduction in the yield on interest-earning assets, primarily in the loan portfolio and other-interest earning assets, which reduced interest income, and (ii) an increase in the provision for loan loss. These were partially offset by the decrease in interest expense due to the drop in the cost of deposits.

The average yield on our investment securities portfolio increased 4 basis points, from 4.71% to 4.75%, due to the purchase of new investment securities at slightly higher market rates than the yields on the principal paydowns we received. The yield on investment securities did not decrease as did the yields on other interest earning assets because most of the bonds and notes in our investment portfolio have either fixed interest rates or interest rates that react more slowly to changes in market interest rate conditions. The average balance of our investment portfolio increased by $9,574,688, or 8.62%, between the periods. The increase in volume and the increase in yield resulted in an overall $375,072 increase in interest income from investment securities. The investment securities portfolio represented 90.3% of average non-loan interest earning assets in the 2008 period compared to 83.6% in the 2007 period.

Interest Expense. Interest expense was $1,866,141 for the nine months ended September 30, 2008, compared to $2,622,257 for the nine months ended September 30, 2007, a decrease of 28.8%. The decrease was primarily the result of the repayment of the subordinated debt in August 2008 coupled with a decrease in the rates we paid on deposits, specifically time deposits (a 126 basis point decrease in cost) and money market accounts (a 55 basis point decrease in cost). Our average cost of funds, excluding the effect of interest-free demand deposits, decreased to 2.03% from 2.82% between the periods due to a decline in market interest rates that began in approximately September 2007.

Net Interest Income Before Provision for Loan Losses. Net interest income before the provision for loan losses was $6,342,472 for the nine months ended September 30, 2008, a decrease of $332,871, or 5.0% over the $6,675,343 in the comparable 2007 period. The decrease resulted principally from a decrease in the yield on our loan portfolio, which was greater than the decrease in the average cost of our deposits, including demand deposits, partially offset by a decrease in the cost of time deposits and an increase in interest income from our investment security portfolio. Our net interest spread decreased to 3.53% in the first nine months of 2008 from 3.58% in the same period of 2007 and our net interest margin, which includes the effect of interest-free demand deposits and capital as funding sources, decreased to 4.29% in the first nine months of 2008 from 4.59% in the same period of 2007.

Provision for Loan Losses. We took a provision for loan losses of $125,000 for the nine months ended September 30, 2008 compared to a credit to the provision for loan losses of $45,000 for the nine months ended September 30, 2007. The increase in the provision was the result of an increase in loan delinquencies and charge-offs. The provision for loan losses in any period depends upon the amount necessary to bring the allowance for loan losses to the level management believes is appropriate, after taking into account charge offs and recoveries. Our allowance for loan losses is based on management's evaluation of the risks inherent in our loan portfolio and the general economy. Management periodically evaluates both broad categories of performing loans and problem loans individually to assess the appropriate level of the allowance.

Although management uses available information to assess the appropriateness of the allowance on a quarterly basis in consultation with outside advisors and the board of directors, changes in national or local economic conditions, the circumstances of individual borrowers, or other factors, may change, increasing the level of problem loans and requiring an increase in the level of the allowance. The allowance for loan losses represented 1.45% of total loans at September 30, 2008, but there can be no assurance that a higher level, or a higher provision for loan losses, will not be necessary in the future.

Non-interest Expense. Non-interest expense was $5,536,057 for the nine months ended September 30, 2008, compared to $5,464,468 for the nine months ended September 30, 2007. The principal causes of the $71,589 increase were:

† $60,867 increase in occupancy expenses due to higher utility costs and the operation of our new main office in Great Kills, which opened in February 2007;

† $136,975 increase in legal expenses primarily due to new collection matters and because in 2007 we received a reimbursement from our insurance company of legal fees previously expensed.

† $104,452 increase in other expenses due to a $74,013 increase in advertising expenses in connection with the Bank's new advertising campaign and a $40,110 recovery in 2007 of part of a reserve expensed in 2005 for a legal claim that we settled for less than the reserve in 2007

† $246,906 decrease in salaries and benefits expense, due in part to the retirement of the former president and reduced incentive and ESOP compensation expense.

Income Tax Expense. Income tax expense was $1,144,592 for the nine months ended September 30, 2008, compared to income tax expense of $1,337,997 for the nine months ended September 30, 2007. The reduction in income tax expense was due to the $396,552 decrease in income before income taxes in the 2008 period. Our effective tax rate for the nine months ended September 30, 2008 was 46.2% and for the quarter ended September 30, 2007 was 46.6%.

                               VSB Bancorp, Inc.
                      Consolidated Average Balance Sheets
                                  (unaudited)


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