Forward-Looking Statements and Factors that Could Affect Future Results

Certain statements contained in this Annual Report on Form 10-K that are not statements of historical fact constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (the "Act"), notwithstanding that such statements are not specifically identified as such. In addition, certain statements may be contained in the Corporation's future filings with the SEC, in press releases, and in oral and written statements made by or with the approval of the Corporation that are not statements of historical fact and constitute forward-looking statements within the meaning of the Act. Examples of forward-looking statements include, but are not limited to:
(i) projections of revenues, expenses, income or loss, earnings or loss per share, the payment or nonpayment of dividends, capital structure and other financial items; (ii) statements of plans, objectives and expectations of Cullen/Frost or its management or Board of Directors, including those relating to products or services; (iii) statements of future economic performance; and
(iv) statements of assumptions underlying such statements. Words such as "believes", "anticipates", "expects", "intends", "targeted", "continue", "remain", "will", "should", "may" and other similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements.

Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those in such statements. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to:

¨ Local, regional, national and international economic conditions and the impact they may have on the Corporation and its customers and the Corporation's assessment of that impact.

¨ Volatility and disruption in national and international financial markets.

¨ Government intervention in the U.S. financial system.

¨ Changes in the mix of loan geographies, sectors and types or the level of non-performing assets and charge-offs.

¨ Changes in estimates of future reserve requirements based upon the periodic review thereof under relevant regulatory and accounting requirements.

¨ The effects of and changes in trade and monetary and fiscal policies and laws, including the interest rate policies of the Federal Reserve Board.

¨ Inflation, interest rate, securities market and monetary fluctuations.

¨ The effect of changes in laws and regulations (including laws and regulations concerning taxes, banking, securities and insurance) with which the Corporation and its subsidiaries must comply.

¨ The soundness of other financial institutions.

¨ Political instability.

¨ Impairment of the Corporation's goodwill or other intangible assets.

¨ Acts of God or of war or terrorism.

¨ The timely development and acceptance of new products and services and perceived overall value of these products and services by users.

¨ Changes in consumer spending, borrowings and savings habits.

¨ Changes in the financial performance and/or condition of the Corporation's borrowers.

¨ Technological changes.

¨ Acquisitions and integration of acquired businesses.

¨ The ability to increase market share and control expenses.

¨ The Corporation's ability to attract and retain qualified employees.

¨ Changes in the competitive environment in the Corporation's markets and among banking organizations and other financial service providers.

¨ The effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board and other accounting standard setters.

¨ Changes in the Corporation's liquidity position.

¨ Changes in the Corporation's organization, compensation and benefit plans.

¨ The costs and effects of legal and regulatory developments including the resolution of legal proceedings or regulatory or other governmental inquiries and the results of regulatory examinations or reviews.

¨ Greater than expected costs or difficulties related to the integration of new products and lines of business.

¨ The Corporation's success at managing the risks involved in the foregoing items.

Forward-looking statements speak only as of the date on which such statements are made. The Corporation undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made, or to reflect the occurrence of unanticipated events.

Application of Critical Accounting Policies and Accounting Estimates

The accounting and reporting policies followed by the Corporation conform, in all material respects, to accounting principles generally accepted in the United States and to general practices within the financial services industry. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. While the Corporation bases estimates on historical experience, current information and other factors deemed to be relevant, actual results could differ from those estimates.

The Corporation considers accounting estimates to be critical to reported financial results if (i) the accounting estimate requires management to make assumptions about matters that are highly uncertain and (ii) different estimates that management reasonably could have used for the accounting estimate in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, could have a material impact on the Corporation's financial statements.

Accounting policies related to the allowance for loan losses are considered to be critical, as these policies involve considerable subjective judgment and estimation by management. The allowance for loan losses is a reserve established through a provision for loan losses charged to expense, which represents management's best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The Corporation's allowance for loan loss methodology includes allowance allocations calculated in accordance with Accounting Standards Codification (ASC) Topic 310, "Receivables" and allowance allocations calculated in accordance with ASC Topic 450, "Contingencies." The level of the allowance reflects management's continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality, present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio, as well as trends in the foregoing. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management's judgment, should be charged off. While management utilizes its best judgment and information available, the ultimate adequacy of the allowance is dependent upon a variety of factors beyond the Corporation's control, including the performance of the Corporation's loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications. See the section captioned "Allowance for Loan Losses" elsewhere in this discussion and Note 3 - Loans in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data elsewhere in this report for further details of the risk factors considered by management in estimating the necessary level of the allowance for loan losses.

Overview

The following discussion and analysis presents the more significant factors affecting the Corporation's financial condition as of December 31, 2012 and 2011 and results of operations for each of the years in the three-year period ended December 31, 2012. This discussion and analysis should be read in conjunction with the Corporation's consolidated financial statements, notes thereto and other financial information appearing elsewhere in this report. The Corporation acquired a human resources consulting firm in the Houston market area, with offices in Dallas and Austin, in 2012 and an insurance agency in the San Antonio market area in 2011. All of the Corporation's acquisitions during the reported periods were accounted for as purchase transactions, and as such, their related results of operations are included from the date of acquisition, though none of these acquisitions had a significant impact on the Corporation's financial statements during their respective reporting periods.

Taxable-equivalent adjustments are the result of increasing income from tax-free loans and investments by an amount equal to the taxes that would be paid if the income were fully taxable based on a 35% federal tax rate, thus making tax-exempt yields comparable to taxable asset yields.

Dollar amounts in tables are stated in thousands, except for per share amounts.

Results of Operations

Net income totaled $238.0 million, or $3.86 diluted per common share, in 2012 compared to $217.5 million, or $3.54 diluted per common share, in 2011 and $208.8 million, or $3.44 diluted per common share, in 2010.

Selected income statement data, returns on average assets and average equity and dividends per share for the comparable periods were as follows:

                                               2012           2011           2010
                                             - ------------------------------------- --

    Taxable-equivalent net interest income   $ 668,176      $ 642,066      $ 616,319
    Taxable-equivalent adjustment               63,315         60,290         52,860
                                             - ------------------------------------- --
    Net interest income                        604,861        581,776        563,459
    Provision for loan losses                   10,080         27,445         43,611
    Non-interest income                        288,787        290,002        282,033
    Non-interest expense                       575,093        558,098        535,541
                                             - ------------------------------------- --
    Income before income taxes                 308,475        286,235        266,340
    Income taxes                                70,523         68,700         57,576
                                             - ------------------------------------- --
    Net income                               $ 237,952      $ 217,535      $ 208,764
                                             - ------------------------------------- --
    Earnings per common share:
    Basic                                    $    3.87      $    3.55      $    3.44
    Diluted                                       3.86           3.54           3.44
    Return on average assets                      1.14 %         1.17 %         1.21 %
    Return on average equity                     10.03          10.01          10.30

Net income for 2012 increased $20.4 million, or 9.4%. The increase was primarily the result of a $23.1 million increase in net interest income and a $17.4 million decrease in the provision for loan losses partly offset by $17.0 million increase in non-interest expense, a $1.8 million increase in income tax expense and a $1.2 million decrease in non-interest income. Net income for 2011 increased $8.8 million, or 4.2%. The increase was primarily the result of an $18.3 million increase in net interest income, a $16.2 million decrease in the provision for loan losses and an $8.0 million increase in non-interest income partly offset by a $22.6 million increase in non-interest expense and an $11.1 million increase in income tax expense.

Details of the changes in the various components of net income are further discussed below.

Net Interest Income

Net interest income is the difference between interest income on earning assets, such as loans and securities, and interest expense on liabilities, such as deposits and borrowings, which are used to fund those assets. Net interest income is the Corporation's largest source of revenue, representing 67.7% of total revenue during 2012. Net interest margin is the ratio of taxable-equivalent net interest income to average earning assets for the period. The level of interest rates and the volume and mix of earning assets and interest-bearing liabilities impact net interest income and net interest margin.

The Federal Reserve Board influences the general market rates of interest, including the deposit and loan rates offered by many financial institutions. The Corporation's loan portfolio is significantly affected by changes in the prime interest rate. The prime interest rate, which is the rate offered on loans to borrowers with strong credit, remained at 3.25% during 2012, 2011 and 2010. The Corporation's loan portfolio is also impacted, to a lesser extent, by changes in the London Interbank Offered Rate (LIBOR). At December 31, 2012, the one-month and three-month U.S. dollar LIBOR rates were 0.21% and 0.31%, respectively, while at December 31, 2011, the one-month and three-month U.S. dollar LIBOR rates were 0.30% and 0.58%, respectively. The intended federal funds rate, which is the cost of immediately available overnight funds, remained at zero to 0.25% during 2012, 2011 and 2010.

The Corporation's balance sheet has historically been asset sensitive, meaning that earning assets generally reprice more quickly than interest-bearing liabilities. Therefore, the Corporation's net interest margin was likely to increase in sustained periods of rising interest rates and decrease in sustained periods of declining interest rates. During the fourth quarter of 2007, in an effort to make the Corporation's balance sheet less sensitive to changes in interest rates, the Corporation entered into various interest rate swaps which effectively converted certain variable-rate loans into fixed-rate instruments for a period of time. During the fourth quarter of 2008, the Corporation also entered into an interest rate swap which effectively converted variable-rate debt into fixed-rate debt for a period of time. As a result of these actions, the Corporation's balance sheet was more interest-rate neutral and changes in interest rates had a less significant impact on the Corporation's net interest margin than would have otherwise been the case. During the fourth quarter of 2009, a portion of the interest rate swaps on variable-rate loans were terminated, while the remaining interest rate swaps on variable-rate loans were terminated during the fourth quarter of 2010. These actions increased the asset sensitivity of the Corporation's balance sheet. The deferred accumulated gain applicable to the settled interest rate contracts included in accumulated other comprehensive income totaled $68.0 million ($44.2 million on an after-tax basis) at December 31, 2012. The deferred gain will be recognized ratably in earnings through October 2014. See Note 15 - Derivative Financial Instruments in the accompanying notes to consolidated financial statements included elsewhere in this report for additional information related to these interest rate swaps.

The Corporation is primarily funded by core deposits, with non-interest-bearing demand deposits historically being a significant source of funds. This lower-cost funding base is expected to have a positive impact on the Corporation's net interest income and net interest margin in a rising interest rate environment. The Dodd-Frank Act repealed the federal prohibition on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts beginning July 21, 2011. Although the ultimate impact of this legislation on the Corporation has not yet been determined, the Corporation may begin to incur interest costs associated with demand deposits in the future as market conditions warrant. See Item 7A. Quantitative and Qualitative Disclosures About Market Risk elsewhere in this report for information about the expected impact of this legislation on the Corporation's sensitivity to interest rates. Further analysis of the components of the Corporation's net interest margin is presented below.

The following table presents the changes in taxable-equivalent net interest income and identifies the changes due to differences in the average volume of earning assets and interest-bearing liabilities and the changes due to changes in the average interest rate on those assets and liabilities. The changes in net interest income due to changes in both average volume and average interest rate have been allocated to the average volume change or the average interest rate change in proportion to the absolute amounts of the change in each. The Corporation's consolidated average balance sheets along with an analysis of taxable-equivalent net interest income are presented on pages 144 and 145 of this report.

                                              2012 vs. 2011                                     2011 vs. 2010
                               --------------------------------------------      --------------------------------------------
                                 Increase (Decrease) Due                           Increase (Decrease) Due
                                       to Change in                                      to Change in
                               ----------------------------                      ----------------------------
                                   Rate            Volume          Total             Rate            Volume          Total

Interest-bearing deposits      $        449      $   (2,506 )    $   (2,057 )    $          -      $    1,456      $    1,456
Federal funds sold and
resell agreements                        (1 )            44              43                11             (24 )           (13 )
Securities:
Taxable                             (55,750 )        61,110           5,360           (19,601 )        25,271           5,670
Tax-exempt                           (6,268 )        10,737           4,469            (1,296 )        18,607          17,311
Loans, net of unearned
discounts                           (16,472 )        20,277           3,805            (7,188 )        (4,128 )       (11,316 )
                               -- ------------------------------------------------------------------------------------------- --
Total earning assets                (78,042 )        89,662          11,620           (28,074 )        41,182          13,108
Savings and interest
checking                               (840 )           343            (497 )          (1,258 )           307            (951 )
Money market deposit
accounts                             (3,360 )         1,114          (2,246 )          (4,517 )         1,056          (3,461 )
Time accounts                          (783 )          (449 )        (1,232 )          (2,428 )          (741 )        (3,169 )
Public funds                            (79 )           (26 )          (105 )            (168 )           (45 )          (213 )
Federal funds purchased and
repurchase agreements                  (176 )             4            (172 )            (219 )            94            (125 )
Junior subordinated
deferrable interest
debentures                               23               -              23               142            (341 )          (199 )
Subordinated notes payable
and other notes                      (6,272 )        (3,988 )       (10,260 )            (342 )        (4,011 )        (4,353 )
Federal Home Loan Bank
advances                                  -              (1 )            (1 )             (13 )          (155 )          (168 )
                               -- ------------------------------------------------------------------------------------------- --
Total interest-bearing
liabilities                         (11,487 )        (3,003 )       (14,490 )          (8,803 )        (3,836 )       (12,639 )
                               -- ------------------------------------------------------------------------------------------- --
Net change                     $    (66,555 )    $   92,665      $   26,110      $    (19,271 )    $   45,018      $   25,747
                               -- ------------------------------------------------------------------------------------------- --

Taxable-equivalent net interest income for 2012 increased $26.1 million, or 4.1%, compared to 2011. The increase primarily related to an increase in the average volume of interest-earning assets partly offset by a decrease in the net interest margin. The average volume of interest-earning assets for 2012 increased $2.2 billion or 13.4% compared to 2011. The net interest margin decreased 29 basis points from 3.88% during 2011 to 3.59% during 2012. The decrease in the net interest margin was partly due to an increase in the relative proportion of average interest-earning assets invested in lower-yielding, taxable securities during 2012 compared to 2011 while the relative proportion of average interest-earning assets invested in higher-yielding loans decreased. The impact of this shift was partly mitigated by a decrease in the relative proportion of average interest-earning assets invested in lower-yielding interest-bearing deposits. The net interest margin was also negatively impacted by a decrease in the average yield on securities, as further discussed below. The average yield on interest-earning assets decreased 40 basis points to 3.73% during 2012 from 4.13% during 2011 while the average cost of funds decreased 16 basis points from 0.40% during 2011 to 0.24% during 2012. The average yield on interest-earning assets is primarily impacted by changes in market interest rates as well as changes in the volume and relative mix of interest-earning assets. As stated above, market interest rates have remained at historically low levels during the reported periods. The effect of lower average market interest rates during the reported periods on the average yield on average interest-earning assets was partly limited by the aforementioned interest rate swaps on variable-rate loans.

Taxable-equivalent net interest income for 2011 increased $25.7 million, or 4.2%, compared to 2010. The increase primarily resulted from an increase in the average volume of interest-earning assets partly offset by a decrease in the net interest margin. The average volume of interest-earning assets for 2011 increased $1.4 billion, or 9.4%, compared to 2010. The net interest margin decreased 20 basis points from 4.08% during 2010 to 3.88% during 2011. The decrease in the net interest margin was partly due to a 31 basis point decrease in the average yield on interest earning assets from 4.44% during 2010 to 4.13% during 2011 while the average cost of funds only decreased 15 basis points from 0.55% during 2010 to 0.40% during 2011. The negative effect of the decrease in the average yield on interest-earning assets on taxable-equivalent net interest income exceeded the positive effect of the decrease in the average cost of funds. The decrease in the average yield on interest-earning assets was partly due to an increase in the relative proportion of average interest-earning assets invested in lower-yielding interest-bearing deposits during 2011 compared to 2010 while the relative proportion of average interest-earning assets invested in higher-yielding loans decreased. The average yield on interest-earning assets was also negatively impacted by a decrease in the average yield on securities.

The average volume of loans increased $413.9 million, or 5.1%, in 2012 compared to 2011 and decreased $82.2 million, or 1.0%, in 2011 compared to 2010. Loans made up approximately 44.5% of average interest-earning assets during 2012 compared to 48.0% during 2011 and 53.0% in 2010. The average yield on loans was 4.82% during 2012 compared to 5.02% during 2011 and 5.11% during 2010. Loans generally have significantly higher yields compared to securities, interest-bearing deposits and federal funds sold and resell agreements and, as such, have a more positive effect on the net interest margin.

The average volume of securities increased $2.7 billion in 2012 compared to 2011 and increased $998.6 million in 2011 compared to 2010. Securities made up approximately 47.0% of average interest-earning assets in 2012 compared to 37.0% in 2011 and 34.0% in 2010. The average yield on securities was 3.31% in 2012 compared to 4.57% in 2011 and 5.02% in 2010. The decrease in the average yield on securities was partly due to a decrease in the yield on taxable securities as proceeds from principal repayments were reinvested at lower market rates. Furthermore, a large portion of the growth in taxable securities was in lower-yielding U.S. Treasury securities. The decrease in the average yield on securities was also partly related to a decrease in the relative proportion of higher-yielding, tax-exempt municipal securities in 2012 compared to 2011. The relative proportion of higher-yielding, tax-exempt municipal securities to total average securities totaled 27.4% in 2012 compared to 35.2% in 2011 and 37.0% in 2010. The average yield on taxable securities was 2.10% in 2012 compared to 3.27% in 2011 and 3.84% in 2010, while the average taxable-equivalent yield on tax-exempt securities was 6.68% in 2012 compared to 6.97% in 2011 and 7.04% in 2010.

Average federal funds sold, resell agreements and interest-bearing deposits during 2012 decreased $899.1 million, or 35.8%, compared to 2011 and increased $519.2 million, or 26.0%, in 2011 compared to 2010. Federal funds sold, resell agreements and interest-bearing deposits made up approximately 8.5% of average interest-earning assets in 2012 compared to approximately 15.0% in 2011 and 13.0% in 2010. The combined average yield on federal funds sold, resell agreements and interest-bearing deposits was 0.27% in 2012 compared to 0.26% in 2011 and 0.25% in 2010. The decrease in federal funds sold, resell agreements and interest-bearing deposits during 2012 compared to 2011 was due to the reinvestment of funds into higher-yielding securities and loans. The increase in federal funds sold, resell agreements and interest-bearing deposits during 2011 compared to 2010 was primarily due to significant deposit growth, as further discussed below.

Average deposits increased $2.1 billion, or 13.6%, in 2012 compared to 2011 and $1.2 billion, or 8.4%, in 2011 compared to 2010. Average interest-bearing deposits increased $786.5 million in 2012 compared to 2011 and $459.8 million in 2011 compared to 2010, while average non-interest-bearing deposits increased $1.3 billion in 2012 compared to 2011 and $715.2 million in 2011 compared to 2010. The ratio of average interest-bearing deposits to total average deposits was 59.4% in 2012 compared to 62.3% in 2011 and 64.2% in 2010. The average cost of interest-bearing deposits and total deposits was 0.18% and 0.10% in 2012 . . .