**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.**

**FORM 10-K**

(Annual Report Under Section 13of the Securities Exchange Act of 1934)

For the fiscal year ended December 31,2006

Commission File No. 001-16101

**BANCORP RHODE ISLAND, INC.**

(Exact Name of Registrantas Specified in Its Charter)

| **Rhode Island**                 | ** ** | **05-0509802**       |
|----------------------------------|------------|----------------------|
| (State or Other  Jurisdiction of |       | (IRS Employer        |
| Incorporation or  Organization)  |       | Identification  No.) |

 

**ONE TURKS HEAD PLACE,PROVIDENCE, RI  02903**

(Address of PrincipalExecutive Offices)

**(401) 456-5000**

**(Issuer’s Telephone Number,Including Area Code)**

**Securitiesregistered pursuant to Section 12(b) of the Act:  None**

**Securitiesregistered pursuant to Section 12(g) of the Act:**

**Common Stock, par value$0.01 per share**

(Title of Class)

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. Yes o  No x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act. Yes o  No x

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed by Section 13of the Securities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the Registrant was required to file such reports), and(2) has been subject to such filing requirements for the past 90 days. Yesx  No o

Indicate by checkmark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of Registrant’sknowledge, in definitive proxy or information statement incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer, as defined in Section 12b-2of the Exchange Act of 1934.

| Large accelerated filer o |   | Accelerated filer  x |   | Non-accelerated  filer o |
|---------------------------|--------|----------------------|--------|--------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2of the Act). Yes o  No x

As of June 30, 2006,the aggregate market value of the voting common equity of the Registrant heldby non-affiliates of the Registrant, based on the closing price on the NasdaqGlobal Select Market SM was $143,973,245.

As of February 28, 2007, there were 4,829,430shares of common stock (par value $0.01 per share) of the Registrant issued andoutstanding.

**Documentsincorporated by reference:**

Portions of Bancorp RhodeIsland’s Definitive Proxy Statement for the 2007 Annual Meeting of Shareholdersare incorporated by reference into Parts II and III of this Form 10-K.

See pages 61to 63 for the exhibit index.

 

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**Bancorp Rhode Island, Inc.**Annual Report on Form 10-KTable of Contents
| Description    | ** ** | ** ** | ** ** | ** **                                                                                                         | ** ** | **Page  Number** |
|----------------|------------|------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|------------------|
| Part I.   |       | Item 1     | —     | Business                                                                                                           |       | 1                |
|           |       | Item 1A    | —     | Risk Factors                                                                                                       |       | 17               |
|           |       | Item 1B    | —     | Unresolved Staff Comments                                                                                          |       | 21               |
|           |       | Item 2     | —     | Properties                                                                                                         |       | 22               |
|           |       | Item 3     | —     | Legal Proceedings                                                                                                  |       | 22               |
|           |       | Item 4     | —     | Submission of Matters to a Vote of Security Holders                                                                |       | 22               |
| Part II.  |       | Item 5     | —     | Market for the Company’s Common Stock, Related  Stockholder Matters and Issuer Purchases of Equity Securities |       | 23               |
|           |       | Item 6     | —     | Selected Consolidated Financial Data                                                                               |       | 24               |
|           |       | Item 7     | —     | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                        |       | 25               |
|           |       | Item 7A    | —     | Qualitative and Quantitative Disclosures About Market  Risk                                                        |       | 55               |
|           |       | Item 8     | —     | Financial Statements and Supplementary Data                                                                        |       | 57               |
|           |       | Item 9     | —     | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure                              |       | 57               |
|           |       | Item 9A    | —     | Controls and Procedures                                                                                            |       | 58               |
|           |       | Item  9B   | —     | Other  Information                                                                                                 |       | 58               |
| Part III. |       | Item 10    | —     | Directors, Executive Officers and Corporate Governance                                                             |       | 58               |
|           |       | Item 11    | —     | Executive Compensation                                                                                             |       | 59               |
|           |       | Item 12    | —     | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                    |       | 60               |
|           |       | Item 13    | —     | Certain Relationships, Related Transactions, and  Director Independence                                            |       | 60               |
|           |       | Item 14    | —     | Principal Accountant Fees and Services                                                                             |       | 60               |
| Part IV.  |       | Item 15    | —     | Exhibits and Financial Statement Schedules                                                                         |       | 61               |
|           |       | Signatures |       | 64                                                                                                                 |

 

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**PART I**

**SPECIALNOTE REGARDING FORWARD LOOKING STATEMENTS**

Wemake certain forward looking statements in this Annual Report on Form 10-Kand in other documents that we incorporate by reference into this report thatare based upon our current expectations and projections about current events.We intend these forward looking statements to be covered by the safe harborprovisions for “forward looking statements” within the meaning of Section 27Aof the Securities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended, and we are including this statement forpurposes of these safe harbor provisions. You can identify these statements byreference to a future period or periods by our use of the words “estimate,” “project,”“may,” “believe,” “intend,” “anticipate,” “plan,” “seek,” “expect” and similarterms or variations of these terms. These forward looking statements include:

·       statementsof our goals, intentions and expectations;

·       statementsregarding our business plans and prospects and growth and operating strategies;

·       statementsregarding the quality of our products and our loan and investment portfolios;and

·       estimatesof our risks and future costs and benefits.

Actual results may differ materially from those setforth in forward looking statements as a result of these and other risks anduncertainties, including those detailed herein under Item 1A, “Risk Factors”,and from time to time in other filings with the Federal Deposit InsuranceCorporation (“FDIC”) and the Securities and Exchange Commission (“SEC”). Wehave included important factors in the cautionary statements included orincorporated in this document, particularly under Item 1A, “Risk Factors”, thatwe believe could cause actual results or events to differ materially from theforward looking statements that we make. Our forward looking statements do notreflect the potential impact of any future acquisitions, mergers, dispositions,joint ventures or investments we may make. We do not assume any obligation toupdate any forward looking statements.

**ITEM 1*.*BUSINESS**

**Introduction**

Bancorp Rhode Island, Inc.(“we” or the “Company”), a Rhode Island corporation, is the holding company forBank Rhode Island (the “Bank”). The Company has no significant assets otherthan the common stock of the Bank. For this reason, substantially all of thediscussion in this document relates to the operations of the Bank and itssubsidiaries.

The Bank is a commercialbank chartered as a financial institution in the State of Rhode Island and wasformed in 1996 as a result of the acquisition of certain assets and liabilitiesdivested in connection with the merger of Fleet Financial Group, Inc. andShawmut National Corporation. Headquartered in Providence, Rhode Island, theBank conducts business through 16 full-service branches, with 11 located inProvidence County, 4 located in Kent County and 1 located in Washington County.The Bank augments its branch network through online banking services andautomatic teller machines (“ATMs”), both owned and leased, located throughoutRhode Island.

The Bank provides acommunity banking alternative in the greater Providence market which isdominated by three large banking institutions, two national and one regional.Based on total deposits as of June 30, 2006 (excluding one bank that drawsits deposits primarily from the internet), the Bank is the fifth largest bankin Rhode Island and the only mid-sized commercially focused bank headquarteredin Providence, the State’s capital. The Bank offers its customers a wide rangeof business, commercial real estate, consumer and residential loans and leases,deposit products, nondeposit investment products, cash 

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management and onlinebanking services, private banking and other banking products and servicesdesigned to meet the financial needs of individuals and small- to mid-sizedbusinesses. As a full-service community bank, the Bank seeks to differentiateitself from its large bank competitors through superior personal service,responsiveness and local decision-making. The Bank’s deposits are insured bythe FDIC, subject to regulatory limits.

One of the Bank’sprincipal subsidiaries, BRI Investment Corp., a Rhode Island corporationwholly-owned by the Bank, engages in the maintenance and management ofintangible investments and the collection and distribution of the income fromsuch investments.

The Company’s headquartersand executive management are located at One Turks Head Place, Providence, RhodeIsland 02903 and its telephone number is (401) 456-5000. The Bank alsomaintains an internet website at http://www.bankri.com.

The Company makes available free of charge through itswebsite at http://www.bankri.com all reports it electronically files with, orfurnishes to, the SEC, including its Annual Report on Form 10-K, QuarterlyReports on Form 10-Q and Current Reports on Form 8-K, aswell as any amendments to those reports, as soon as reasonably practicableafter those documents are filed with, or furnished to, the SEC. These filingsare also accessible on the SEC’s website at http://www.sec.gov.

**Overview**

The Company, through theBank, concentrates its business efforts in three main areas. First, the Bankemphasizes commercial lending. The high concentration of small to mid-sizebusinesses in our predominately urban franchise makes deployment of funds inthe commercial lending area practicable. Moreover, the Bank believes it canattract commercial customers from larger competitors through a higher level ofservice and its ability to set policies and procedures, as well as makedecisions, locally. Second, the Bank has sought to grow its demand deposit,savings and other transaction-based accounts, collectively referred to as “coredeposits”. The Bank has stressed development of full relationships withcustomers, including its commercial customers, who tend to be more relationshiporiented than those who are seeking stand-alone or single transaction products.Third, the Bank seeks to leverage its knowledge and customer base to developrelated lines of business. Thus, the Bank has grown its consumer loan portfolioand added sales of investment products; more recently the Bank has added aprivate banking group and acquired an equipment leasing company.

In March 2006, theBank marked its 10th anniversary in business. During those 10years, the Company has grown its assets, deposits and customer basesignificantly and has expanded the depth and breadth of its management team andstaff. Also, the Bank has substantially enlarged and improved its branchnetwork, enhanced its operating systems and infrastructure and has become aneffective competitive force in the Greater Providence marketplace.

The past year representeda watershed year for the Company. It marked the beginning of the Company’stransition from a young, high growth *de**novo* bank into a more mature institution, which seeks tobetter leverage the footprint it has built and investments it has made over itsfirst ten years. Thus, the Company sought to combine its strong external focuson high quality loan and deposit growth, with (i) the absorption of theCompany’s major 2005 and 2004 initiatives, which included three new branches(with our branch network now expanded into Washington County), the creation ofa private bank and acquisition of a leasing subsidiary, (ii) the deploymentof the $21.5 million of net capital raised in April 2005 and (iii) internallydirected efforts to both rationalize the Company’s organizational structure andbetter control operational costs. Additionally, the Company took measurablesteps to deal with the industry-wide pressure on net interest margins presentedby the flat-to-inverted yield curve and the intensified competition fordeposits. The Company believes that the measures adopted have improved theCompany’s 

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internal operations,increased the value of the franchise and positioned the Company for greatersuccess in the years to come.

In 2005, the Companyrealigned its executive management ranks. By the end of 2006, each of the proxyofficers had at least a year’s experience in their respective new positions andwere functioning effectively as a team. In 2006, the Company added to the nexttier of management, including commercial lending, information technology andmarketing and invested in its security and audit functions. In the commerciallending area, the Company recruited a new director of corporate banking and anew head of business lending, both of whom had strong track records locally atone of the major national banks. Both of these senior managers were added tothe Company without any loss of the existing talent in the Bank’s pace-settingcommercial lending group, which continued to achieve market-leading results.

The commercial lendinggroup produced commercial loan growth of 18.6% in 2006, with commercial loanoutstandings increasing from $438.3 million at the prior year-end to $519.8million at December 31, 2006. Two of the initiatives begun by the Companyin 2005 contributed to this growth. The Company’s equipment leasing subsidiary,Macrolease, has contributed high-quality, high-yielding assets to the Company’sbalance sheet, as well as provided a new source of fee income from leaseoriginations for third parties. In addition, the Company’s private bankinggroup is attracting more high net worth individuals, including professionals,to the Bank’s customer base.

The Company’s loan andlease growth did not come at the expense of credit quality as the Bank’s creditculture remained strong. Nonperforming assets were minimal at December 31,2006 at 0.14% of total loans and 0.10% of total assets, respectively.

Competition for depositsremained intense in the Bank’s primary market area. However, the Bank’s focuson core deposits drove increases in demand deposit accounts of $15.2 million,or 8.2%, year-over-year. At December 31, 2006, total deposits increased$35.5 million, or 3.6%, from the December 31, 2005 balance of $981.0million. Additionally, the deposit base at the Bank’s newest branches continuesto grow. Total deposits at the Bank’s North Kingstown branch exceed $40million, while the Lincoln branch is ahead of plan at $27 million and EastGreenwich has attained $16 million in total deposits. As is typicalindustry-wide, the deposit mix and yield curve have lengthened the timerequired for these branches to achieve profitability.

During 2006, the Bank alsoimplemented deposit fee enhancement programs. As a result of these programs andthe demand deposit account growth referred to above, the Bank experienced a10.8% increase in deposit fee income over the course of the year.

In late 2006, the Bankalso announced its plans to adopt a new service model for its branches. TheCompany plans to move toward the “Universal Banker” model, a single in-branch touch point for allbanking services, which removes the traditional split between the teller andcustomer service representative. By having one person service thecustomer’s needs, the Bank believes it will elevate its service levels as wellas improve operational efficiencies. This concept will be phased in graduallythroughout 2007.

There also was increasedactivity in the treasury and finance area in 2006. The Bank expanded itsfunding options and the finance group undertook stronger investor relations’efforts. Additionally, the Company restructured a portion of its investmentportfolio in September 2006 to improve earnings in future periods by capitalizing on atemporary increase in security valuations due to movements in the yield curve.The Company sold $62 million of its available for sale securities andreinvested the sales proceeds into higher-yielding securities. This investmentportfolio restructuring resulted in pretax losses of $859,000; however, theeffect of these security losses on shareholders’ equity was minimal as thesecurities had been carried at market value on the balance sheet. As a resultof this investment portfolio repositioning, the Company anticipates an increase of futurepretax interest income of over $900,000 by the end of 2007.

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In late 2005, the Bank began a detailed examination ofits operational processes and procedures. The intention was to move from “evolved”to “engineered” processes. As a result, by September 2006, the Company wasable to eliminate 24 positions, primarily in its back office. Additionally, inthe latter part of 2006, the Company created a loan services unit (“LSU”). TheLSU will handle underwriting, processing and monitoring of business creditrelationships up to $1 million. The Company is streamlining its approach forsmaller credits with the objectives of improved monitoring and more efficientprocessing of these credits. The Company’s process review continues in a numberof areas and the Company expects to gain additional efficiencies over time.Throughout 2007, management plans to significantly limit growth of noninterestexpenses as the Company expects margin pressure to persist.

**LendingActivities**

The Bank’s businessstrategy has been to grow its commercial and consumer loan portfolios whileallowing its residential mortgage loan portfolio to decline gradually as apercent of total loans. The Bank has allocated substantial resources to itscommercial and consumer lending functions to facilitate and promote such growth.From December 31, 2001, until December 31, 2006, commercial loan andlease outstandings have increased $280.4 million, or 117.2%, and consumer loanoutstandings have increased $159.2 million, or 259.3%. Commercial loans andleases increased from 39.2% of total loans and leases at December 31,2001, to 51.8% of total loans and leases at December 31, 2006, andconsumer and other loans increased from 10.0% of total loans and leases at December 31,2001, to 22.0% of total loans and leases at December 31, 2006. Meanwhile,residential mortgage loans decreased from 50.8% of total loans and leases at December 31,2001, to 26.3% of total loans and leases at December 31, 2006.

The Bank offers a varietyof loan facilities to serve both commercial and consumer borrowers primarilywithin the State of Rhode Island and nearby areas of Massachusetts.Approximately 66% of Rhode Island businesses and 74% of Rhode Island jobs arelocated in Providence and Kent Counties. More than 98% of Rhode Islandbusinesses have fewer than 100 employees. The Bank believes the financing needsof these businesses generally match the Bank’s lending profile and that theBank’s branches are well positioned to facilitate the generation of loans fromthis customer base.

For most of 2006, the Bank’scommercial lending function was organized into three groups. The commercialreal estate group originates nonowner-occupied commercial real estate,multi-family residential real estate and construction loans. The businesslending group originates business loans, often referred to as commercial andindustrial loans, including owner-occupied commercial real estate loans, termloans, revolving lines of credit and equipment leases (through the Bank’ssubsidiary, Macrolease). The third group is the business development group(formerly the small business group), responsible for origination of a varietyof real estate and non-real estate loans for business lending relationships ofapproximately $250,000 or less, also referred to as small business loans. (TheBank’s branch network also plays a role in the origination of small businessloans.)

In the latter part of2006, the Bank reorganized its commercial business lending function, changingresponsibilities and creating one more group. The business lending group nowconcentrates its efforts on relationships in excess of $1 million. Businesslending relationships under $1 million are now generally originated by the Bank’sbusiness development group, which formerly concentrated solely on smallbusiness loans. Underwriting, processing and monitoring of the bulk of businesscredit relationships of under $1 million have moved to the newly created LSU.The Company is streamlining its approach for smaller credits with theobjectives of improved monitoring and more efficient processing of thesecredits.

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The Bank also satisfies a variety of consumer creditneeds by providing home equity term loans, home equity lines of credit, directautomobile loans, savings secured loans and personal loans, in addition toresidential mortgage loans.

The Bank has tiered lending authorities. Certainsenior executives have lending approval authority of up to $1.25 million. Allextensions of credit of more than $1.25 million (up to the Bank’s house lendinglimit of $10.0 million) per customer relationship require the approval of theCredit Committee, which consists of members of the Bank’s senior management andone outside director. Exceptions to the Bank’s house lending limit require theapproval of a committee of the Board of Directors. Other officers have limitedlending authorities that can be exercised subject to lending policy guidelinesto facilitate volume production and process flow.

The Bank issues loan commitments to prospectiveborrowers subject to various conditions. Commitments generally are issued inconjunction with commercial loans and residential mortgage loans and typicallyare for periods up to 90 days. The proportion of the total value of commitmentsderived from any particular category of loan varies from time to time anddepends upon market conditions. At December 31, 2006, the Bank had $229.5million of aggregate loan commitments outstanding to fund a variety of loans.

Overall, loans and leases produced total interestincome of $63.0 million, or 77.6% of total interest and dividend income, in2006 and $53.8 million, or 77.4%, of total interest and dividend income, during2005.

*CommercialReal Estate and Multi-Family Loans—**The*Bank originatesloans secured by mortgages on owner-occupied and nonowner-occupied commercialand multi-family residential properties. At December 31, 2006,owner-occupied commercial real estate loans totaled $140.8 million, or 14.0% ofthe total loan portfolio. Many of these customers have other commercialborrowing relationships with the Bank, as the Bank finances their other businessneeds. Generally these customer relationships are handled in the Bank’sbusiness lending group. Nonowner-occupied commercial real estate loans totaled$102.4 million, or 10.2% of the total loan portfolio, and multi-familyresidential loans totaled $34.3 million, or 3.4% of the total loan portfolio,and are generally handled in the Bank’s commercial real estate group. Thesereal estate secured commercial loans are offered as both fixed and adjustablerate products. The Bank typically charges higher interest rates on these loansthan those charged on adjustable rate loans secured by one- to four-familyresidential units. Additionally, the Bank may charge origination fees on theseloans.

The Bank’s underwriting practices for permanentcommercial real estate and multi-family residential loans are intended toassure that the property securing these loans will generate a positive cashflow after operating expenses and debt service payments. The Bank requiresappraisals before making a loan and generally requires the personal guaranteeof the borrower. Permanent loans on commercial real estate and multi-familyproperties generally are made at a loan-to-value ratio of no more than 80%.

Loans secured by nonowner-occupied commercial realestate and multi-family properties involve greater risks than owner-occupiedproperties because repayment generally depends on the rental income generatedby the property. In addition, because the payment experience on loans securedby nonowner-occupied properties is often dependent on successful operation andmanagement of the property, repayment of the loan is usually more subject toadverse conditions in the real estate market or the general economy than is thecase with owner-occupied real estate loans. Also, the nonowner-occupied commercialreal estate and multi-family residential business is cyclical and subject todownturns, over-building and local economic conditions.

*Commercialand Industrial Loans—**The*Bank originates non-real estatecommercial loans that, in most instances, are secured by equipment, accountsreceivable or inventory, as well as the personal 

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guarantees of theprincipal owners of the borrower. Unlike many community banks, the Bank is ableto offer asset-based commercial loan facilities that monitor advances against receivablesand inventories on a formula basis. A number of commercial and industrial loansare granted in conjunction with the U.S. Small Business Administration’s(“SBA”) loan guaranty programs and include some form of SBA credit enhancement.Additionally, through the newly established LSU, the Bank is expanding its useof credit scoring in evaluating business loans of up to $750,000. Commerciallending activities are supported by noncredit products and services, such asletters of credit and cash management services, which are responsive to theneeds of the Bank’s commercial customers.

At December 31, 2006, commercial and industrialloans totaled $106.0 million, or 10.6% of the total loan portfolio. Generally,commercial and industrial loans have relatively shorter maturities thanresidential and commercial real estate loans, or are at adjustable rateswithout interest rate caps. Unlike residential and commercial real estateloans, which generally are based on the borrower’s ability to make repaymentfrom employment and rental income and which are secured by real property whosevalue tends to be relatively easily ascertainable, commercial and industrialloans are typically made on the basis of the borrower’s ability to makerepayment from the cash flow of the business and are generally secured bybusiness assets, such as accounts receivable, equipment and inventory. As aresult, the availability of funds for the repayment of commercial andindustrial loans may be significantly dependent on the success of the businessitself. Further, the collateral securing the loans may be difficult to value,may fluctuate in value based on the success of the business and may deteriorateover time.

*Leases—**With*the Macroleaseplatform, the Bank originates equipment leases for its own portfolio, as wellas originating leases for third parties as a source of noninterest income. Inaddition, the Bank historically has purchased equipment leases from originatorsoutside of the Bank. The U.S. Government and its agencies are the principallessees on the vast majority of these purchased leases. These “government”leases generally have maturities of five years or less and are not made inreliance on residual collateral values. At December 31, 2006, leasestotaled $56.3 million, or 10.8% of the commercial loan and lease portfolio,with $32.4 million of Macrolease-generated leases and $23.9 million ofgovernment leases.

*SmallBusiness Loans—**The*Bank utilizes the term “smallbusiness loans” to describe business lending relationships of approximately$250,000 or less which it originates through business development officers andits branch network. These loans are generally secured by the assets of thebusiness, as well as the personal guarantees of the business’ principal owners.A number of these loans are granted in conjunction with the SBA’s Low-Doc andExpress programs and include some form of SBA credit enhancement. AtDecember 31, 2006, small business loans totaled $41.8 million, or 4.2% ofthe total loan portfolio. Generally, small business loans are granted at higherrates than commercial and industrial loans. These loans have relativelyshort-term maturities or are at adjustable rates without interest rate caps.

The Bank’s underwriting practices for small businessloans are designed to provide quick turn-around and minimize the fees andexpenses to the customer. Accordingly, the Bank utilizes a credit scoringprocess to assist in evaluating potential borrowers. The Bank distinguishesitself from larger financial institutions by providing personalized servicethrough a branch manager or business development officer assigned to thecustomer relationships. Lending to small businesses may involve additionalrisks as a result of their more limited financial and personnel resources.

*ConstructionLoans—**The***Bankoriginates residential construction loans to individuals and professionalbuilders to construct one- to four-family residential units, either as primaryresidences or for resale. The Bank also makes construction loans for thepurpose of constructing multi-family or commercial properties. AtDecember 31, 2006, outstanding construction loans totaled $37.2 million,or 3.7% of the total loan portfolio. In addition, the Bank offers interest-onlyconstruction loans during the construction period.

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The Bank’s underwriting practices for constructionloans are similar to those for commercial real estate loans, but they also areintended to assure completion of the project and take into account thefeasibility of the project, among other things. As a matter of practice, theBank generally lends an amount sufficient to pay a percentage of the property’sacquisition costs and a majority of the construction costs but requires thatthe borrower have equity in the project. The Bank requires property appraisalsand generally the personal guarantee of the borrower, as is the case withcommercial real estate loans.

The risks associated with construction lending aregreater than those with commercial real estate lending and multi-family lendingon existing properties for a variety of reasons. The Bank seeks to minimizethese risks by, among other things, often using the inspection services of aconsulting engineer for commercial construction loans, advancing money duringstages of completion and generally lending for construction of propertieswithin its market area to borrowers who are experienced in the type ofconstruction for which the loan is made, as well as by adhering to the lendingstandards described above. The Bank generally requires from the borrower evidenceof either pre-sale or pre-lease commitments on certain percentages of theconstruction project for which the loan is made.

*ResidentialMortgage Loans—**The*Bank’s one- to four-familyresidential mortgage loan portfolio consists primarily of whole loans purchasedfrom other financial institutions. Currently, the Bank purchases fixed- andadjustable-rate (“ARM”) mortgage whole loans from other financial institutionsboth in New England and elsewhere in the country. The Bank anticipatescontinuing to purchase residential mortgage loans until such time as itscommercial and consumer loan originations are sufficient to fully utilizeavailable cash flows. With the exception of one pool of mortgages ofapproximately $28 million, servicing rights related to the whole loan mortgageportfolio are retained by the mortgage servicing companies. The Bank pays aservicing fee ranging from .25% to .375% to the mortgage servicing companiesfor administration of the loan portfolios. As of December 31, 2006, approximately30% of the residential mortgage loan portfolio consisted of loans secured byreal estate outside of New England.

Additionally, largely as an accommodation to theBank’s customers, fixed- and variable-rate mortgages are offered throughout theBank’s branch network. The majority of these mortgages are transferred to theBank’s correspondent third parties under precommitments to fund thesetransactions. However, the Bank does retain a portion of these residentialmortgages for its own portfolio. In 2006, fees from these loans originated forthird parties decreased to $159,000 from $184,000 in the prior year. Overall,the Bank anticipates that its residential mortgage loan portfolio will declinelong-term as it focuses its resources on commercial and consumer lending.

At December 31, 2006, one- to four-familyresidential mortgage loans totaled $264.0 million, or 26.3% of the total loanportfolio. The fixed rate portion of this portfolio totaled $96.1 million andhad original maturities of 15 to 30 years. The adjustable rate portion of thisportfolio totaled $167.9 million and generally had original maturities of 30years. Interest rates on adjustable rate loans are set for an initial period ofone, three, five, seven or ten years with annual adjustments for the remainderof the loan. These loans have periodic rate adjustment caps of primarily 2% andlifetime rate adjustment caps of either 5% or 6%. There are no prepaymentpenalties for the one- to four-family residential mortgage loans.

Although adjustable rate mortgage loans allow the Bankto increase the sensitivity of its assets to changes in market interest rates,the terms of such loans include limitations on upward and downward rateadjustments. These limitations increase the likelihood of prepayments due to refinancingsduring periods of falling interest rates, particularly if rate adjustment capskeep the loan rate above market rates. Additionally, these limitations couldkeep the market value of the portfolio below market during periods of risinginterest rates, particularly if rate adjustment caps keep the loan rate belowmarket rates.

*Consumer and Other Loans—**The***Bank originates a variety of term loans and line of creditloans for consumers. At December 31, 2006, the consumer loan portfoliototaled $220.6 million, or 22.0% of the total loan portfolio, and was comprisedprimarily of home equity term loans and home equity lines of 

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credit. These loansand lines of credit are generally offered for up to 80% of the appraised valueof the borrower’s home, less the amount of the remaining balance of theborrower’s first mortgage. The Bank also offers direct automobile loans,savings secured loans and personal loans.

**InvestmentActivities**

Investments, an important component of the Company’sdiversified asset structure, are a source of earnings in the form of interestand dividends, and provide a source of liquidity to meet lending demands andfluctuations in deposit flows. Overall, the portfolio, comprised primarily ofovernight investments, U.S. agency securities, corporate debt securities,mortgage-backed securities (“MBSs”), collateralized mortgage obligations(“CMOs”) and Federal Home Loan Bank of Boston (“FHLB”) stock, represents$397.7 million, or 26.9% of total assets, as of December 31, 2006.The vast majority of these securities are rated investment grade by at leastone major rating agency.

Loans and leases generally provide a better returnthan investments, and accordingly, the Company seeks to emphasize theirgeneration rather than increasing its investment portfolio. The investments aremanaged by the Bank’s Chief Financial Officer and Treasurer, subject to thesupervision and review of the Asset/Liability Committee and are made incompliance with the Investment Policy approved by the Bank’s Board of Directors.

In September 2006, the Company restructured aportion of its investment portfolio to improve earnings in future periods bycapitalizing on a temporary increase in security valuations due to movements inthe yield curve. The Company sold $62 million of its available for salesecurities and reinvested the sales proceeds into higher-yielding securities.This investment portfolio restructuring resulted in pretax losses of $859,000;however, the effect of these security losses on shareholders’ equity wasminimal as the securities had been carried at market value on the balancesheet. As a result of this investment portfolio repositioning, the Companyanticipates an increase of future pretax interest income of over $900,000 bythe end of 2007.

Overall, in 2006,investments produced total interest and dividend income of $18.2 million, or22.4% of total interest and dividend income compared to $15.7 million, or22.6%, of total interest and dividend income, during 2005.

**Deposits**

Deposits are the principal source of funds for use inlending and for other general business purposes. The Bank attracts depositsfrom businesses, non-profit entities, governmental entities and the generalpublic by offering a variety of deposit products ranging in maturity fromdemand-type accounts to certificates of deposit (“CDs”). The Bank relies mainlyon quality customer service and diversified products, as well as competitivepricing policies and advertising, to attract and retain deposits. The Bankemphasizes retail deposits obtained locally.

The Bank seeks to develop relationships with itscustomers in order to become their primary bank. In order to achieve this, theBank has stressed growing its core deposit account base. Core depositsincreased moderately on a dollar amount basis compared to the prior year (up$6.8 million, or 1.1%). Within core deposits, the Bank increased demand depositaccounts to $200.3 million at December 31, 2006 from $185.1 million atDecember 31, 2005. Within total deposit growth, however, the balance sheetmix changed from the prior year due to the continuing growth of CD balances.Core deposits as percentage of total deposits decreased to 62.4% atDecember 31, 2006 from 64.0% at December 31, 2005.

As a by-product of the Bank’s emphasis on checkingaccount growth, as well as deposit fee enhancement programs, service charges ondeposit accounts (which include insufficient funds (“NSF”) fees) have grownover the years and represents the largest source of noninterest income for theCompany. 

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Service charges on depositaccounts produced a double-digit percentage increase from the prior year withan increase of $494,000, or 10.8%, from $4.6 million for 2005, to $5.1 millionfor 2006.

Although the Bank would prefer growth in lower-costingcore accounts, during 2006, customers displayed a preference forhigher-yielding savings and term deposit accounts. CD balances grew to$381.7 million at December 31, 2006, compared to $353.0 million atDecember 31, 2005, an increase of $28.7 million, or 8.1%. Thisincrease includes approximately $30.0 million of brokered CDs atDecember 31, 2006, whereas the Bank did not have any brokered CDs at the prior-yearend.

The Bank generally charges early withdrawal penaltieson its CDs in an amount equal to three months’ interest on accounts withoriginal maturities of one year or less and six months’ interest on accountswith original maturities longer than one year. Interest credited to an accountduring any term may be withdrawn without penalty at any time during the term.Upon renewal of a CD, only interest credited during the renewal term may bewithdrawn without penalty during the renewal term. The Bank’s withdrawalpenalties are intended to offset the potentially adverse effects of thewithdrawal of funds during periods of rising interest rates.

As a general policy, theBank systematically reviews the deposit accounts it offers to determine whetherthe accounts continue to meet customers’ needs and the Bank’s asset/liabilitymanagement goals. This review is the responsibility of the Pricing Committee,which meets weekly to determine, implement and monitor pricing policies andpractices consistent with the Bank’s Asset and Liability Committee’s strategy,as well as overall earnings and growth goals. The Pricing Committee analyzesthe cost of funds and also reviews the pricing of deposit related fees andcharges.

**Borrowings**

The Bank also derives cash flows from several sources,including loan repayments, deposit inflows and outflows, sales of available forsale investment securities and FHLB and other borrowings. Loan repayments anddeposit inflows and outflows are significantly influenced by prevailing interestrates, competition and general economic conditions.

The Bank utilizesborrowings on both a shorter- and longer-term basis to compensate forreductions in normal sources of funds on a daily basis and as opportunitiespresent themselves. Additionally, the Bank will utilize borrowings as part ofthe Bank’s overall strategy to manage interest rate risk. At December 31,2006, total borrowings stood at $337.1 million compared to $344.8 million atDecember 31, 2005.

**NondepositInvestment Products and Services**

Since January 2001,the Bank has managed a nondeposit investment program through which it makesavailable to its customers a variety of mutual funds, fixed- andvariable-annuities, stocks, bonds and other fee-based products. Theseinvestment products are offered through an arrangement with Commonwealth EquityServices, Inc., of Waltham, Massachusetts (“Commonwealth”). Commissions onnondeposit investment products for the years ending December 31, 2006,2005 and 2004 were $872,000, $849,000 and $973,000, respectively.

**Employees**

At December 31, 2006,the Company had 228 full-time and 42 part-time employees. The Company’semployees are not represented by any collective bargaining unit, and theCompany believes its employee relations are good. The Company maintains abenefit program that includes health and dental insurance, life and long-termdisability insurance and a 401(k) plan.

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**Supervision andRegulation**

*Overview—**The*Company and theBank are subject to extensive governmental regulation and supervision. Federaland state laws and regulations govern numerous matters affecting the Bankand/or the Company, including changes in the ownership or control, maintenanceof adequate capital, financial condition, permissible types, amounts and termsof extensions of credit and investments, permissible non-banking activities,the level of reserves against deposits and restrictions on dividend payments.These regulations are intended primarily for the protection of depositors andcustomers, rather than for the benefit of shareholders. Compliance with suchregulation involves significant costs to the Company and the Bank and mayrestrict their activities. In addition, the passage of new or amended federaland state legislation could result in additional regulation of, andrestrictions on, the operations of the Company and/or the Bank. The Companycannot predict whether any legislation currently under consideration will beadopted or how such legislation or any other legislation that might be enactedin the future would affect the business of either the Company or the Bank. Thefollowing descriptions of applicable statutes and regulations are not intendedto be complete descriptions of these provisions or their effects on the Companyand the Bank, but are brief summaries which are qualified in their entirety byreference to such statutes and regulations.

The Company and the Bank are subject to extensiveperiodic reporting requirements concerning financial and other information. Inaddition, the Bank and the Company must file such additional reports as theregulatory and supervisory authorities may require. The Company also is subjectto the reporting and other dictates of the Securities Exchange Act of 1934, asamended (the “Exchange Act”), and the Sarbanes-Oxley Act of 2002. Since 2002,changes to SEC rules have accelerated the reporting of numerous internalevents and increased the Company’s filing obligations and related costs.

The Company is a bank holding company registered underthe Bank Holding Company Act of 1956, as amended (the “BHC Act”). As a bankholding company, the Company is regulated by the Board of Governors of theFederal Reserve System (the “FRB”), and also is subject to certain laws of theState of Rhode Island.

The Bank is a Rhode Islandchartered non-member bank of the Federal Reserve System. The Bank’s depositsare insured by the Bank Insurance Fund (the “BIF”) of the FDIC. Accordingly,the Bank is subject to the supervision and regulation of the FDIC and the RhodeIsland Department of Business Regulation (the “Department of BusinessRegulation”).

**Rhode IslandRegulation**

As a state chartered financial institution, the Bankis subject to the continued regulation and supervision and periodic examinationby the Department of Business Regulation. Rhode Island law also imposesreporting requirements on the Bank. Rhode Island statutes and regulationsgovern among other things, investment powers, deposit activity, trust powersand borrowings. The approval of the Department of Business Regulation isrequired to establish, close or relocate a branch, merge with other banks,amend the Bank’s Charter or By-laws and undertake certain other enumeratedactivities.

If it appears to the Department of Business Regulationthat a Rhode Island bank has violated its charter, or any law or regulation, oris conducting its business in an unauthorized or unsafe manner, or that thebank has been notified by its federal insurer of such insurer’s intent toterminate deposit insurance, the Director of the Department of BusinessRegulation (the “Director”) may, under certain circumstances, restrict thewithdrawal of deposits, order any person to cease violating any Rhode Islandstatutes or rules and regulations or cease engaging in any unsafe, unsoundor deceptive banking practice, order that capital be restored, or suspend orremove directors, committee members, officers or employees who have violatedthe Rhode Island banking statutes, or a rule or regulation or orderthereunder, or who are reckless or incompetent in the conduct of the bank’sbusiness.

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Rhode Island law also requires any person or personsdesiring to acquire “control”, as defined in the BHC Act, of any Rhode Islandfinancial institution to file an extensive application with the Director. Theapplication requires detailed information concerning the Bank, the transactionand the principals involved. The Director may disapprove the acquisition if theproposed transaction would result in a monopoly, the financial stability of theinstitution would be jeopardized, the proposed management lacks competence, orthe acquisition would not promote public convenience and advantage. The Companyis also subject to the Rhode Island Business Combination Act.

In addition, whenever theDepartment of Business Regulation considers it advisable, the Department mayconduct an examination of a Rhode Island bank holding company, such as theCompany. Every Rhode Island bank holding company also must file an annualfinancial report with the Department of Business Regulation.

**FederalSupervision:  FDIC**

*Overview—**The***FDIC issues rules and regulations, conducts periodicinspections, requires the filing of certain reports and generally supervisesthe operations of its insured state chartered banks, that, like the Bank, arenot members of the Federal Reserve System. The FDIC’s powers have been enhancedin the past two decades by federal legislation. With the passage of theFinancial Institutions Reform, Recovery and Enforcement Act of 1989, the CrimeControl Act of 1990, and the Federal Deposit Insurance Corporation ImprovementAct of 1991 (“FDICIA”), federal bank regulatory agencies, including the FDIC,were granted substantial additional enforcement powers to restrict theactivities of financial institutions and to impose or seek the imposition ofincreased civil and/or criminal penalties upon financial institutions and theindividuals who manage or control such institutions.

The Bank is subject to the FDIC regulatory capitalrequirements. An FDIC-insured bank also must conform to certain standards,limitations, and collateral requirements with respect to certain transactionswith affiliates such as the Company. Further, an FDIC-insured bank is subjectto laws and regulations that limit the amount of, and establish requiredapproval procedures, reporting requirements and credit standards with respectto, loans and other extensions of credit to officers, directors and principalshareholders of the Company, the Bank, and any subsidiary of the Bank, and totheir related interests. FDIC approval also is required prior to the Bank’sredemption of any stock. The prior approval of the FDIC or, in somecircumstances, another regulatory agency, is required for mergers andconsolidations. In addition, notice to the FDIC is required prior to theclosing of any branch office, and the approval of the FDIC is required in orderto establish or relocate a branch facility.

Proceedings may be instituted against any FDIC-insuredbank, or any officer or director or employee of such bank and any otherinstitution affiliated parties who engage in unsafe and unsound practices,breaches of any fiduciary duty, or violations of applicable laws, regulations,regulatory orders and agreements. The FDIC has the authority to terminateinsurance of accounts, to issue orders to cease and desist, to remove officers,directors and other institution affiliated parties, and to impose substantialcivil money penalties.

*DepositInsurance—**The*Bank’s deposits are insured bythe BIF of the FDIC to the legal maximum for each separately insured depositor.The Federal Deposit Insurance Act, as amended (the “FDI Act”), provides thatthe FDIC shall set deposit insurance assessment rates on a semiannual basis andrequires the FDIC to increase deposit insurance assessments whenever the ratioof BIF reserves to insured deposits in the BIF is less than 1.25%.

The FDIC has established a risk-based bank assessmentsystem the rates of which are determined on the basis of a particularinstitution’s supervisory rating and capital level. The Bank paid a minimumassessment of $2,000 in 2006; however, it is possible that the FDIC couldimpose assessment rates in the future in connection with declines in theinsurance funds or increases in the amount of insurance coverage. 

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An increase in theassessment rate could have a material adverse effect on the Company’s earnings,depending on the amount of the increase. Under the Federal Deposit InsuranceReform Act of 2005, which became law in 2006, the Bank received a one-timeassessment credit of $585,000 that can be applied against future premiums,subject to certain limitations.

The FDIC may terminate the deposit insurance of anyinsured depository institution if the FDIC determines that the institution hadengaged in or is engaging in unsafe or unsound practices, is in an unsafe orunsound condition to continue operations, or has violated any applicable law,regulation, order or any condition imposed by the FDIC.

*CapitalAdequacy—**FDIC-insured* institutions must meetspecified minimal capital requirements and are subject to varying regulatoryrestrictions based upon their capital levels. All banks are subject torestrictions on capital distributions (such as dividends, stock repurchases andredemptions) and payment of management fees if, after making such distributionsor payment, the institution would be undercapitalized. FDIC-insured banks thathave the highest regulatory rating and are not anticipating or experiencingsignificant growth are required to maintain a leverage capital ratio(calculated using Tier 1 capital, as defined below, to total assets) of atleast 3.0%. All other banks are required to maintain a minimum leverage capitalratio of 1.0% to 2.0% above 3.0%, with a minimum of 4.0%.

In addition, the FDIC has adopted capital guidelinesbased upon ratios of a bank’s capital to total assets adjusted for risk, whichrequire FDIC-insured banks to maintain a total capital-to-risk weighted assetsratio (“Risk-Based Capital Ratio”) of at least 8.0% and a Tier 1 Risk-BasedCapital Ratio of at least 4.0%. The guidelines provide a general framework forassigning assets and off-balance sheet items (such as standby letters ofcredit) to broad risk categories and provide procedures for the calculation ofthe Risk-Based Capital Ratio. Tier 1 (sometimes referred to as “core”) capitalconsists of common shareholders’ equity, qualifying, non-cumulative perpetualpreferred stock, and minority interests in the equity accounts of consolidatedsubsidiaries. “Supplementary” or Tier 2 capital includes perpetual debt,mandatory convertible debt securities, a limited amount of subordinated debt,other preferred stock, and a limited amount of loan loss reserves. Certainintangible assets are deducted in computing the Capital Ratios.

*PromptCorrective Action Provisions—**In* order to resolvethe problems of undercapitalized institutions, FDICIA established a systemknown as “prompt corrective action”. Under prompt corrective action provisionsand implementing regulations, every institution is classified into one of fivecategories reflecting the institution’s capitalization. These categories arethe following: well capitalized, adequately capitalized, undercapitalized,significantly undercapitalized and critically undercapitalized. For aninstitution to be well capitalized, it must have a total Risk-Based CapitalRatio of at least 10%, a Tier 1 Risk-Based Capital Ratio of at least 6% and aTier 1 leverage ratio of at least 5% and not be subject to any specific capitalorder or directive. In contrast, an institution will be deemed to besignificantly undercapitalized if it has a total Risk-Based Capital Ratio thatis less than 6%, or a Tier 1 Risk-Based Capital Ratio that is less than 3%, ora leverage ratio that is less than 3%, and will be deemed to be criticallyundercapitalized if the bank has a ratio of tangible equity to total assetsthat is equal to or less than 2%.

As of December 31, 2006, the Bank’s Tier 1leverage ratio was 7.18%, its total Risk-Based Capital Ratio was 10.32% and itsTier 1 Risk-Based Capital Ratio was 11.54%. Based upon the above ratios, theBank is considered “well capitalized” for regulatory capital purposes.Additionally, at December 31, 2006, the Company had approximately $17million of additional capital (held at the parent company), which is availableto support the Bank’s future growth.

The activities in which a depository institution mayengage and the remedies available to federal regulators vary depending upon thecategory described above into which an institution’s level of capital falls. Ateach successive downward capital level, institutions are subject to morerestrictions on their activities. For example, only “well capitalized”institutions may accept brokered deposits without prior 

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regulatory approval(brokered deposits are defined to include deposits with an interest rate whichis 75 basis points above prevailing rates paid on similar deposits in aninstitution’s normal market area).

The FDIC has broad powers to take prompt correctiveaction to resolve problems of insured depository institutions, depending upon aparticular institution’s level of capital. For example, a bank which does notmeet applicable minimum capital requirements or is deemed to be in a “troubled”condition may be subject to additional restrictions, including a requirement ofwritten notice to federal regulatory authorities prior to certain proposedchanges in senior management or directors of the institution. Undercapitalized,significantly undercapitalized and critically undercapitalized institutionsalso are subject to a number of other requirements and restrictions.

*Safetyand Soundness Standards—**The*FDI Act alsodirects each federal banking agency to prescribe standards for safety andsoundness for insured depository institutions and their holding companiesrelating to operations, management, asset quality, earnings and stockvaluation.

*Examination—**FDIC***requires that nearly all insured depository institutionshave annual, on-site regulatory examinations and annual audits by anindependent public accountant. Management must prepare an annual report,attested to by the independent public accountant, confirming management’sresponsibility in preparing financial statements, maintaining internal controlsfor financial reporting and complying with safety and soundness standards. Theaudit process must be overseen by an independent audit committee composed ofoutside directors, provided that the federal banking agencies may permit the committeeto include inside directors if the bank is unable to find competent outsidedirectors, so long as outside directors comprise a majority of the committee.

**FederalSupervision:  FRB**

The BHC Act mandates that the prior approval of theFRB must be obtained in order for the Company to engage in certain activitiessuch as acquiring or establishing additional banks or non-banking subsidiariesor merging with other institutions.

In addition to the needfor obtaining the approval of the FRB for particular kinds of transactions, abank holding company is required by the FRB to adhere to certain capitaladequacy standards. It is the position of the FRB that a bank holding company,such as the Company, should be a source of financial strength to its subsidiarybanks such as the Bank. In general, the FRB has adopted substantially identicalcapital adequacy guidelines as the FDIC. Such standards are applicable to bankholding companies and their bank subsidiaries on a consolidated basis forholding companies, like the Company, with consolidated assets in excess of $150million. If a bank holding company’s capital levels fall below the minimumrequirements established by the capital adequacy guidelines, the holdingcompany will be expected to develop and implement a plan, acceptable to theFRB, to achieve adequate levels of capital within a reasonable time. Until suchcapital levels are achieved, the holding company may be denied approval by theFRB for certain activities such as those described in the preceding paragraph.As of December 31, 2006, on a consolidated basis, the Company’s Tier 1Leverage Ratio was 8.37%, its total Risk-Based Capital Ratio was 12.05% and itsTier 1 Risk-Based Capital Ratio was 13.27%. Based upon the above ratios, theCompany is considered “well capitalized” for regulatory capital purposes.

**Restrictions onTransactions with Affiliates and Insiders**

The Bank is subject to certain federal statuteslimiting transactions with non-banking affiliates and insiders.Section 23A of the Federal Reserve Act limits loans or other extensions ofcredit to, asset purchases with and investments in affiliates of the Bank, suchas the Company, to ten percent (10%) of the Bank’s capital and surplus.Further, such loans and extensions of credit, as well as certain othertransactions, are required to be secured in specified amounts. Section 23Bof the Federal Reserve Act, among other things, requires that certaintransactions between the Bank and its affiliates must be on terms 

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substantially the same, orat least as favorable to the Bank, as those prevailing at the time forcomparable transactions with or involving other nonaffiliated persons. In theabsence of comparable transactions, any transaction between the Bank and itsaffiliates must be on terms and under circumstances, including credit standardsthat in good faith would be offered to or would apply to nonaffiliated persons.

The restrictions on loans to officers, directors,principal shareholders and their related interests (collectively referred toherein as “insiders”) contained in the Federal Reserve Act and Regulation Oapply to all institutions and their subsidiaries. These restrictions includelimits on loans to one borrower and conditions that must be met before suchloans can be made. Loans made to insiders and their related interests cannotexceed the institution’s total unimpaired capital and surplus. Insiders aresubject to enforcement actions for knowingly accepting loans in violation ofapplicable restrictions. All extensions of credit by the Bank to its insidersare in compliance with these restrictions and limitations.

Loans outstanding toexecutive officers and directors of the Bank, including their immediatefamilies and affiliated companies (“related parties”), aggregated $5.4 millionat December 31, 2006 and $5.6 million at December 31, 2005.Loans to related parties are made in the ordinary course of business undernormal credit terms, including interest rates and collateral, prevailing at thetime of origination for comparable transactions with other persons, and do notrepresent more than normal credit risk.

**Interstate Banking**

The Riegle-Neal InterstateBanking and Branching Efficiency Act of 1994 facilitated the interstateexpansion and consolidation of banking organizations by permitting (i) bankholding companies such as the Company, that are adequately capitalized andmanaged, to acquire banks located in states outside their home statesregardless of whether such acquisitions are authorized under the law of thehost state, (ii) the interstate merger of banks after June 1, 1997,subject to the right of individual states to “opt in” early or “opt out” ofthis authority prior to such date, (iii) banks to establish new brancheson an interstate basis provided that such action is specifically authorized bythe law of the host state, (iv) foreign banks to establish, with approvalof the appropriate regulators in the United States, branches outside their homestates to the same extent that national or state banks located in such statewould be authorized to do so and (v) banks to receive deposits, renew timedeposits, close loans and receive payments on loans and other obligations asagent for any bank or thrift affiliate, whether the affiliate is located in thesame or different state. Rhode Island adopted “opt in” legislation, whichpermits full interstate banking acquisition and branching.

**Gramm-Leach-BlileyAct**

In late 1999, Congress enacted the Gramm-Leach-BlileyAct (the “G-L-B Act”), which repealed provisions of the 1933 Glass-Steagall Actthat required separation of the commercial and investment banking industries.The G-L-B Act expands the range of non-banking activities that certain bankholding companies may engage in while preserving existing authority for bankholding companies to engage in activities that are closely related to banking.In order to engage in these new non-banking activities, a bank holding companymust qualify and register with the FRB as a “financial holding company” bydemonstrating that each of its banking subsidiaries is “well capitalized” and“well managed” and has a rating of “Satisfactory” or better under the CommunityReinvestment Act of 1977.

Under the G-L-B Act and its implementing regulations,financial holding companies may engage in any activity that (i) is financialin nature or incidental to a financial activity under the G-L-B Act or(ii) is complementary to a financial activity and does not impose asubstantial risk to the safety and soundness of depository institutions or thefinancial system generally. The G-L-B Act and its accompanying regulationsspecify certain activities that are financial in nature such as acting asprincipal, agent or broker for insurance; underwriting, dealing in or making amarket in securities; and providing financial and 

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investment advice. The newfinancial activities authorized by the G-L-B Act may also be engaged in by a“financial subsidiary” of a national or state bank, except for insurance orannuity underwriting, insurance company portfolio investments, real estateinvestments and development and merchant banking, which must be conducted in afinancial holding company. The FRB and the Secretary of the Treasury have theauthority to decide whether other activities are also financial in nature orincidental thereto, taking into account changes in technology, changes in thebanking marketplace, competition for banking services and other pertinentfactors. Although the Company may meet the qualifications to become a financialholding company, it has no current plans to elect such status.

The G-L-B Act also establishes a system of functionalregulation, under which the federal banking agencies will regulate the bankingactivities of financial holding companies and banks’ financial subsidiaries,the SEC will regulate their securities activities and state insuranceregulators will regulate their insurance activities. In addition, the G-L-B Actprovides protections against the transfer and use by financial institutions ofconsumers’ nonpublic, personal information. The G-L-B Act contains a variety ofadditional provisions, which, among others, impose additional regulatoryrequirements on certain depository institutions and reduce certain otherregulatory burdens, modify the laws governing the Community Reinvestment Act of1977, and address a variety of other legal and regulatory issues affecting bothday-to-day operations and long-term activities of financial institutions.

In granting other types offinancial institutions more flexibility, the G-L-B Act may increase the numberand type of institutions engaging in the same or similar activities as those ofthe Company and the Bank, thereby creating a more competitive atmosphere.However, management believes this legislation and implementing regulations havehad a more substantial impact on regional and national holding companies andbanks than on community-based institutions engaged principally in traditionalbanking activities.

**Other Aspects ofFederal and State Laws**

*CommunityReinvestment Act—**The*Community Reinvestment Act of1977 (“CRA”) and the regulations issued thereunder are intended to encouragebanks to help meet the credit needs of their service area, including low andmoderate income neighborhoods, consistent with the safe and sound operations ofthe banks. Under CRA, banks are rated on their performance in meeting thesecredit needs and the rating of a bank’s performance is public. In connectionwith the filing of an application to conduct certain transactions, the CRAperformance record of the banks involved are reviewed. Under the Bank’s lastCRA examination, the Bank received a “Satisfactory” rating.

*USAPATRIOT Act—**The***USAPATRIOT Act of 2001 (the “Patriot Act”), designed to deny terrorists and othersthe ability to obtain anonymous access to the United States financial system,has significant implications for depository institutions, brokers, dealers andother businesses involved in the transfer of money. The Patriot Act requiresfinancial institutions to implement additional policies and procedures withrespect to, or additional measures designed to address, the following matters,among others:  money laundering;suspicious activities and currency transaction reporting; and currency crimes.

*Sarbanes-OxleyAct of 2002—**In*July 2002, Congress enactedthe Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”) which imposed significantadditional requirements and restrictions on publicly-held companies, such asthe Company. These provisions include requirements governing the independence,composition and responsibilities of audit committees, financial disclosures andreporting and restrictions on personal loans to directors and officers.Sarbanes-Oxley, among other things*,*mandates chief executive and chief financial officer certifications of periodicfinancial reports, additional financial disclosures concerning off-balancesheet items, and speedier transaction reporting requirements for executiveofficers, directors and 10% shareholders. Rules promulgated by the SECpursuant to Sarbanes-Oxley impose obligations and restrictions on auditors andaudit committees intended to enhance their independence 

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from management. Inaddition, penalties for non-compliance with the Exchange Act are heightened.The Company has not experienced any significant difficulties in complying withthis legislation. However, the Company has incurred, and expects to continue toincur, costs in connection with its compliance with Section 404 ofSarbanes-Oxley which requires management to undertake an assessment of theadequacy and effectiveness of the Company’s internal controls over financialreporting and requires the Company’s auditors to attest to, and report on,management’s assessment and the operating effectiveness of these controls.

*InsuranceSales—**Rhode*Island legislation enacted in1996 permits financial institutions to participate in the sale of insuranceproducts, subject to certain restrictions and license requirements. Theregulatory approvals required from the Department of Business Regulation andthe FDIC depend upon the form and structure used to engage in such activities.

*Check21—**The***CheckClearing for the 21st Century Act, or “Check 21” as it is commonlyknown, became effective in late 2004. Check 21 facilitates check collection bycreating a new negotiable instrument called a “substitute check”, which permits,but does not require, banks to replace original checks with substitute checksor information from the original check and process check informationelectronically. Banks that do use substitute checks must comply with certainnotice and recredit rights. Check 21 is expected to cut the time and costinvolved in physically transporting paper items and reduce float, i.e., thetime between the deposit of a check in a bank and payment, especially in casesin which items were not already being delivered same-day or overnight. The Bankis currently implementing the Check 21 authority and expects to incur minimaladditional costs until all banks have adopted Check 21.

*Miscellaneous—**The*Company and/orthe Bank also are subject to federal and state statutory and regulatoryprovisions covering, among other things, reserve requirements, securityprocedures, currency and foreign transactions reporting, insider and affiliatedparty transactions, management interlocks, sales of non-deposit investmentproducts, loan interest rate limitations, truth-in-lending, electronic fundstransfers, funds availability, truth-in-savings, home mortgage disclosure andequal credit opportunity.

**Effect ofGovernmental Policy**

The Company’s revenues consist of cash dividends paidto it by the Bank. Such payments are restricted pursuant to various state andfederal regulatory limitations. Banking is a business that depends heavily oninterest rate differentials. One of the most significant factors affecting theBank’s earnings is the difference between the interest rates paid by the Bankon its deposits and its other borrowings, on the one hand, and, on the otherhand, the interest rates received by the Bank on loans extended to itscustomers and on securities held in the Bank’s portfolio. The value and yieldsof its assets and the rates paid on its liabilities are sensitive to changes inprevailing market rates of interest. Thus, the earnings and growth of the Bankwill be influenced by general economic conditions, the monetary and fiscal policiesof the federal government, and policies of regulatory agencies, particularlythe FRB, which implement national monetary policy. The nature and impact on theBank of any future changes in such policies cannot be predicted.

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**ITEM 1A.**        RISKFACTORS

**Overview**

Investing in our commonstock involves a degree of risk. The risks and uncertainties described beloware not the only ones facing our Company. Additional risks and uncertaintiesmay also impair our business operations. If any of the following risks actuallyoccur, our business, financial condition or results of operations would likelysuffer.

**Risks Related toOur Business**

*Competition withother financial institutions could adversely affect our franchise growth andprofitability.*

We face significant competition from a variety oftraditional and nontraditional financial service providers both within andoutside of Rhode Island, both in making loans and generating deposits. Our mostsignificant competition comes from two national banking institutions and onelarge regional banking institution that have significant market share positionsin Rhode Island. These large banks have well-established, broad distributionnetworks and greater financial resources than we do, which have enabled them tomarket their products and services extensively, offer access to a greaternumber of locations and products, and price competitively.

We also face competition from a number of localfinancial institutions with branches in Rhode Island and in nearbyMassachusetts, some of which have been acquired by both local and out-of-stateservice providers. Additionally, we face competition from out-of-statefinancial institutions which have established loan production offices in ourmarketplace, and from non-bank competitors.

Competition for depositsalso comes from short-term money market funds, other corporate and governmentsecurities funds and non-bank financial service providers such as mutual fundcompanies, brokerage firms, insurance companies and credit unions. Many of ournon-bank competitors have fewer regulatory constraints as those imposed onfederally insured state chartered banks, which gives these competitors anadvantage over us in providing certain services. Such competition may limit ourgrowth and profitability in the future.

*Changes in regionaland national economic conditions could adversely affect our profitability.*

The population in our market area is growing slowlyand economic growth in the Rhode Island area has been slow to moderate over thepast several years. New England has trailed other parts of the nation in termsof general economic growth. Additionally, Rhode Island businesses, like manycompanies throughout the United States, are struggling with rapidly increasinghealth care costs, which may adversely affect the earnings and growth potentialfor such companies, which may in turn negatively impact Rhode Island’s abilityto attract and retain businesses in the State.

Our borrowers’ ability tohonor their repayment commitments is generally dependent upon the level ofeconomic activity and general health of the regional economy. Furthermore,economic conditions beyond our control, such as the strength of credit demandby customers and changes in the general levels of interest rates, may have asignificant impact on our operations, including decreases in the value ofcollateral securing loans. Therefore, an economic recession in this market areaadversely affecting growth could cause significant increases in nonperformingassets, thereby reducing operating profits or causing operating losses,impairing liquidity and eroding capital.

*Fluctuations ininterest rates could adversely impact our net interest margin.*

Our earnings and cashflows are heavily dependent on net interest margin, which is the differencebetween interest income that we earn on loans and investments and the interestexpense paid on deposits 

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andother borrowings. When maturities of assets and liabilities are not balanced, arapid increase or decrease in interest rates could have an adverse effect onour net interest margin and results of operation. Interest rates are highlysensitive to factors that are beyond our control, including general economicconditions, inflation rates, flattening or inversion of the yield curve, businessactivity levels, money supply and the policies of various government andregulatory authorities. For example, increases in the discount rate by theBoard of Governors of the Federal Reserve System usually lead to risinginterest rates, which affects interest income, interest expense and the fairvalue of the investment portfolio. In addition, governmental policies such asthe creation of a tax deduction for individual retirement accounts couldincrease savings rates and may affect our cost of funds. The nature, timing andeffect of any future changes in interest rates on us and our future results ofoperations are not predictable.

*Change in thecomposition of our loan and lease portfolio may result in greater risk oflosses.*

At December 31, 2006,51.8% of our loan and lease portfolio consisted of commercial real estate,business and construction loans and leases, an increase from 46.1% of our loanand lease portfolio at December 31, 2005. We intend to continue toemphasize the origination of these types of loans and leases. These loansgenerally have greater risk of nonpayment and loss than residential mortgageloans because repayment of these types of loans often depends on the successfulbusiness operation and income stream of the borrowers. Such loans typicallyinvolve larger loan balances to single borrowers or groups of related borrowersthan do individual one-to four-family residential loans. Consequently, anadverse development with respect to one loan or one credit relationship canexpose us to a significantly greater risk of loss compared to an adversedevelopment with respect to a single one-to four-family residential mortgageloan.

*Our allowance forloan and lease losses may be insufficient to cover actual loan and leaselosses.*

The risk of loan and leaselosses varies with, among other things, business and economic conditions, thecharacter and size of the portfolio, loan growth, delinquency trends, industryloss experience, nonperforming loan trends, the creditworthiness of borrowersand, in the case of a collateralized loan, the value of the collateral. Basedupon such factors, our management arrives at an appropriate allowance for loanand lease losses by maintaining a risk rating system that classifies all loansand leases into varying categories by degree of credit risk, and establishes alevel of allowance associated with each category. As part of our ongoingevaluation process, including a formal quarterly analysis of allowances, wemake various subjective judgments as to the appropriate level of allowance withrespect to each category, judgments as to the categorization of any individualloan or lease, as well as additional subjective judgments in ascertaining theprobability and extent of any potential losses. If our subjective judgments proveto be incorrect, our allowance for loan and lease losses may not cover inherentlosses in our loan and lease portfolio, or if bank regulatory officials orchanges in economic conditions require us to increase the allowance for loanand lease losses, earnings could be significantly and adversely affected.Material additions to our allowance would materially decrease net income. At December 31,2006, the allowance for loan and lease losses totaled $12.4 million,representing 1.23% of total loans.

*Our growth strategymay limit increases in profitability.*

We have sought to increasethe size of our franchise by pursuing business development opportunities andhave grown substantially since inception. To the extent additional branches areopened, through the current expansion plan or otherwise, we are likely toexperience higher operating expenses relative to operating income from the newbranches, which may limit increases in profitability over the course of theexpansion plan. The ability to increase profitability by establishing newbranches is dependent on our ability to identify advantageous branch locationsand generate new deposits and loans from those locations and an attractive mixof deposits that will create an acceptable level of net income. There can be noassurance that new and relocated branches will generate an acceptable level ofnet income or that we will 

18

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be ableto successfully establish new branch locations in the future. In addition,there can be no assurance that we will be successful in developing new businesslines or that any new products or services introduced will be profitable.

*Our growth issubstantially dependent on our management team.*

Our future success andprofitability are substantially dependent upon the management and banking abilitiesof our senior executives, who have substantial background and experience inbanking and financial services, as well as personal contacts, in the RhodeIsland market and the region generally. Competition for such personnel isintense, and there is no assurance we will be successful in retaining suchpersonnel. Changes in key personnel and their responsibilities may bedisruptive to business and could have a material adverse effect on ourbusiness, financial condition and results of operations.

*Our operatinghistory is not necessarily indicative of future operating results.*

The Company, as theholding company of the Bank, has no significant assets other than the commonstock of the Bank. While we have operated profitably since the first fullquarter of operations, future operating results may be affected by manyfactors, including regional economic conditions, interest rate fluctuations andother factors that may affect banks in general, all of which factors may limitor reduce our growth and profitability. For example, the yield curve has beenflat-to-inverted during the past two years. Also, customers in the past fewyears have indicated a preference for higher-yielding term deposit and savingsaccount products. Similarly, our lower-costing core deposits have increased ata more moderate rate. We cannot predict whether this increased demand forhigher rate products is permanent or will abate. Similarly, nonperforming assetlevels and loan and lease losses have been low since inception. Industry experiencesuggests that this is unlikely to continue indefinitely.

*Our controls andprocedures may fail or be circumvented.*

Management regularlyreviews and updates our internal controls, disclosure controls and proceduresand corporate governance policies and procedures. Systems of controls are basedupon certain assumptions and can only provide reasonable, not absolute,assurance that system objectives are met. Potential failure or circumvention ofour controls and procedures or failure to comply with regulations related tocontrols and procedures could have an adverse effect on our business, resultsof operations and financial condition.

*We face varioustechnological risks.*

We rely heavily oncommunication and information systems to conduct business. Potential failures,interruptions or breaches in system security could result in disruptions orfailures in our key systems, such as general ledger, deposit or loan systems.We have developed policies and procedures aimed at preventing and limiting theeffect of failure, interruption or security breaches of information systems;however, there cannot be assurance that these incidences will not occur, or ifthey do occur, that they will be appropriately addressed. The occurrence of anyfailures, interruptions or security breaches of our information systems coulddamage our reputation, result in the loss of business, subject us to increasedregulatory scrutiny or subject us to civil litigation and possible financialliability, any of which could have an adverse effect on our results ofoperation and financial condition.

*We encountertechnological change continually.*

The financial servicesindustry continually undergoes technological change. Effective use oftechnology increases efficiency and enables banks and financial servicesinstitutions to better serve customers and reduce costs. Our future successdepends, in part, upon our ability to meet the needs of 

19

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customersby effectively using technology to provide the products and services thatsatisfy customer demands, as well as create operational efficiencies.Additionally, many of our competitors have greater resources to invest intechnological improvements. Inability to keep pace with technological changeaffecting the financial services industry could have an adverse impact on ourbusiness and as a result, our financial condition and results of operation.

*Extensivegovernment regulation and supervision have a significant impact on ouroperations.*

We operate in a highly regulated industry and aresubject to examination, supervision and comprehensive regulation by variousregulatory agencies. These regulations are intended primarily for theprotection of depositors and customers, rather than for the benefit ofinvestors. Our compliance with these regulations is costly and restrictscertain activities, including payment of dividends, mergers and acquisitions,investments, loans and interest rates charged, interest rates paid on depositsand locations of offices. We are also subject to capitalization guidelinesestablished by regulators, which require maintenance of adequate capital tosupport growth. Furthermore, the addition of new branches requires the approvalof the FDIC as well as state banking authorities in Rhode Island.

The laws and regulationsapplicable to the banking industry could change at any time. There is no way topredict the effects of these changes on our business and profitability. Becausegovernment regulation greatly affects the business and financial results of allcommercial banks and bank holding companies, the cost of compliance with newlaws and regulations applicable to the banking industry could adversely affectoperations and profitability.

**Risks Related tothe Company’s Common Stock**

*Our common stockhas limited liquidity.*

Even though our common stock is currently traded onthe Nasdaq Stock Market’s Global Select MarketSM, it has less liquidity than the averagestock quoted on a national securities exchange. Because of this limitedliquidity, it may be more difficult for investors to sell a substantial numberof shares and any such sales may adversely affect the stock price.

We cannot predict theeffect, if any, that future equity offerings, issuance of common stock inacquisition transactions, or the availability of shares of common stock forsale in the market, will have on the market price of our common stock. Wecannot give assurance that sales of substantial amounts of common stock in themarket, or the potential for large amounts of sales in the market, would notcause the price of our common stock to decline or impair future ability toraise capital through sales of common stock.

*Fluctuations in theprice of our stock could adversely impact your investment.*

The market price of ourcommon stock may be subject to significant fluctuations in response tovariations in the quarterly operating results, changes in management,announcements of new products or services by us or competitors, legislative orregulatory changes, general trends in the industry and other events or factorsunrelated to our performance. The stock market has experienced price and volumefluctuations which have affected the market price of the common stock of manycompanies for reasons frequently unrelated to the operating performance ofthese companies, thereby adversely affecting the market price of thesecompanies’ common stock. Accordingly, there can be no assurance that the marketprice of our common stock will not decline.

20

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*There arelimitations on our ability to pay dividends.*

Our ability to paydividends is subject to the financial condition of the Bank, as well as otherbusiness considerations. Payment of dividends by the Company is also restrictedby statutory limitations. These limitations could have the effect of reducingthe amount of dividends we can declare.

*Certain Anti-Takeovermeasures affect the ability of shareholders to effect takeover transactions.*

We are subject to the Rhode Island BusinessCombination Act which, subject to certain exceptions, prohibits businesscombinations involving certain shareholders of publicly held corporations for aperiod of five years after such shareholders acquire 10% or more of theoutstanding voting stock of the corporation. In addition, our Articles ofIncorporation and By-laws, among other things, provide that, in addition to anyvote required by law, the affirmative vote of two-thirds of the holders of ourvoting stock, voting as a single class, is required for approval of allbusiness combinations.

Our Board of Directorsalso has the authority, without further action by shareholders, to issueadditional preferred stock in one or more series and to fix by resolution, therights, preferences and privileges of such series to the extent permitted bylaw. Our Board could designate certain rights and privileges for such preferredstock which would discourage unsolicited tender offers or takeover proposals orhave anti-takeover effects. Our Articles also provide for three classes ofdirectors to be elected for staggered three year terms, which make it moredifficult to change the composition of our Board. All of these provisions maymake it more difficult to effect a takeover transaction.

*Directors andexecutive officers own a significant portion of our common stock.*

Our directors andexecutive officers, as a group, beneficially owned approximately 22.8% of ouroutstanding common stock as of December 31, 2006. As a result of theirownership, the directors and executive officers would have the ability, if theyvote their shares in a like manner, to significantly influence the outcome ofall matters submitted to shareholders for approval, including the election ofdirectors.

**ITEM 1B.**       UNRESOLVEDSTAFF COMMENTS

None.

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**ITEM 2.**                PROPERTIES

The Bank presently has a network of 16 branch officeslocated in Providence, Kent and Washington Counties. Seven of these branchoffice facilities are owned and nine are leased. Facilities are generallyleased for a period of one to ten years with renewal options. The terminationof any short-term lease would not have a material adverse effect on theoperations of the Bank. The Company’s offices are in good physical conditionand are considered appropriate to meet the banking needs of the Bank’scustomers.

The following are thelocations of the Bank’s offices:

| **Location**                                  | ** ** | ** ** | ** ** | **Size  (Square feet)** | ** ** | **Year Opened  or Acquired** | ** ** | **Owned or  Leased** | ** ** | **Lease  Expiration Date** | ** ** |
|-----------------------------------------------|------------|------------|------------|------------------------------|------------|----------------------------------------|------------|---------------------------|------------|---------------------------------|------------|
| *Branch  offices:*                            |       |       |       |                         |       |                                   |       |                      |       |                            |       |   |   |   |   |
| 1047 Park Avenue,  Cranston, RI.              |       |       | 4,700      |                         |       |                                   | 1996       |                      |       | Owned                           |       |   | N.A. |   |   |
| 383 Atwood  Avenue, Cranston, RI.             |       |       | 4,700      |                         |       |                                   | 1996       |                      |       | Owned                           |       |   | N.A. |   |   |
| 2104 Plainfield  Pike, Cranston, RI.          |       |       | 700        |                         |       |                                   | 2002       |                      |       | Owned                           |       |   | N.A. |   |   |
| 1269 South County  Trail, East Greenwich, RI. |       |       | 2,600      |                         |       |                                   | 2005       |                      |       | Leased                          |       |   | 5/31/25 |   |   |
| 999 South  Broadway, East Providence, RI.     |       |       | 3,200      |                         |       |                                   | 1996       |                      |       | Leased                          |       |   | 11/30/12 |   |   |
| 195 Taunton  Avenue, East Providence, RI.     |       |       | 3,100      |                         |       |                                   | 1996       |                      |       | Leased                          |       |   | 2/28/08 |   |   |
| 1440 Hartford  Avenue, Johnston, RI.          |       |       | 4,700      |                         |       |                                   | 1996       |                      |       | Land  Leased                    |       |   | 12/31/07 |   |   |
| 625 G. Washington  Highway, Lincoln, RI.      |       |       | 1,000      |                         |       |                                   | 2005       |                      |       | Leased                          |       |   | 12/31/12 |   |   |
| Ten Rod Road,  North Kingstown, RI.           |       |       | 4,000      |                         |       |                                   | 2004       |                      |       | Land  Leased                    |       |   | 6/30/19 |   |   |
| One Turks Head  Place, Providence, RI.        |       |       | 5,000      |                         |       |                                   | 1996       |                      |       | Leased                          |       |   | 4/30/09 |   |   |
| 165 Pitman  Street, Providence, RI.           |       |       | 3,300      |                         |       |                                   | 1998       |                      |       | Leased                          |       |   | 10/31/08 |   |   |
| 445 Putnam Pike,  Smithfield, RI.             |       |       | 3,500      |                         |       |                                   | 1996       |                      |       | Leased                          |       |   | 7/31/09 |   |   |
| 1062 Centerville  Road, Warwick, RI.          |       |       | 2,600      |                         |       |                                   | 1996       |                      |       | Owned                           |       |   | N.A. |   |   |
| 1300 Warwick  Avenue, Warwick, RI.            |       |       | 4,200      |                         |       |                                   | 1996       |                      |       | Leased                          |       |   | 6/30/09 |   |   |
| 2975 West Shore  Road, Warwick, RI.           |       |       | 3,500      |                         |       |                                   | 2000       |                      |       | Leased                          |       |   | 3/31/10 |   |   |
| 1175 Cumberland  Hill Road, Woonsocket, RI.   |       |       | 3,300      |                         |       |                                   | 1998       |                      |       | Owned                           |       |   | N.A. |   |   |
| *Administrative  and operational offices:*    |       |       |       |                         |       |                                   |       |                      |       |                            |       |   |   |   |   |
| 625 G. Washington  Highway, Lincoln, RI.      |       |       | 23,600     |                         |       |                                   | 2003       |                      |       | Leased                          |       |   | 12/31/12 |   |   |
| One Turks Head  Place, Providence, RI.        |       |       | 20,600     |                         |       |                                   | 1999       |                      |       | Leased                          |       |   | 6/30/09 |   |   |
| One Ames Court,  Plainview, NY                |       |       | 4,400      |                         |       |                                   | 2005       |                      |       | Leased                          |       |   | 1/31/08 |   |   |
| *Planned  branch offices:*                    |       |       |       |                         |       |                                   |       |                      |       |                            |       |   |   |   |   |
| 90 Point Judith  Road, Narragansett, RI       |       |       | (A)        |                         |       |                                   | N.A.       |                      |       | Leased                          |       |   | 3/31/27 |   |   |
| 499 Smithfield Avenue,  Pawtucket, RI.        |       |       | (A)        |                         |       |                                   | N.A.       |                      |       | Leased                          |       |   | 5/31/21 |   |   |

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(A)       Facilitycurrently under construction or in planning.

**ITEM 3*.****               *LEGALPROCEEDINGS

The Company is involvedonly in routine litigation incidental to the business of banking, none of whichthe Company’s management expects to have a material adverse effect on theCompany.

**ITEM 4.**                SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

There were no matters submitted to a vote of securityholders in the fourth quarter of 2006.

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**PART II**

**ITEM 5.**                MARKETFOR THE COMPANY’S COMMON STOCK, RELATED STOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES

Ourcommon stock is traded on the Nasdaq Global Select MarketSM under the symbol “BARI”. The following tablesets forth certain information regarding our common stock for the periodsindicated.

| ** **     | ** ** | **Stock Price** | ** ** | **Dividend** | ** ** |
|----------------|------------|----------------------|------------|--------------|------------|
| ** **     | ** ** | **High**             | ** ** | **Low**      | ** ** | **Paid** | ** ** |
| 2005:          |       |                 |       |         |       |   |   |   |   |
| First Quarter  |       | $                    | 40.00      |         | $          | 35.96 |   |   | $ | 0.15 |   |   |
| Second Quarter |       | 38.07                |       | 35.39        |       |   | 0.15 |   |   |
| Third Quarter  |       | 37.45                |       | 35.11        |       |   | 0.15 |   |   |
| Fourth Quarter |       | 36.55                |       | 33.29        |       |   | 0.15 |   |   |
| 2006:          |       |                 |       |         |       |   |   |   |   |
| First Quarter  |       | $                    | 35.65      |         | $          | 32.75 |   |   | $ | 0.15 |   |   |
| Second Quarter |       | 39.94                |       | 33.31        |       |   | 0.15 |   |   |
| Third Quarter  |       | 45.40                |       | 38.91        |       |   | 0.15 |   |   |
| Fourth Quarter |       | 45.37                |       | 42.09        |       |   | 0.15 |   |   |

 

As of February 28, 2007, there were approximately1,700 holders of record of our common stock.

The following graph andtable show changes in the value of $100 invested on December 31, 2001through December 31, 2006, in our common stock, the Russell 3000, and theSNL Financial L.C. New England Bank Index. The investment values are based onshare price appreciation plus dividends paid in cash, assuming that dividendswere reinvested on the date they were paid.

**Total ReturnPerformance**

****

| ** **                       | ** ** | **Period Ending** | ** ** |
|----------------------------------|------------|------------------------|------------|
| **Index**                        | ** ** | ** **             | ** ** | **12/31/01** | ** ** | **12/31/02** | ** ** | **12/31/03** | ** ** | **12/31/04** | ** ** | **12/31/05** | ** ** | **12/31/06** | ** ** |
| Bancorp Rhode  Island, Inc. |       |                   | 100.00     |   |   |   | 134.74 |   |   |   | 198.56 |   |   |   | 242.99 |   |   |   | 207.50 |   |   |   | 273.86 |   |   |
| Russell 3000                     |       |                   | 100.00     |   |   |   | 78.46 |   |   |   | 102.83 |   |   |   | 115.11 |   |   |   | 122.16 |   |   |   | 141.35 |   |   |
| SNL New England Bank  Index      |       |                   | 100.00     |   |   |   | 75.43 |   |   |   | 124.46 |   |   |   | 131.63 |   |   |   | 131.49 |   |   |   | 155.20 |   |   |
|                                  |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

23

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**ITEM 6. SELECTEDCONSOLIDATED FINANCIAL DATA**

Thefollowing table represents selected consolidated financial data as of and forthe years ended December 31, 2006, 2005, 2004, 2003 and 2002. The selectedconsolidated financial data set forth below does not purport to be complete andshould be read in conjunction with, and are qualified in their entirety by, themore detailed information, including the Consolidated Financial Statements andrelated Notes, and “Management’s Discussion and Analysis of Financial Conditionand Results of Operations”, appearing elsewhere herein.

| ** **                                          | ** ** | **As of and for the year ended December 31,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| ** **                                          | ** ** | **2006**                                                                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                          | ** ** | **(Dollars in thousands, except per share data)**       | ** ** |
| Statements of operations data:       |       |                                                                                  |       |   |   |   |   |   |   |   |   |
| Interest income                                     |       | $                                                                                     | 81,202     |   | $ | 69,520 |   | $ | 57,719 |   | $ | 51,773 |   | $ | 53,507 |   |
| Interest expense                                    |       | 38,974                                                                                |       | 26,619 |   | 19,625 |   | 19,453 |   | 22,180 |   |
| Net interest  income                                |       | 42,228                                                                                |       | 42,901 |   | 38,094 |   | 32,320 |   | 31,327 |   |
| Provision for loan  and lease losses                |       | 1,202                                                                                 |       | 1,423 |   | 836 |   | 1,524 |   | 1,808 |   |
| Noninterest income                                  |       | 8,988                                                                                 |       | 9,274 |   | 8,581 |   | 8,830 |   | 7,083 |   |
| Noninterest  expense                                |       | 38,727                                                                                |       | 36,343 |   | 32,929 |   | 28,866 |   | 25,091 |   |
| Income before  taxes                                |       | 11,287                                                                                |       | 14,409 |   | 12,910 |   | 10,760 |   | 11,511 |   |
| Income taxes                                        |       | 3,576                                                                                 |       | 4,840 |   | 4,296 |   | 3,546 |   | 3,849 |   |
| Net income                                          |       | $                                                                                     | 7,711      |   | $ | 9,569 |   | $ | 8,614 |   | $ | 7,214 |   | $ | 7,662 |   |
| Per share data:                                     |       |                                                                                  |       |   |   |   |   |   |   |   |   |
| Basic earnings per  common share                    |       | $                                                                                     | 1.62       |   | $ | 2.14 |   | $ | 2.17 |   | $ | 1.89 |   | $ | 2.04 |   |
| Diluted earnings  per common share                  |       | $                                                                                     | 1.57       |   | $ | 2.04 |   | $ | 2.04 |   | $ | 1.77 |   | $ | 1.92 |   |
| Dividends per  common share                         |       | $                                                                                     | 0.60       |   | $ | 0.60 |   | $ | 0.58 |   | $ | 0.56 |   | $ | 0.53 |   |
| Dividend pay-out  ratio                             |       | 38.2                                                                                  | %          | 29.4 | % | 28.4 | % | 31.6 | % | 27.6 | % |
| Book value per  common share                        |       | $                                                                                     | 23.39      |   | $ | 22.21 |   | $ | 19.68 |   | $ | 18.53 |   | $ | 17.59 |   |
| Tangible book  value per common share               |       | $                                                                                     | 21.03      |   | $ | 19.83 |   | $ | 16.99 |   | $ | 15.76 |   | $ | 14.73 |   |
| Average common  shares outstanding—            |       |                                                                                  |       |   |   |   |   |   |   |   |   |
| Basic                                               |       | 4,766,854                                                                             |       | 4,478,081 |   | 3,975,413 |   | 3,819,232 |   | 3,758,214 |   |
| Average common  shares outstanding—            |       |                                                                                  |       |   |   |   |   |   |   |   |   |
| Diluted                                             |       | 4,920,569                                                                             |       | 4,697,134 |   | 4,222,856 |   | 4,085,878 |   | 3,996,670 |   |
| Balance sheet data:                                 |       |                                                                                  |       |   |   |   |   |   |   |   |   |
| Total assets                                        |       | $                                                                                     | 1,479,099  |   | $ | 1,442,782 |   | $ | 1,239,069 |   | $ | 1,093,971 |   | $ | 1,012,877 |   |
| Investment  securities                              |       | 103,425                                                                               |       | 150,959 |   | 104,600 |   | 98,595 |   | 101,329 |   |
| Mortgage-backed  securities                         |       | 240,462                                                                               |       | 234,858 |   | 159,946 |   | 106,618 |   | 156,114 |   |
| Total loans and  leases receivable                  |       | 1,004,292                                                                             |       | 950,806 |   | 886,301 |   | 814,282 |   | 670,658 |   |
| Allowance for loan  and lease losses                |       | 12,377                                                                                |       | 11,665 |   | 11,454 |   | 10,690 |   | 9,784 |   |
| Goodwill, net                                       |       | 11,317                                                                                |       | 11,234 |   | 10,766 |   | 10,766 |   | 10,766 |   |
| Deposits                                            |       | 1,016,423                                                                             |       | 980,969 |   | 880,674 |   | 811,283 |   | 761,911 |   |
| Borrowings                                          |       | 337,097                                                                               |       | 344,769 |   | 271,386 |   | 203,622 |   | 179,305 |   |
| Total  shareholders’ equity                    |       | 112,085                                                                               |       | 104,832 |   | 78,923 |   | 72,107 |   | 66,427 |   |
| Average balance sheet  data:                        |       |                                                                                  |       |   |   |   |   |   |   |   |   |
| Total assets                                        |       | $                                                                                     | 1,451,959  |   | $ | 1,347,510 |   | $ | 1,168,454 |   | $ | 1,046,741 |   | $ | 947,205 |   |
| Investment  securities                              |       | 144,460                                                                               |       | 131,711 |   | 102,827 |   | 91,153 |   | 71,481 |   |
| Mortgage-backed  securities                         |       | 227,973                                                                               |       | 209,004 |   | 132,946 |   | 123,524 |   | 177,753 |   |
| Total loans and  leases receivable                  |       | 980,598                                                                               |       | 916,273 |   | 848,550 |   | 747,174 |   | 622,545 |   |
| Allowance for loan  and lease losses                |       | 12,002                                                                                |       | 11,560 |   | 11,072 |   | 10,739 |   | 9,375 |   |
| Goodwill, net                                       |       | 11,290                                                                                |       | 11,067 |   | 10,766 |   | 10,766 |   | 10,766 |   |
| Deposits                                            |       | 965,194                                                                               |       | 928,374 |   | 858,739 |   | 779,540 |   | 706,338 |   |
| Borrowings                                          |       | 362,721                                                                               |       | 306,344 |   | 227,365 |   | 192,068 |   | 174,668 |   |
| Total  shareholders’ equity                    |       | 106,874                                                                               |       | 95,922 |   | 74,704 |   | 69,010 |   | 61,922 |   |
| Operating ratios:                                   |       |                                                                                  |       |   |   |   |   |   |   |   |   |
| Interest rate  spread                               |       | 2.50                                                                                  | %          | 2.92 | % | 3.07 | % | 2.91 | % | 3.04 | % |
| Net interest  margin                                |       | 3.06                                                                                  | %          | 3.35 | % | 3.44 | % | 3.28 | % | 3.48 | % |
| Efficiency ratio  (a)                               |       | 75.62                                                                                 | %          | 69.66 | % | 70.55 | % | 70.15 | % | 65.32 | % |
| Return on average  assets                           |       | 0.53                                                                                  | %          | 0.71 | % | 0.74 | % | 0.69 | % | 0.81 | % |
| Return on average  equity                           |       | 7.22                                                                                  | %          | 9.98 | % | 11.53 | % | 10.45 | % | 12.37 | % |
| Asset quality ratios:                               |       |                                                                                  |       |   |   |   |   |   |   |   |   |
| Nonperforming loans  to total loans                 |       | 0.14                                                                                  | %          | 0.04 | % | 0.08 | % | 0.30 | % | 0.11 | % |
| Nonperforming  assets to total assets               |       | 0.10                                                                                  | %          | 0.03 | % | 0.06 | % | 0.23 | % | 0.08 | % |
| Allowance for loan  and lease losses to             |       |                                                                                  |       |   |   |   |   |   |   |   |   |
| nonperforming  loans                                |       | 875.94                                                                                | %          | 2,810.84 | % | 1,562.62 | % | 434.20 | % | 1,329.35 | % |
| Allowance for loan  and lease losses to total loans |       | 1.23                                                                                  | %          | 1.23 | % | 1.29 | % | 1.31 | % | 1.46 | % |
| Net loans  charged-off to average loans outstanding |       | 0.05                                                                                  | %          | 0.13 | % | 0.01 | % | 0.08 | % | 0.05 | % |

 

24

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| ** **                                                | ** ** | **As of and for the year ended December 31,** | ** ** |
|-----------------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| ** **                                                | ** ** | **2006**                                                                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                | ** ** | **(Dollars in thousands, except per share data)**       | ** ** |
| Capital ratios:                                           |       |                                                                                  |       |   |   |   |   |   |   |   |   |
| Average shareholders’ equity to average total assets |       | 7.36                                                                                  | %          | 7.11 | % | 6.40 | % | 6.59 | % | 6.54 | % |
| Tier I leverage ratio                                     |       | 8.37                                                                                  | %          | 8.21 | % | 7.06 | % | 6.76 | % | 6.19 | % |
| Tier I risk-based capital ratio                           |       | 12.05                                                                                 | %          | 12.62 | % | 10.01 | % | 9.71 | % | 9.63 | % |
| Total risk-based  capital ratio                           |       | 13.27                                                                                 | %          | 13.87 | % | 11.26 | % | 10.92 | % | 10.88 | % |

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(a)              Calculated by dividing total noninterestexpenses by net interest income plus noninterest income.

**ITEM 7.**                MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

**Introduction**

Bancorp RhodeIsland, Inc., a Rhode Island corporation, is the holding company for BankRhode Island. The Company has no significant assets other than the common stockof the Bank. For this reason, substantially all of the discussion in thisdocument relates to the operations of the Bank and its subsidiaries.

The Bank is a commercialbank chartered as a financial institution in the State of Rhode Island. TheBank pursues a community banking mission and is principally engaged inproviding banking products and services to businesses and individuals in RhodeIsland and nearby areas of Massachusetts. The Bank is subject to competitionfrom a variety of traditional and nontraditional financial service providersboth within and outside of Rhode Island. The Bank offers a wide variety ofbusiness, commercial real estate, consumer and residential loans and leases,deposit products, nondeposit investment products, cash management, private bankingand other banking products and services designed to meet the financial needs ofindividuals and small- to mid-sized businesses. The Bank also offers bothcommercial and consumer on-line banking products and maintains a web site at http://www.bankri.com. The Companyand Bank are subject to the regulations of certain federal and state agenciesand undergo periodic examinations by those regulatory authorities. The Bank’sdeposits are insured by the FDIC, subject to regulatory limits. The Bank isalso a member of the FHLB.

**Overview**

The past year markedanother period of growth for the Company. The Company increased its commercialloan and lease portfolio by over 18%. Consumer loans grew 7.6% in 2006, withmuch of the growth coming in the first half of the year. Demand deposit accountgrowth of 8.2% led the overall total deposit increase of 3.6% in 2006. Also,the Company strengthened its senior management team and reorganized its lendingfunction. For a fuller narrative commentary on these matters, refer to Item 1,“Business”.

The primary drivers of theCompany’s operating income are net interest income, which is strongly affectedby the net yield on interest-earning assets (“net interest margin”), and thequality of the Company’s assets.

The Company’s net interestincome represents the difference between its interest income and its cost offunds. Interest income depends on the amount of interest-earning assetsoutstanding during the year and the interest rates earned thereon. Cost offunds is a function of the average amount of deposits and borrowed moneyoutstanding during the year and the interest rates paid thereon. Because theCompany’s assets are not identical in duration and in repricing dates to itsliabilities, the spread between the two is vulnerable to changes in marketinterest rates as well as the overall shape of the yield curve. Thesevulnerabilities are inherent to the business of banking and are commonlyreferred to as “interest rate risk”. How to measure interest rate risk and,once measured, how much risk to take are based on numerous assumptions andother subjective judgments. See discussion under “*Asset andLiability Management*”.

25

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The quality of the Company’s assets also influencesits earnings. Loans and leases that are not being paid on a timely basis andexhibit other weaknesses can result in the loss of principal and/or loss ofinterest income. Additionally, the Company must make timely provisions to itsallowance for loan and lease losses as a result of its estimates as topotential future losses; these additions, which are charged against earnings,are necessarily greater when greater potential losses are expected. Further, theCompany will incur expenses as a result of resolving troubled assets. All ofthese form the “credit risk” that the Company takes on in the ordinary courseof its business and is further discussed under “*FinancialCondition—Asset Quality*”.

The Company’s business strategy has been toconcentrate its asset generation efforts on commercial and consumer loans andits deposit generation efforts on checking and savings accounts. These depositaccounts are commonly referred to as “core deposit accounts”. This strategy isbased on the Company’s belief that it can distinguish itself from its largercompetitors, and indeed attract customers from them, through a higher level ofservice and through its ability to set policies and procedures, as well as makedecisions, locally. The loan and deposit products referenced also tend to begeared more toward customers who are relationship oriented than those who areseeking stand-alone or single transaction products. The Company believes thatits service-oriented approach enables it to compete successfully forrelationship-oriented customers. Additionally, the Company is predominantly anurban franchise with a high concentration of businesses making deployment offunds in the commercial lending area practicable. Commercial loans areattractive, among other reasons, because of their higher yields. Similarly,core deposits are attractive because of their generally lower interest cost andpotential for fee income.

In recent years, the Company also has sought toleverage business opportunities presented by its customer base, franchisefootprint and resources. In 2005, the Bank formed a private banking divisionand completed the Bank’s first acquisition with the acquiring of an equipmentleasing company located in Long Island, New York (“Macrolease”). The Bank usesthe Macrolease platform to increase its portfolio of equipment leases and togenerate additional income by also originating equipment leases for thirdparties. The Company also has introduced Macrolease to the Bank’s commercialcustomers, thereby expanding the Bank’s product offerings.

The deposit market in Rhode Island is highlyconcentrated. The State’s three largest banks have an aggregate market share of85% (based upon June 2006 FDIC statistics, excluding one bank that drawsits deposits primarily from the internet) in Providence and Kent Counties, theBank’s primary marketplace. Competition for loans and deposits has remainedintense during the past few years. This competition has most recently resultedin an increase in competitors’ advertising and promotional product offerings inprint and television media, as well as direct mailings.

In 2006, approximately 82.5% of the Company’s totalrevenues (defined as net interest income plus noninterest income) were derivedfrom its level of net interest income. The Company continued efforts todiversify its sources of revenue, with emphasis on expanding sources ofnoninterest income (primarily fees and charges for products and services theBank offers). The Company experienced growth in 2006 in the areas of servicecharges on deposit accounts and commissions on leases originated for thirdparties.

During 2006, the Company’s focus on core depositaccounts produced a modest increase in core deposits, with the decreases in NOWand money market accounts being offset by gains in demand deposit accounts andsavings accounts. However, competitive market forces and rising rates haveresulted in upward repricing of savings account products. Additionally,customer demand for higher-yielding CDs remained strong. These factors, alongwith the prolonged flattening of the yield curve, have contributed to highercosts and compression in the net interest margin. The Bank experienced anoverall decrease in net interest margin, as 2006’s net interest margin of 3.06%was 29 basis points lower than 2005’s net interest margin of 3.35%.

26

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The future operatingresults of the Company will again depend on the ability to maintain and expandnet interest margin, while minimizing exposure to credit risk, along withincreasing sources of noninterest income, while controlling the growth ofnoninterest or operating expenses.

**Critical AccountingPolicies**

Accounting policiesinvolving significant judgments and assumptions by management, which have, orcould have, a material impact on the carrying value of certain assets or netincome, are considered critical accounting policies. The Company considers thefollowing to be its critical accounting policies: allowance for credit losses,review of goodwill for impairment and income taxes. There have been nosignificant changes in the methods or assumptions used in accounting policiesthat require material estimates or assumptions.

*Allowance forcredit losses*

Arriving at an appropriate level of allowance for loanand lease losses and reserve for unfunded lending commitments, collectivelyreferred to as the allowance for credit losses, necessarily involves asignificant degree of judgment. First and foremost in arriving at anappropriate allowance is the creation and maintenance of a risk rating systemthat accurately classifies all loans, leases and commitments into varyingcategories by degree of credit risk. Such a system also establishes a level ofallowance associated with each category of loans and requires early identificationand reclassification of deteriorating credits. Besides numerous subjectivejudgments as to the number of categories, appropriate level of allowance withrespect to each category and judgments as to categorization of any individualloan or lease, additional subjective judgments are involved when ascertainingthe probability as well as the extent of any potential losses. The Company’songoing evaluation process includes a formal analysis of the allowance eachquarter, which considers, among other factors, the character and size of theloan and lease portfolio, business and economic conditions, loan growth,delinquency trends, nonperforming loan trends, charge-off experience and otherasset quality factors. These factors are based on observable information, aswell as subjective assessment and interpretation. A similar process is employedwith respect to unfunded lending commitments.

Nonperforming commercial, commercial real estate andsmall business loans in excess of a specified dollar amount are deemed to be “impaired”.The estimated reserves necessary for each of these credits is determined byreviewing the fair value of the collateral, the present value of expectedfuture cash flows, and where available, the observable market price of theloans. Provisions for losses on the remaining commercial, commercial realestate, small business, residential mortgage and consumer loans and leases arebased on pools of similar loans or leases using a combination of paymentstatus, historical loss experience, industry loss experience, market economicfactors, delinquency rates and qualitative adjustments.

Management uses availableinformation to establish the allowance for loan and lease losses at the levelit believes is appropriate. However, future additions to the allowance may benecessary based on changes in estimates or assumptions resulting from changesin economic conditions and other factors. In addition, various regulatoryagencies, as an integral part of their examination process, periodically reviewthe Company’s allowance for credit losses. Such agencies may require theCompany to recognize adjustments to the allowance based on their judgmentsabout information available to them at the time of their examination.

*Review of goodwillfor impairment*

In March 1996, the Bank acquired certain assetsand assumed certain liabilities from Fleet Financial Group, Inc. andrelated entities. This acquisition was accounted for utilizing the purchasemethod of 

27

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accounting and generated$17.5 million of goodwill. This goodwill was amortized in the years priorto 2002, resulting in a net balance of $10.8 million on the Company’sbalance sheet as of December 31, 2001. Effective January 1, 2002, inaccordance with Statement of Financial Accounting Standards (“SFAS”) 142 “*Goodwill and Other Intangible Assets*” and SFAS 147 “*Acquisitions of Certain Financial Institutions*”, the Companyceased amortizing this goodwill and began to review it at least annually forimpairment.

On May 1, 2005, the Bank acquired certainoperating assets from Macrolease International Corporation. This acquisitionwas accounted for utilizing the purchase method of accounting and has generated$551,000 of goodwill.

Goodwill is evaluated forimpairment using market value comparisons for similar institutions, such asprice to earnings multiples, price to deposit multiples and price to equitymultiples. This valuation technique utilizes verifiable market multiples, aswell as subjective assessment and interpretation. The application of differentmarket multiples, or changes in judgment as to which market transactions arereflective of the Company’s specific characteristics, could affect theconclusions reached regarding possible impairment. In the event that theCompany were to determine that its goodwill were impaired, the recognition ofan impairment charge could have an adverse impact on its results of operationsin the period that the impairment occurred or on its financial position.

*Income taxes*

Certain areas of accounting for income taxes requiremanagement’s judgment, including determining the expected realization ofdeferred tax assets. Judgments are made regarding various tax positions, whichare often subjective and involve assumptions about items that are inherentlyuncertain. If actual factors and conditions differ materially from estimatesmade by management, the actual realization of the net deferred tax assets couldvary materially from the amounts previously recorded.

Deferred tax assets arisefrom items that may be used as a tax deduction or credit in future income taxreturns, for which a financial statement tax benefit has already beenrecognized. The realization of the net deferred tax asset generally dependsupon future levels of taxable income and the existence of prior years’ taxableincome to which refund claims could be carried back. Valuation allowances arerecorded against those deferred tax assets determined not likely to berealized. Deferred tax liabilities represent items that will require a futuretax payment. They generally represent tax expense recognized in our financialstatements for which payment has been deferred, or a deduction taken on our taxreturn but not yet recognized as an expense in our financial statements.Deferred tax liabilities are also recognized for certain non-cash items such asgoodwill.

**Results ofOperations**

*Net Interest Income*

Net interest income for2006 was $42.2 million, compared to $42.9 million for 2005 and$38.1 million for 2004. The net interest margin decreased in 2006 to3.06%, compared to 3.35% in 2005. In 2004, the net interest margin was 3.44%.The decrease in net interest income of $673,000, or 1.6%, during 2006 wasprimarily attributable to compression in the net interest margin. Averageearning assets increased $99.6 million, or 7.8%, and average interest-bearingliabilities increased $87.7 million, or 8.3%, during 2006, compared to2005.

*Average Balances,Yields and Costs*

The following table sets forth certain informationrelating to the Company’s average balance sheet and reflects the average yieldon assets and average cost of liabilities for the years indicated. Such yields 

28

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and costs are derived bydividing income or expense by the average balance of assets or liabilities.Average balances are derived from daily balances and include nonperformingloans.

| ** **                                       | ** ** | **Year ended December 31** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                       | ** ** | ** **                                | ** ** | **Interest** | ** ** | ** ** | ** ** | ** ** | ** ** | **Interest** | ** ** | ** ** | ** ** | ** ** | ** ** | **Interest** | ** ** | ** ** | ** ** |
| ** **                                       | ** ** | **Average**                               | ** ** | **earned/** | ** ** | **Average** | ** ** | **Average** | ** ** | **earned/** | ** ** | **Average** | ** ** | **Average** | ** ** | **earned/** | ** ** | **Average** | ** ** |
| ** **                                       | ** ** | **balance**                               | ** ** | **paid** | ** ** | **yield** | ** ** | **balance** | ** ** | **paid** | ** ** | **yield** | ** ** | **balance** | ** ** | **paid** | ** ** | **yield** | ** ** |
| ** **                                       | ** ** | **(Dollars in thousands)**                | ** ** |
| **Assets**                                       |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Earning assets:                                  |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Overnight  investments                           |       | $                                         | 9,931      |   | $ | 517 |   |   | 5.21 | % |   | $ | 8,015 |   | $ | 201 |   |   | 2.51 | % |   | $ | 12,286 |   | $ | 138 |   |   | 1.12 | % |   |
| Investment  securities                           |       | 144,460                                   |       | 6,245 |   |   | 4.32 | % |   | 131,711 |   | 5,537 |   |   | 4.20 | % |   | 102,827 |   | 4,452 |   |   | 4.33 | % |   |
| Mortgage-backed  securities                      |       | 227,973                                   |       | 10,542 |   |   | 4.62 | % |   | 209,004 |   | 9,313 |   |   | 4.46 | % |   | 132,946 |   | 5,709 |   |   | 4.29 | % |   |
| Stock in the FHLB                                |       | 16,473                                    |       | 906 |   |   | 5.50 | % |   | 14,842 |   | 647 |   |   | 4.36 | % |   | 10,811 |   | 308 |   |   | 2.85 | % |   |
| Loans receivable:                                |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial loans  and leases                     |       | 473,851                                   |       | 34,381 |   |   | 7.26 | % |   | 421,429 |   | 28,015 |   |   | 6.65 | % |   | 369,263 |   | 23,092 |   |   | 6.25 | % |   |
| Residential  mortgage loans                      |       | 288,374                                   |       | 15,352 |   |   | 5.32 | % |   | 307,659 |   | 15,670 |   |   | 5.09 | % |   | 337,825 |   | 17,087 |   |   | 5.06 | % |   |
| Consumer and other  loans                        |       | 218,373                                   |       | 13,259 |   |   | 6.07 | % |   | 187,185 |   | 10,137 |   |   | 5.42 | % |   | 141,462 |   | 6,933 |   |   | 4.90 | % |   |
| Total earning  assets                            |       | 1,379,435                                 |       | 81,202 |   |   | 5.89 | % |   | 1,279,845 |   | 69,520 |   |   | 5.43 | % |   | 1,107,420 |   | 57,719 |   |   | 5.21 | % |   |
| Cash and due from  banks                         |       | 22,274                                    |       |   |   |   |   |   |   | 25,218 |   |   |   |   |   |   |   | 23,170 |   |   |   |   |   |   |   |
| Allowance for loan  and lease losses             |       | (12,002                                   | )          |   |   |   |   |   |   | (11,560 | ) |   |   |   |   |   |   | (11,072 | ) |   |   |   |   |   |   |
| Premises and  equipment                          |       | 14,840                                    |       |   |   |   |   |   |   | 13,765 |   |   |   |   |   |   |   | 12,709 |   |   |   |   |   |   |   |
| Goodwill, net                                    |       | 11,290                                    |       |   |   |   |   |   |   | 11,067 |   |   |   |   |   |   |   | 10,766 |   |   |   |   |   |   |   |
| Accrued interest  receivable                     |       | 5,840                                     |       |   |   |   |   |   |   | 5,174 |   |   |   |   |   |   |   | 4,584 |   |   |   |   |   |   |   |
| Bank-owned life  insurance                       |       | 20,841                                    |       |   |   |   |   |   |   | 18,452 |   |   |   |   |   |   |   | 16,026 |   |   |   |   |   |   |   |
| Prepaid expenses  and other assets               |       | 9,441                                     |       |   |   |   |   |   |   | 5,549 |   |   |   |   |   |   |   | 4,851 |   |   |   |   |   |   |   |
| Total assets                                     |       | $                                         | 1,451,959  |   |   |   |   |   |   |   | $ | 1,347,510 |   |   |   |   |   |   |   | $ | 1,168,454 |   |   |   |   |   |   |   |
| **Liabilities  and Shareholders’ Equity**   |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities:                    |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                        |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| NOW accounts                                     |       | $                                         | 71,188     |   | 356 |   |   | 0.50 | % |   | $ | 94,296 |   | 590 |   |   | 0.63 | % |   | $ | 123,064 |   | 1,172 |   |   | 0.95 | % |   |
| Money market  accounts                           |       | 8,757                                     |       | 161 |   |   | 1.84 | % |   | 17,577 |   | 235 |   |   | 1.34 | % |   | 16,315 |   | 213 |   |   | 1.31 | % |   |
| Savings accounts                                 |       | 349,675                                   |       | 7,929 |   |   | 2.27 | % |   | 337,756 |   | 4,734 |   |   | 1.40 | % |   | 325,019 |   | 3,899 |   |   | 1.20 | % |   |
| Certificate of  deposit accounts                 |       | 355,908                                   |       | 14,030 |   |   | 3.94 | % |   | 304,572 |   | 8,962 |   |   | 2.94 | % |   | 225,381 |   | 5,638 |   |   | 2.50 | % |   |
| Overnight and  short-term borrowings             |       | 44,241                                    |       | 2,124 |   |   | 4.80 | % |   | 23,019 |   | 652 |   |   | 2.83 | % |   | 16,643 |   | 157 |   |   | 0.94 | % |   |
| Wholesale  repurchase agreements                 |       | 20,000                                    |       | 870 |   |   | 4.35 | % |   | 9,417 |   | 276 |   |   | 2.93 | % |   | — |   | — |   |   | 0.00 | % |   |
| FHLB borrowings                                  |       | 279,922                                   |       | 12,044 |   |   | 4.30 | % |   | 255,350 |   | 9,898 |   |   | 3.88 | % |   | 193,234 |   | 7,505 |   |   | 3.88 | % |   |
| Subordinated  deferrable interest debentures     |       | 18,558                                    |       | 1,460 |   |   | 7.87 | % |   | 18,558 |   | 1,272 |   |   | 6.85 | % |   | 17,487 |   | 1,041 |   |   | 5.95 | % |   |
| Total  interest-bearing liabilities              |       | 1,148,249                                 |       | 38,974 |   |   | 3.39 | % |   | 1,060,545 |   | 26,619 |   |   | 2.51 | % |   | 917,143 |   | 19,625 |   |   | 2.14 | % |   |
| Noninterest-bearing  deposits                    |       | 179,666                                   |       |   |   |   |   |   |   | 174,173 |   |   |   |   |   |   |   | 168,960 |   |   |   |   |   |   |   |
| Other liabilities                                |       | 17,170                                    |       |   |   |   |   |   |   | 16,870 |   |   |   |   |   |   |   | 7,647 |   |   |   |   |   |   |   |
| Total liabilities                                |       | 1,345,085                                 |       |   |   |   |   |   |   | 1,251,588 |   |   |   |   |   |   |   | 1,093,750 |   |   |   |   |   |   |   |
| Shareholders’  equity                       |       | 106,874                                   |       |   |   |   |   |   |   | 95,922 |   |   |   |   |   |   |   | 74,704 |   |   |   |   |   |   |   |
| Total liabilities  and shareholders’ equity |       | $                                         | 1,451,959  |   |   |   |   |   |   |   | $ | 1,347,510 |   |   |   |   |   |   |   | $ | 1,168,454 |   |   |   |   |   |   |   |
| Net interest  income                             |       |                                      |       | $ | 42,228 |   |   |   |   |   |   |   | $ | 42,901 |   |   |   |   |   |   |   | $ | 38,094 |   |   |   |   |   |
| Net interest rate  spread                        |       |                                      |       |   |   |   | 2.50 | % |   |   |   |   |   |   | 2.92 | % |   |   |   |   |   |   | 3.07 | % |   |
| Net interest rate  margin                        |       |                                      |       |   |   |   | 3.06 | % |   |   |   |   |   |   | 3.35 | % |   |   |   |   |   |   | 3.44 | % |   |

 

29

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*Rate/VolumeAnalysis*

Thefollowing table sets forth certain information regarding changes in the Company’sinterest income and interest expense for the periods indicated. For eachcategory of interest-earning assets and interest-bearing liabilities,information is provided on changes attributable to (i) changes in rate(changes in rate multiplied by old average balance) and (ii) changes involume (changes in average balances multiplied by old rate). The net changeattributable to the combined impact of rate and volume was allocatedproportionally to the individual rate and volume changes.

| ** **                                      | ** ** | **Year ended December 31,**     | ** ** |
|-------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                      | ** ** | **2006 vs. 2005**                    | ** ** | **2005 vs. 2004** | ** ** |
| ** **                                      | ** ** | **Increase/ (decrease) due to** | ** ** | **Increase/(decrease) due to** | ** ** |
| ** **                                      | ** ** | **Rate**                                       | ** ** | **Volume** | ** ** | **Total** | ** ** | **Rate** | ** ** | **Volume** | ** ** | **Total** | ** ** |
| ** **                                      | ** ** | **(In thousands)**                        | ** ** |
| Interest income:                                |       |                                           |       |   |   |   |   |   |   |   |   |   |   |
| Overnight investments                           |       | $                                              | 258        |   | $ | 58 |   | $ | 316 |   | $ | 124 |   | $ | (61 | ) | $ | 63 |   |
| Investment securities                           |       | 239                                            |       | 469 |   | 708 |   | (132 | ) | 1,217 |   | 1,085 |   |
| Mortgage-backed securities                      |       | 418                                            |       | 811 |   | 1,229 |   | 223 |   | 3,381 |   | 3,604 |   |
| Stock in the FHLB                               |       | 182                                            |       | 77 |   | 259 |   | 199 |   | 140 |   | 339 |   |
| Commercial loans and leases                     |       | 2,204                                          |       | 4,162 |   | 6,366 |   | 1,519 |   | 3,404 |   | 4,923 |   |
| Residential mortgage loans                      |       | 693                                            |       | (1,011 | ) | (318 | ) | 118 |   | (1,535 | ) | (1,417 | ) |
| Consumer and other loans                        |       | 1,368                                          |       | 1,754 |   | 3,122 |   | 786 |   | 2,418 |   | 3,204 |   |
| Total interest income                           |       | 5,362                                          |       | 6,320 |   | 11,682 |   | 2,837 |   | 8,964 |   | 11,801 |   |
| Interest expense:                               |       |                                           |       |   |   |   |   |   |   |   |   |   |   |
| NOW accounts                                    |       | (105                                           | )          | (129 | ) | (234 | ) | (346 | ) | (236 | ) | (582 | ) |
| Money market accounts                           |       | 69                                             |       | (143 | ) | (74 | ) | 5 |   | 17 |   | 22 |   |
| Savings accounts                                |       | 3,022                                          |       | 173 |   | 3,195 |   | 677 |   | 158 |   | 835 |   |
| Certificate of deposit accounts                 |       | 3,387                                          |       | 1,681 |   | 5,068 |   | 1,111 |   | 2,213 |   | 3,324 |   |
| Overnight & short-term borrowings      |       | 632                                            |       | 840 |   | 1,472 |   | 416 |   | 79 |   | 495 |   |
| FHLB and other borrowings                       |       | 1,736                                          |       | 1,004 |   | 2,740 |   | (81 | ) | 2,750 |   | 2,669 |   |
| Capital trust and other subordinated securities |       | 188                                            |       | — |   | 188 |   | 164 |   | 67 |   | 231 |   |
| Total interest expense                          |       | 8,929                                          |       | 3,426 |   | 12,355 |   | 1,946 |   | 5,048 |   | 6,994 |   |
| Net interest  income                            |       | $                                              | (3,567)    |   | $ | 2,894 |   | $ | (673) |   | $ | 891 |   | $ | 3,916 |   | $ | 4,807 |   |

 

**Comparison of YearsEnded December 31, 2006 and December 31, 2005**

*General*

Net income for 2006 decreased $1.9 million, or 19.4%,from $9.6 million for 2005. Earnings per diluted common share (“EPS”) decreasedalso from $2.04 for 2005 to $1.57 for 2006. The 2006 earnings represented areturn on average assets of 0.53% and a return on average equity of 7.22% for2006, as compared to a return on average assets of 0.71% and a return onaverage equity of 9.98% for 2005.

Net income and EPS for 2006 were negatively impactedby approximately $558,000 or $0.11, net of taxes, due to the investmentportfolio restructuring the Company undertook in the third quarter of 2006 inan effort to improveearnings in future periods. The effect of these security losses onshareholders’ equity was minimal as the securities had been carried at marketvalue on the balance sheet. As a result of this investment portfoliorepositioning, the Company anticipates an increase of future pretax interestincome of over $900,000 by the end of 2007.

To provide additionalanalysis regarding the Company’s operating results, the following tablesset forth certain information relating to the reconciliation of GAAP netincome, EPS and related operating 

30

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ratios to pro forma amounts,which adjust for securities gains and losses over the past two years.Management believes this information is useful to the investor in comparing theCompany’s operating results to the prior year.

| ** **                            | ** ** | **Year ended December 31,**                     | ** ** |
|---------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                                       | ** ** | **2005** | ** ** |
| ** **                            | ** ** | **(In thousands,  except per share data)** | ** ** |
| Net income (GAAP)                     |       | $                                                              | 7,711      |   | $ | 9,569 |   |
| Adjust for:                           |       |                                                           |       |   |   |
| Securities losses (gains), net of tax |       | 558                                                            |       | (118 | ) |
| Pro forma net  income                 |       | $                                                              | 8,269      |   | $ | 9,451 |   |
| Diluted earnings  per share (GAAP)    |       | $                                                              | 1.57       |   | $ | 2.04 |   |
| Effect of:                            |       |                                                           |       |   |   |
| Securities losses (gains), net of tax |       | 0.11                                                           |       | (0.03 | ) |
| Pro forma diluted  earnings per share |       | $                                                              | 1.68       |   | $ | 2.01 |   |

 

| ** **                           | ** ** | **Year Ended December 31, 2006** | ** ** |
|--------------------------------------|------------|------------------------------------------------------|------------|
| ** **                           | ** ** | **Return on**                                   | ** ** | **Return on** | ** ** | **Efficiency** | ** ** |
| ** **                           | ** ** | **Average Assets**                              | ** ** | **Average Equity** | ** ** | **Ratio** | ** ** |
| GAAP ratios                          |       |                                                 | 0.53       | % |   |   | 7.22 | % |   |   | 75.62 | % |   |
| Effect of:                           |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Security losses  (gains), net of tax |       |                                                 | 0.04       | % |   |   | 0.52 | % |   |   | -1.25 | % |   |
| Pro forma ratios                     |       |                                                 | 0.57       | % |   |   | 7.74 | % |   |   | 74.37 | % |   |

 

| ** **                          | ** ** | **Year Ended December 31, 2005** | ** ** |
|-------------------------------------|------------|------------------------------------------------------|------------|
| ** **                          | ** ** | **Return on**                                   | ** ** | **Return on** | ** ** | **Efficiency** | ** ** |
| ** **                          | ** ** | **Average Assets**                              | ** ** | **Average Equity** | ** ** | **Ratio** | ** ** |
| GAAP ratios                         |       |                                                 | 0.71       | % |   |   | 9.98 | % |   |   | 69.66 | % |   |
| Effect of:                          |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Security losses (gains), net of tax |       |                                                 | -0.01      | % |   |   | -0.12 | % |   |   | 0.24 | % |   |
| Pro forma ratios                    |       |                                                 | 0.70       | % |   |   | 9.86 | % |   |   | 69.90 | % |   |

 

On a pro forma basis,operating results for 2006 were down as compared to 2005. Margin compressionled to a decline in net interest income of $673,000, despite an increase intotal average earning assets of approximately $100 million. The increases innoninterest income of $754,000, led primarily by increases in deposit servicecharges and commissions on originations of loans and leases, were offset byincreased noninterest expenses. In addition to the aforementioned additions tothe senior management team, the noninterest expenses for 2006 include the fullyear operating costs of Macrolease, the private banking group and the twonewest branches, all of which began midway through 2005.

*Net Interest Income*

For 2006, net interest income was $42.2 million,compared to $42.9 million for 2005. The net interest margin for 2006 was 3.06%compared to a net interest margin of 3.35% for 2005. The decrease in netinterest income of $673,000, or 1.6%, was attributable to margin pressures asthe average earning assets increased $99.6 million, or 7.8%, and averageinterest-bearing liabilities increased $87.7 million, or 8.3%, over thepreceding year. The decrease of 29 basis points in the net interest margin wasdue to the compression of the yield curve, competitive asset pricing, increasesin CD balances and heightened competition for savings and other core depositsin the Company’s market area.

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*Interest Income—Investments*

Total investment income(consisting of interest on overnight investments, investment securities andMBSs, and dividends on FHLB stock) was $18.2 million for 2006, compared to$15.7 million for 2005. This increase in total investment income of $2.5million, or 16.0%, was attributable to a 25 basis point increase in the overallyield on investments, from 4.32% in 2005 to 4.57% in 2006, along with anincrease in the average balance of investments of approximately $35 million.

*Interest Income—Loansand Leases*

Interest from loans was $63.0 million for 2006, andrepresented a yield on total loans of 6.42%. This compares to $53.8 million ofinterest, and a yield of 5.87%, for 2005. Increased interest income resultingfrom growth in the average balance of loans of $64.3 million, or 7.0%, wasaugmented by an increase in the yield on loans of 55 basis points.

The average balance of thevarious components of the loan portfolio changed as follows: commercial loansand leases increased $52.4 million, or 12.4%; consumer and other loansincreased $31.2 million, or 16.7%; and residential mortgage loans decreased$19.3 million, or 6.3%. The yield on the various components of the loanportfolio changed as follows: commercial loans and leases increased 61 basispoints, to 7.26%; consumer and other loans increased 66 basis points, to 6.07%;and residential mortgage loans increased 23 basis points, to 5.32%. The yieldson loans and leases benefited primarily from the interest rate increases in2006.

*Interest Expense—Depositsand Borrowings*

Interest paid on deposits and borrowings increased by$12.4 million, or 46.4%, due to both market area competition as well as risesin short-term market interest rates during 2006. The overall average cost forinterest-bearing liabilities increased 88 basis points from 2.51% for 2005, to3.39% for 2006. The average balance of total interest-bearing liabilitiesincreased $87.7 million, or 8.3%, from $1.06 billion in 2005, to $1.15 billionin 2006. The growth in deposit average balances was centered primarily in CDaccounts (up $51.4 million, or 16.9%) and savings accounts (up $11.9 million,or 3.5%). These increases were partially offset by a decrease in NOW accounts(down $23.1 million, or 24.5%) and money market accounts (down $8.8 million, or50.2%).

In addition, the average balance of borrowingsincreased as compared to the prior year, as the Bank utilized short-termborrowings (up $21.2 million, or 92.2%), FHLB funding (up $24.6 million, or9.6%) and wholesale repurchase agreements (up $10.6 million, or 112.4%) to funda portion of the new asset growth. The balance of wholesale repos has remainedconstant at $20 million since midway through the fourth quarter of 2005.Overall, the cost of nondepositborrowings increased 60 basis points in 2006 to 4.55%, compared to 3.95% in theprior year.

The rise in liabilitycosts can be attributed to a number of factors. With the rises in interestrates during 2006, customer demand for higher-yielding deposit products hasstrengthened. Additionally, competition for deposits has become intense andextensive bank advertising has increased customer awareness of attractiverates. Moreover, online banking has enabled customers to more actively managetheir finances and has facilitated the movement of available funds from demanddeposit accounts and normally lower-costing deposit accounts intohigher-yielding deposit products. In an effort to attract and retain customersand deposit relationships, the Bank has offered not only the typically higher-costingCDs, but also higher-yielding savings and NOW accounts.

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*Provision for Loanand Lease Losses*

The provision for loan and lease losses was $1.2million for 2006, compared to $1.4 million for 2005. The allowance, expressedas a percentage of total loans and leases, was 1.23% as of December 31,2006, compared to 1.23% at the prior year-end and stood at 876.0% ofnonperforming loans and leases at December 31, 2006, compared to 2810.8%of nonperforming loans and leases at December 31, 2005. Net charge-offsfor 2006 were $490,000, compared to $1.2 million for 2005.

In 2006, the Company reclassified the reserve forunfunded lending commitments (December 31, 2005 year-end balance of$503,000) from the allowance for loan and lease losses to other liabilities.The Company has reclassified prior period amounts accordingly, as illustratedwithin the activity analysis table on page 47. These reclassificationsresulted in adjustments to the prior period ending and average balances of theallowance for loan and lease losses and other liabilities, the allocation ofthe allowance for loan and lease losses, as well as previously reported expenseamounts for the provision for loan and lease losses and other expenses andrelated asset quality ratios. Also see discussion under *“Allowancefor Credit Losses”.*

Management evaluatesseveral factors including new loan originations, actual and estimatedcharge-offs, risk characteristics of the loan and lease portfolio and generaleconomic conditions when determining the provision for loan and lease losses.As the loan and lease portfolio continues to grow and mature, or if economicconditions worsen, management believes it possible that the level ofnonperforming assets will increase, which in turn may lead to increases to theprovision for loan and lease losses. Also see discussion under “*Allowance for Credit Losses*”.

*Noninterest Income*

Totalnoninterest income decreased by $286,000, or 3.1%, from $9.3 million for 2005,to $9.0 million for 2006. The following table sets forth the components ofnoninterest income:

| ** **                                     | ** ** | **Year ended December 31,** | ** ** |
|------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                     | ** ** | **2006**                                   | ** ** | **2005** | ** ** |
| ** **                                     | ** ** | **(In thousands)**                    | ** ** |
| Service charges  on deposit accounts           |       | $                                          | 5,055      |   | $ | 4,561 |   |
| Commissions on  nondeposit investment products |       | 872                                        |       | 849 |   |
| Income from  bank-owned life insurance         |       | 785                                        |       | 691 |   |
| Loan related fees                              |       | 694                                        |       | 1,024 |   |
| Commissions on  loans originated for others    |       | 159                                        |       | 184 |   |
| (Loss)/gain on  available for sale securities  |       | (859                                       | )          | 181 |   |
| Other income                                   |       | 2,282                                      |       | 1,784 |   |
| Total noninterest  income                      |       | $                                          | 8,988      |   | $ | 9,274 |   |

 

In September 2006, the Company restructured aportion of its investment portfolio to improve earnings in future periods bycapitalizing on a temporary increase in security valuations due to movements inthe yield curve. The Company sold $62 million of its available for salesecurities and reinvested the sales proceeds into higher-yielding securities.This investment portfolio restructuring resulted in losses of $859,000;however, the effect of these security losses on shareholders’ equity wasminimal as the securities had been carried at market value on the balancesheet. As a result of this investment portfolio repositioning, the Company anticipatesan increase of future investment income of over $900,000 by the end of 2007.

Excluding securities gainsand losses, noninterest income increased $754,000, or 8.3%. Deposit accountservice charges continue to represent the largest source of noninterest incomefor the Company and produced the highest growth within the category with anincrease of $494,000, or 10.8%, to $5.1 million for 2006, compared to $4.6million in the prior year. Income from bank-owned life insurance 

33

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(“BOLI”)increased $94,000, or 13.6% from the prior year as a result of additionalpurchases of insurance throughout the year. The Company also conducted atax-free exchange of a portion of its BOLI to other life insurance carriers inthe fourth quarter of 2006, which should increase income from BOLI in futureyears. In addition, the Company experienced a moderate increase in commissionson nondeposit investment products of $23,000, or 2.7%. Other income increasedby $498,000, or 27.9%, with increases in customer related sweep activity andcommissions from leases originated for third parties. These increases innoninterest income were partially offset by a decline in commissions on loansoriginated for others of $25,000, or 13.6% and a decrease in loan related feesof $330,000, or 32.2%. Loan related fees in 2005 were higher primarily as aresult of increased prepayment activity in 2005.

*Noninterest Expense*

Noninterest expenses for 2006 increased a total of$2.4 million, or 6.6%, to $38.7 million. The following table sets forth thecomponents of noninterest expense:

| ** **                                | ** ** | **Year ended December 31,** | ** ** |
|-------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                | ** ** | **2006**                                   | ** ** | **2005** | ** ** |
| ** **                                | ** ** | **(In thousands)**                    | ** ** |
| Salaries and  employee benefits           |       | $                                          | 20,636     |   | $ | 19,476 |   |
| Occupancy and  equipment                  |       | 4,971                                      |       | 4,695 |   |
| Data processing                           |       | 2,880                                      |       | 2,759 |   |
| Professional  services                    |       | 2,186                                      |       | 2,017 |   |
| Marketing                                 |       | 1,880                                      |       | 1,584 |   |
| Loan servicing                            |       | 917                                        |       | 968 |   |
| Loan workout and  other real estate owned |       | 188                                        |       | 217 |   |
| Other expenses                            |       | 5,069                                      |       | 4,627 |   |
| Total noninterest  expense                |       | $                                          | 38,727     |   | $ | 36,343 |   |

 

Overall, noninterest expenses reflected the continuedgrowth of the Company resulting in higher operating costs. Such growth includesthe Bank opening two new branches in Lincoln and East Greenwich, Rhode Islandand the addition of Macrolease and One Trust & Private Banking (alloccurring during the second quarter of 2005). Also, additions were made to theCompany’s business ranks over the past year. The increases in costs werecentered in the following areas: salaries and benefits (up $1.2 million, or6.0%) and occupancy and equipment costs (up $276,000, or 5.9%).

Marketing costs were up by $296,000, or 18.7%,reflective of increased advertising spending and sponsorship of customerevents. Additionally, professional services costs increased $169,000, or 8.4%,partially as a result of increased investor relations costs. Also, dataprocessing costs increased $121,000, or 4.4%. Other expenses increased by$442,000, or 9.6%, as compared to 2005, with increases in costs of customerrelated sweep activity, which were in line with the related increase innoninterest income.

Other expenses for 2006 also includes $89,000 relatedto director stock options, the fair value of which was required to be expensedin connection with the adoption of SFAS 123-R, “*Share-Based Payment*”. In 2005, the Company was notrequired to recognize expenses for the estimated fair value of stock options asthe Company accounted for stock options under SFAS 123, *“Accounting forStock-Based Compensation”*. Under SFAS 123, the Company utilized theintrinsic value method prescribed by Accounting Principles Board (“APB”)Opinion No. 25, *“Accounting for StockIssued to Employees”*(“APB25”) and did not recognize expenses for the granting of stock options.Including stock option costs for employee grants, stock option expenses for2006 were $186,000 compared to $49,000 for 2005. The costs recorded in 2005related exclusively to the December 2005 acceleration of vesting ofthen-outstanding stock options.

Additionally, in December 2006, the Companyrecorded insurance recovery proceeds of $803,000 relating to a loss the Companyincurred in the first quarter of 2006 of $868,000. These amounts are 

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recorded net within otherexpenses in the preceding table and on the Consolidated Statement of Operationsfor the year ended December 31, 2006.

Overall, the Company’sefficiency ratio increased to 75.62% for 2006, from 69.66% for 2005; however,after adjusting for securities gains and losses, the pro forma efficiencyratios were 74.37% and 69.90%, respectively.

*Income Tax Expense*

The Company recordedincome tax expense of $3.6 million for 2006, compared to $4.8 million for 2005.This represented total effective tax rates of 31.7% and 33.6%, respectively.Tax-favored income from BOLI, along with the utilization of a Rhode Islandpassive investment company, has reduced the Company’s effective tax rate fromthe 40.9% combined statutory federal and state tax rates.

**Comparison of YearsEnded December 31, 2005 and December 31, 2004**

*General*

Net income for 2005increased $955,000, or 11.1%, to $9.6 million, from $8.6 million for 2004. Earningsper diluted common share (“EPS”) was the same both years at $2.04. The mainfactor for the same level of EPS was the dilutive effect of the issuance ofapproximately 628,000 shares in the second quarter of 2005. The 2005 earningsrepresented a return on average assets of 0.71% and a return on average equityof 9.98% for 2005, as compared to a return on average assets of 0.74% and areturn on average equity of 11.53% for 2004.

*Net Interest Income*

For 2005, net interestincome was $42.9 million, compared to $38.1 million for 2004. The net interestmargin for 2005 was 3.35% compared to a net interest margin of 3.44% for 2004.The increase in net interest income of $4.8 million, or 12.6%, was primarilyattributable to the overall growth of the Company. Average earning assetsincreased $172.4 million, or 15.6%, and average interest-bearingliabilities increased $143.4 million, or 15.6%, over the preceding year.The decrease of 9 basis points in the net interest margin resulted primarilyfrom compression in the interest rate environment, customer demand forhigher-yielding term deposit products and the leverage program the Companyundertook to partially offset the dilution of EPS caused by the issuance ofadditional common stock during the second quarter of 2005.

*Interest Income—Investments*

Total investment income(consisting of interest on overnight investments, investment securities andMBSs, and dividends on FHLB stock) was $15.7 million for 2005, compared to$10.6 million for 2004. This increase in total investment income of $5.1million, or 48.0%, was attributable primarily to higher average balances in2005. While yields on total investments increased moderately during 2005, themajority of the increase in investment income relates to the leverage programreferred to above, which was concluded in the fourth quarter of 2005.

*Interest Income—Loansand Leases*

Interest from loans was $53.8 million for 2005, andrepresented a yield on total loans of 5.87%. This compares to $47.1 million ofinterest, and a yield of 5.55%, for 2004. Increased interest income resultingfrom growth in the average balance of loans of $67.7 million, or 8.0%, wasaugmented by an increase in the yield on loans of 32 basis points.

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The average balance of thevarious components of the loan portfolio changed as follows: commercial loansand leases increased $52.2 million, or 14.1%; consumer and other loansincreased $45.7 million, or 32.3%; and residential mortgage loans decreased$30.2 million, or 8.9%. The yield on the various components of the loanportfolio changed as follows: commercial loans and leases increased 40 basispoints, to 6.65%; consumer and other loans increased 52 basis points, to 5.42%;and residential mortgage loans increased 3 basis points, to 5.09%. The yieldson loans and leases benefited primarily from the increases in short-terminterest rates that occurred throughout 2005.

*Interest Expense—Depositsand Borrowings*

Interest paid on deposits and borrowings increased by$6.9 million, or 35.6%, as short-term market interest rates increased duringthe past year. The overall average cost for interest-bearing liabilitiesincreased 37 basis points from 2.14% for 2004, to 2.51% for 2005. The averagebalance of total interest-bearing liabilities increased $143.4 million, or 15.6%,from $917.1 million in 2004, to $1.06 billion in 2005. The growth in depositaverage balances was centered primarily in CD accounts (up $79.2 million, or35.1%) and savings accounts (up $12.7 million, or 3.9%). These increases weresomewhat offset by a decrease in NOW accounts (down $28.8 million, or 23.4%).Money market accounts remained consistent with prior year average balances,increasing $1.3 million, or 7.7%.

In addition, the Company increased its utilization ofFHLB borrowings (up $45.2 million, or 19.3%). The Company also entered intowholesale repurchase agreements in 2005, aggregating $20 million by the end ofthe year. The cost of nondeposit borrowings increased 11 basis points in 2005to 3.95%, compared to 3.84% in the prior year.

Customer demand for highercost CDs and the longer-term funding required for the leverage program were themain drivers of both the overall average cost and average balance levels ofinterest-bearing liabilities. Liability costs are dependent on a number offactors including general economic conditions, national and local interestrates, competition in the local deposit marketplace, interest rate tiersoffered and the Company’s cash flow needs.

*Provision for Loanand Lease Losses*

The provision for loan and lease losses was $1.4million for 2005, compared to $836,000 for 2004. The allowance, expressed as apercentage of total loans and leases, was 1.23% as of December 31, 2005,compared to 1.29% at the prior year-end and stood at 2810.8% of nonperformingloans and leases at December 31, 2005, compared to 1562.63% ofnonperforming loans and leases at December 31, 2004. Net charge-offs for2005 were $1.2 million, compared to $72,000 for 2004. The increase in netcharge-offs occurred largely during the second quarter and was attributable toone asset-based credit. To resolve the credit, the Bank sold the loan to athird party at a discount, resulting in a $1.2 million charge-off.

During 2006, the Company reclassified the reserve forunfunded lending commitments from the allowance for loan and lease losses toother liabilities. The Company has reclassified prior period amountsaccordingly as previously discussed on page 33 and as illustrated withinthe activity analysis table on page 47.

Management evaluatesseveral factors including new loan originations, actual and estimatedcharge-offs, risk characteristics of the loan and lease portfolio and generaleconomic conditions when determining the provision for loan and lease losses.As the loan and lease portfolio continues to grow and mature, or if economicconditions worsen, management believes it possible that the level ofnonperforming assets will increase, which in turn may lead to increases to theprovision for loan and lease losses. Also see discussion under “*Allowance for Credit Losses*”.

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*Noninterest Income*

Total noninterest income increased $693,000, or 8.1%,from $8.6 million for 2004, to $9.3 million for 2005. Excluding gains on salesof premises and equipment and net gains on investment sales, noninterest incomeincreased $1.1 million or 14.3%. Deposit account service charges continue torepresent the largest source of noninterest income for the Company, showingmodest growth of $47,000, or 1.0%, to $4.6 million for 2005, compared to $4.5million in the prior year. Loan related fees increased $483,000, or 89.3%, asthe Bank experienced a higher level of prepayments in 2005 than in the previousyear. Additionally, growth occurred in commissions on loans originated forthird parties, with an increase of $113,000 from the prior year, or 159%.Commissions on leases originated for third parties of $245,000 and sales ofRhode Island tax credits of $220,000 were the key drivers to the growth inOther Income. On a net basis, gains on sales of investments and mortgage-backedsecurities were up moderately by $91,000 from the prior year. These increaseswere offset by declines in commission on nondeposit investment products asincome was down $124,000, or 12.7%.

Thefollowing table sets forth the components of noninterest income:

| ** **                                     | ** ** | **Year ended December 31,** | ** ** |
|------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                     | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| ** **                                     | ** ** | **(In thousands)**                    | ** ** |
| Service charges  on deposit accounts           |       | $                                          | 4,561      |   | $ | 4,514 |   |
| Loan related fees                              |       | 1,024                                      |       | 541 |   |
| Commissions on  nondeposit investment products |       | 849                                        |       | 973 |   |
| Income from  bank-owned life insurance         |       | 691                                        |       | 641 |   |
| Commissions on  loans originated for others    |       | 184                                        |       | 71 |   |
| Gain on sale of  available for sale securities |       | 181                                        |       | 90 |   |
| Gain on sale of  premises and equipment        |       | —                                     |       | 535 |   |
| Other income                                   |       | 1,784                                      |       | 1,216 |   |
| Total noninterest  income                      |       | $                                          | 9,274      |   | $ | 8,581 |   |

 

*Noninterest Expense*

Noninterest expenses for 2005 increased a total of$3.4 million, or 10.4%, to $36.3 million. This increase was primarily due tohigher operating costs resulting from the continued growth of the Company asthe Bank opened two new branches in 2005 and acquired Macrolease. The increasewas centered in the following areas: salaries and employee benefits (up $2.4million, or 14.1%), occupancy costs (up $457,000, or 17.1%), marketing (up$155,000, or 10.8%), loan workout (up $107,000, or 97.3%) and other expenses(up $471,000, or 11.5%). The Company did experience decreases in loan servicing(down $124,000, or 11.4%) and data processing (down $73,000, or 2.6%).Professional services remained constant with 2004 levels, showing a moderateincrease of $52,000, or 2.6%, as costs incurred to comply with Sarbanes-Oxley Section 404did not decrease. Overall, the Company’s efficiency ratio decreased slightly to69.56% for 2005, from 70.41% for 2004.

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Thefollowing table sets forth the components of noninterest expense:

| ** **                                | ** ** | **Year ended December 31,** | ** ** |
|-------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| ** **                                | ** ** | **(In thousands)**                    | ** ** |
| Salaries and  employee benefits           |       | $                                          | 19,476     |   | $ | 17,072 |   |
| Occupancy and  equipment                  |       | 4,695                                      |       | 4,260 |   |
| Data processing                           |       | 2,759                                      |       | 2,832 |   |
| Professional  services                    |       | 2,017                                      |       | 1,965 |   |
| Marketing                                 |       | 1,584                                      |       | 1,429 |   |
| Loan servicing                            |       | 968                                        |       | 1,092 |   |
| Loan workout and  other real estate owned |       | 217                                        |       | 110 |   |
| Other expenses                            |       | 4,627                                      |       | 4,169 |   |
| Total noninterest  expense                |       | $                                          | 36,343     |   | $ | 32,929 |   |

 

*Income Tax Expense*

The Company recordedincome tax expense of $4.8 million for 2005, compared to $4.3 million for 2004.This represented total effective tax rates of 33.6% and 33.3%, respectively.Tax-favored income from BOLI, along with the utilization of a Rhode Islandpassive investment company, has reduced the Company’s effective tax rate fromthe 40.9% combined statutory federal and state tax rates.

**Financial Condition**

*Loans and LeasesReceivable*

Total loans and leases were $1.0 billion, or 67.9% oftotal assets, at December 31, 2006, compared to $950.8 million, or65.9% of total assets, at December 31, 2005, an increase of$53.5 million, or 5.6%. This increase is centered in commercial andconsumer loans (where the Company concentrates its origination efforts) and waspartially offset by a decrease in residential mortgage loans (which the Companyprimarily purchases). Total loans and leases as of December 31, 2006 aresegmented in three broad categories: commercial loans and leases that aggregate$519.8 million, or 51.8% of the portfolio; residential mortgages thataggregate $263.9 million, or 26.2% of the portfolio; and consumer andother loans that aggregate $220.6 million, or 22.0% of the portfolio.

The Company utilizes the term “small business loans”to describe business lending relationships of approximately $250,000 or less.

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Thefollowing is a summary of loans and leases receivable:

| ** **                                      | ** ** | **December 31,**   | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|
| ** **                                      | ** ** | **2006**                | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                      | ** ** | **(In thousands)** | ** ** |
| Commercial loans and  leases:                   |       |                    |       |   |   |   |   |   |   |   |   |
| Commercial real estate—  owner occupied    |       | $                       | 140,812    |   | $ | 112,987 |   | $ | 93,027 |   | $ | 77,317 |   | $ | 59,249 |   |
| Commercial real estate—  nonowner occupied |       | 102,390                 |       | 95,779 |   | 90,716 |   | 78,083 |   | 81,242 |   |
| Commercial & industrial                |       | 106,017                 |       | 73,620 |   | 78,918 |   | 67,925 |   | 57,389 |   |
| Small business                                  |       | 41,785                  |       | 38,641 |   | 37,820 |   | 30,429 |   | 28,750 |   |
| Multi-family                                    |       | 34,294                  |       | 33,725 |   | 32,415 |   | 28,730 |   | 18,952 |   |
| Construction                                    |       | 37,237                  |       | 37,772 |   | 32,319 |   | 30,632 |   | 18,101 |   |
| Leases and other                                |       | 62,979                  |       | 48,745 |   | 38,116 |   | 19,548 |   | 17,613 |   |
| Subtotal                                        |       | 525,514                 |       | 441,269 |   | 403,331 |   | 332,664 |   | 281,296 |   |
| Unearned lease income                           |       | (6,651                  | )          | (3,366 | ) | (226 | ) | — |   | — |   |
| Net deferred loan origination costs (fees)      |       | 927                     |       | 406 |   | (335 | ) | (398 | ) | (329 | ) |
| Total commercial loans and leases               |       | 519,790                 |       | 438,309 |   | 402,770 |   | 332,266 |   | 280,967 |   |
| Residential  mortgage loans:                    |       |                    |       |   |   |   |   |   |   |   |   |
| One- to four-family adjustable rate             |       | 165,140                 |       | 202,223 |   | 199,031 |   | 232,543 |   | 277,265 |   |
| One- to four-family fixed rate                  |       | 96,880                  |       | 101,598 |   | 115,350 |   | 131,743 |   | 19,310 |   |
| Subtotal                                        |       | 262,020                 |       | 303,821 |   | 314,381 |   | 364,286 |   | 296,575 |   |
| Premium on loans acquired                       |       | 1,979                   |       | 2,257 |   | 1,826 |   | 2,026 |   | 1,248 |   |
| Net deferred loan origination fees              |       | (54                     | )          | (62 | ) | (72 | ) | (82 | ) | (60 | ) |
| Total residential mortgage loans                |       | 263,945                 |       | 306,016 |   | 316,135 |   | 366,230 |   | 297,763 |   |
| Consumer and  other loans:                      |       |                    |       |   |   |   |   |   |   |   |   |
| Home equity—term loans                     |       | 152,484                 |       | 134,932 |   | 110,542 |   | 68,523 |   | 47,906 |   |
| Home equity—lines of credit                |       | 64,208                  |       | 67,959 |   | 53,551 |   | 42,067 |   | 37,381 |   |
| Automobile                                      |       | 178                     |       | 157 |   | 488 |   | 1,455 |   | 3,409 |   |
| Installment                                     |       | 506                     |       | 365 |   | 491 |   | 662 |   | 967 |   |
| Savings secured                                 |       | 587                     |       | 358 |   | 439 |   | 631 |   | 602 |   |
| Unsecured and other                             |       | 1,088                   |       | 1,271 |   | 801 |   | 1,787 |   | 1,063 |   |
| Subtotal                                        |       | 219,051                 |       | 205,042 |   | 166,312 |   | 115,125 |   | 91,328 |   |
| Premium on loans acquired                       |       | —                  |       | 2 |   | 15 |   | 44 |   | 103 |   |
| Net deferred loan origination costs             |       | 1,506                   |       | 1,437 |   | 1,069 |   | 617 |   | 497 |   |
| Total consumer and other loans                  |       | 220,557                 |       | 206,481 |   | 167,396 |   | 115,786 |   | 91,928 |   |
| Total loans and  leases receivable              |       | $                       | 1,004,292  |   | $ | 950,806 |   | $ | 886,301 |   | $ | 814,282 |   | $ | 670,658 |   |

 

*Commercialloans and leases—**During*2006, the commercial loanand lease portfolio (consisting of commercial real estate, commercial &industrial, equipment leases, multi-family real estate, construction and smallbusiness loans) increased $81.5 million, or 18.6%. The primary drivers of thisgrowth occurred in the commercial real estate, commercial & industrialand equipment leasing areas.

The Bank is also active in small business lending inwhich it utilizes credit scoring, in conjunction with traditional reviewstandards, and employs streamlined documentation. Small business loansrepresented 8.0% of the commercial loan and lease portfolio at December 31,2006. The Bank is a participant in the U.S Small Business Administration (“SBA”)Preferred Lender Program in both Rhode Island and Massachusetts. SBA guaranteedloans are found throughout the portfolios managed by the Bank’s various lendinggroups.

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With the addition of Macrolease, the Bank originatesequipment leases for its own portfolio, as well as originating leases for thirdparties as a new source of noninterest income. In addition, the Bankhistorically has purchased equipment leases from originators outside of theBank. The principal lessees were the U.S. Government and its agencies for thevast majority of leases. These “government” leases generally have maturities offive years or less and are not dependent on residual collateral values. At December 31,2006, leases totaled $56.3 million, or 10.8% of the commercial loan and leaseportfolio, with $32.4 million of Macrolease-generated leases and $23.9 millionof government leases.

The Company believes it is well positioned forcontinued commercial growth. Particular emphasis is placed on generation of small-to medium-sized commercial relationships (those relationships with$10.0 million or less in total loan commitments). Unlike most communitybanks, the Bank is able to offer asset-based commercial loan facilities thatmonitor advances against receivables and inventories on a formula basis.

Additionally, in the latter part of 2006, the Bankreorganized its business lending function. The business lending group nowconcentrates its efforts on relationships in excess of $1 million. Businesslending relationships of up to $1 million now can be originated by the Bank’sbusiness development group, which formerly concentrated solely on smallbusiness loans. Underwriting, processing and monitoring of the bulk of businesscredit relationships of under $1 million has been moved to the newly createdLSU. Management believes this reorganization will enable the Bank to expand itsability to reach more borrowers with the same number of personnel as well asachieve more efficient processing and improved monitoring of these credits.

*Residentialmortgage loans—**Residential*mortgage loansdecreased $42.1 million, or 13.8%, as repayments ($48.8 million) exceededthe total of purchases ($5.6 million) and originations($1.5 million). Since inception, the Bank has concentrated its portfoliolending efforts on commercial and consumer lending opportunities, butoriginates mortgage loans for its own portfolio on a limited basis. The Bankdoes not employ any outside mortgage originators, but from time to time,purchases residential mortgage loans from third-party originators. Until suchtime as the Bank can originate sufficient commercial and consumer loans toutilize available cash flow, it intends to continue purchasing residentialmortgage loans as opportunities develop.

*Consumerloans—**During***2006,consumer loan outstandings increased $14.1 million, or 6.8%, to$220.6 million at December 31, 2006, from $206.5 million at December 31,2005. This growth primarily occurred in the first half of the year, with thedecline in growth corresponding to the moderate softening of local market areahousing prices in the second half of the year. However, the Company believesthat these ten- to twenty-year fixed-rate products, along with the floatinglines of credit, still possess attractive cash flow characteristics in thecurrent interest rate environment. Over time, the Company anticipates growth inthese products will continue.

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Thetable below shows loan and lease originations, purchases, sales and repaymentactivities. Included within residential mortgage loan repayments isamortization of premium on purchased residential mortgages.

| ** **                                                      | ** ** | **Year ended December 31,** | ** ** |
|-----------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                      | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                      | ** ** | **(In thousands)**                    | ** ** |
| Originations and  principal additions:                          |       |                                       |       |   |   |   |   |   |   |   |   |
| Loans and leases  purchased:                                    |       |                                       |       |   |   |   |   |   |   |   |   |
| Commercial loans and leases                                     |       | $                                          | 11,454     |   | $ | 9,243 |   | $ | 3,257 |   | $ | — |   | $ | — |   |
| Residential mortgage loans                                      |       | 5,644                                      |       | 56,512 |   | 55,273 |   | 249,656 |   | 166,935 |   |
| Total loans and leases purchased                                |       | 17,098                                     |       | 65,755 |   | 58,530 |   | 249,656 |   | 166,935 |   |
| Loans and leases  originated:                                   |       |                                       |       |   |   |   |   |   |   |   |   |
| Commercial loans and leases                                     |       | 146,802                                    |       | 99,490 |   | 109,560 |   | 106,335 |   | 84,132 |   |
| Residential mortgage loans                                      |       | 1,450                                      |       | 5,009 |   | 9,635 |   | 28,371 |   | 9,345 |   |
| Consumer and other loans                                        |       | 64,715                                     |       | 82,426 |   | 90,655 |   | 65,831 |   | 51,951 |   |
| Total loans and leases originated                               |       | 212,967                                    |       | 186,925 |   | 209,850 |   | 200,537 |   | 145,428 |   |
| Principal  reductions:                                          |       |                                       |       |   |   |   |   |   |   |   |   |
| Net  charge-offs/transfers to OREO:                             |       |                                       |       |   |   |   |   |   |   |   |   |
| Commercial loans and leases                                     |       | (453                                       | )          | (1,205 | ) | (98 | ) | (565 | ) | (400 | ) |
| Residential mortgage loans                                      |       | —                                     |       | — |   | — |   | — |   | (58 | ) |
| Consumer and other loans                                        |       | (37                                        | )          | (7 | ) | (51 | ) | (64 | ) | (93 | ) |
| Total net charge-offs/transfers to OREO                         |       | (490                                       | )          | (1,212 | ) | (149 | ) | (629 | ) | (551 | ) |
| Principal  payments:                                            |       |                                       |       |   |   |   |   |   |   |   |   |
| Commercial loans and leases                                     |       | (78,024                                    | )          | (72,736 | ) | (42,052 | ) | (54,402 | ) | (41,971 | ) |
| Residential mortgage loans                                      |       | (48,763                                    | )          | (71,249 | ) | (114,813 | ) | (210,316 | ) | (188,542 | ) |
| Consumer and other loans                                        |       | (50,205                                    | )          | (42,978 | ) | (39,417 | ) | (41,970 | ) | (21,304 | ) |
| Total principal payments                                        |       | (176,992                                   | )          | (186,963 | ) | (196,282 | ) | (306,688 | ) | (251,817 | ) |
| Change in total  loans and leases receivable (before net items) |       | $                                          | 52,583     |   | $ | 64,505 |   | $ | 71,949 |   | $ | 142,876 |   | $ | 59,995 |   |

 

Thefollowing table sets forth certain information at December 31, 2006,regarding the aggregate dollar amount of certain loans maturing in the loanportfolio based on scheduled payments to maturity. Actual loan principalpayments may vary from this schedule due to refinancings, modifications andother changes in loan terms. Demand loans and loans having no stated scheduleof repayments and no stated maturity are reported as due in one year or less.

| ** **                                                 | ** ** | ** **              | ** ** | **After one,** | ** ** | ** **          | ** ** |
|------------------------------------------------------------|------------|-------------------------|------------|---------------------|------------|---------------------|------------|
| ** **                                                 | ** ** | **One year**       | ** ** | **but within** | ** ** | **After**           | ** ** |
| ** **                                                 | ** ** | **or less**        | ** ** | **five years** | ** ** | **five years** | ** ** |
| ** **                                                 | ** ** | **(In thousands)** | ** ** |
| Construction/permanent  loans                              |       | $                       | 11,005     |                | $          | 17,896              |       | $ | 8,336 |   |
| Commercial &  industrial loans (including leases) |       | 42,069                  |       | 81,383              |       | 39,207              |       |
| Home equity lines  of credit                               |       | 28                      |       | 49                  |       | 64,131              |       |
| Interest-only  residential first mortgages                 |       | —                  |       | —              |       | 25,769              |       |
| Small business  loans                                      |       | 17,445                  |       | 14,478              |       | 9,862               |       |
| Total                                                      |       | $                       | 70,547     |                | $          | 113,806             |       | $ | 147,305 |   |

 

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Thefollowing table sets forth as of December 31, 2006, the dollar amount ofcertain loans due after one year that have fixed interest rates or floating oradjustable interest rates.

| ** **                                                 | ** ** | **Loans due after one year** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                 | ** ** | ** **                                       | ** ** | **Floating or** | ** ** |
| ** **                                                 | ** ** | ** **                                       | ** ** | **adjustable** | ** ** |
| ** **                                                 | ** ** | **Fixed rates**                             | ** ** | **rates** | ** ** |
| ** **                                                 | ** ** | **(In thousands)**                          | ** ** |
| Construction/permanent  loans                              |       |                                             | $          | 6,102 |   |   |   | $ | 20,130 |   |   |
| Commercial &  industrial loans (including leases) |       |                                             | 81,584     |   |   |   | 39,006 |   |   |
| Home equity lines  of credit                               |       |                                             | —     |   |   |   | 64,180 |   |   |
| Interest-only  residential first mortgages                 |       |                                             | 4,841      |   |   |   | 20,928 |   |   |
| Small business  loans                                      |       |                                             | 10,773     |   |   |   | 13,567 |   |   |
| Total                                                      |       |                                             | $          | 103,300 |   |   |   | $ | 157,811 |   |   |

 

*Asset Quality*

The definition of nonperforming assets includesnonperforming loans and other real estate owned (“OREO”). OREO consists of realestate acquired through foreclosure proceedings and real estate acquired throughacceptance of a deed in lieu of foreclosure. Nonperforming loans are defined asnonaccrual loans, loans past due 90 days or more but still accruing andimpaired loans. Under certain circumstances, the Company may restructure theterms of a loan as a concession to a borrower. These restructured loans areconsidered impaired loans. There were no impaired loans included in nonaccrualloans at December 31, 2006, compared to $141,000 and $671,000 of impairedloans at December 31, 2005 and 2004, respectively.

*NonperformingAssets—**At*December 31, 2006, theCompany had nonperforming assets of $1.4 million, or 0.10%, of total assets.This compares to nonperforming assets of $415,000 or 0.03% of total assets, at December 31,2005, and nonperforming assets of $733,000, or 0.06% of total assets, at December 31,2004. Nonperforming assets at December 31, 2006, consisted of residentialloans aggregating $1.3 million and commercial loans aggregating $80,000.Nonperforming assets at December 31, 2005 and 2004 were primarilycomprised of nonaccrual commercial loans and nonaccrual residential loans. TheCompany evaluates the underlying collateral of each nonperforming asset andcontinues to pursue the collection of interest and principal. Managementbelieves that the December 31, 2006 level of nonperforming assets is lowrelative to the size of the Company’s loan portfolio. As the loan portfoliocontinues to grow and mature, or if economic conditions worsen, managementbelieves it possible that the level of nonperforming assets will increase, aswill its level of charged-off loans.

Thefollowing table sets forth information regarding nonperforming assets.

| ** **                                                  | ** ** | **December 31,**                | ** ** |
|-------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                  | ** ** | **2006**                             | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                  | ** ** | **(Dollars in thousands)** | ** ** |
| Nonaccrual loans                                            |       | $                                    | 1,407      |   | $ | 415 |   | $ | 733 |   | $ | 2,462 |   | $ | 736 |   |
| Loans past due 90  days or more, but still accruing         |       | 6                                    |       | — |   | — |   | — |   | — |   |
| Impaired loans  (not included in nonaccrual loans)          |       | —                               |       | — |   | — |   | — |   | — |   |
| Total nonperforming loans                                   |       | 1,413                                |       | 415 |   | 733 |   | 2,462 |   | 736 |   |
| Other  nonperforming assets                                 |       | —                               |       | — |   | — |   | — |   | 58 |   |
| Total nonperforming assets                                  |       | $                                    | 1,413      |   | $ | 415 |   | $ | 733 |   | $ | 2,462 |   | $ | 794 |   |
| Nonperforming  loans as a percent of total loans and leases |       | 0.14                                 | %          | 0.04 | % | 0.08 | % | 0.30 | % | 0.11 | % |
| Nonperforming assets as  a percent of total assets          |       | 0.10                                 | %          | 0.03 | % | 0.06 | % | 0.23 | % | 0.08 | % |

 

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*NonaccrualLoans—**Accrual***of interest income on all loans isdiscontinued when concern exists as to the collectibility of principal orinterest, or typically when a loan becomes over 90 days delinquent.Additionally, when a loan is placed on nonaccrual status, all interestpreviously accrued but not collected is reversed against current period income.Residential mortgage loans are removed from nonaccrual when they become lessthan 90 days past due, and in the case of commercial and consumer loans, whenconcern no longer exists as to the collectibility of principal or interest.Interest collected on nonaccruing loans is either applied against principal orreported as income according to management’s judgment as to the collectibilityof principal. At December 31, 2006, nonaccrual loans totaled $1.4 million.Interest on nonaccrual loans that would have been recorded as additional incomefor the year ended December 31, 2006, had the loans been current inaccordance with their original terms, totaled $50,000. This compares with$23,000 and $29,000 of foregone interest income on nonaccrual loans for theyears ended December 31, 2005 and 2004, respectively.**

Thefollowing table sets forth certain information regarding nonaccrual loans.

| ** **                  | ** ** | **2006**                             | ** ** | **2005**          | ** ** | **2004**      | ** ** |
|-----------------------------|------------|--------------------------------------|------------|-------------------|------------|---------------|------------|
| ** **                  | ** ** | ** **                           | ** ** | **Percent**       | ** ** | ** **    | ** ** | **Percent** | ** ** | ** ** | ** ** | **Percent** | ** ** |
| ** **                  | ** ** | **Principal**                        | ** ** | **of Total** | ** ** | **Principal** | ** ** | **of Total** | ** ** | **Principal** | ** ** | **of Total** | ** ** |
| ** **                  | ** ** | **Balance**                          | ** ** | **Loans**         | ** ** | **Balance**   | ** ** | **Loans** | ** ** | **Balance** | ** ** | **Loans** | ** ** |
| ** **                  | ** ** | **(Dollars in thousands)** | ** ** |
| Nonaccrual loans:           |       |                                 |       |              |       |          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Residential mortgage loans  |       |                                 | $          | 1,327             |       |          |       | 0.13 | % |   |   | $ | 119 |   |   |   | 0.01 | % |   |   | $ | 24 |   |   |   | 0.00 | % |   |
| Commercial loans and leases |       |                                 | 80         |              |       |          | 0.01       | % |   |   | 235 |   |   |   | 0.02 | % |   |   | 709 |   |   |   | 0.08 | % |   |
| Consumer and other loans    |       |                                 | —     |              |       |          | 0.00       | % |   |   | 61 |   |   |   | 0.01 | % |   |   | — |   |   |   | 0.00 | % |   |
| Total nonaccrual  loans     |       |                                 | $          | 1,407             |       |          |       | 0.14 | % |   |   | $ | 415 |   |   |   | 0.04 | % |   |   | $ | 733 |   |   |   | 0.08 | % |   |

 

*Delinquencies—**At***December 31, 2006, $5.9 million of loans were 30 to 89days past due. This compares to $5.3 million and $4.9 million of loans 30 to 89days past due as of December 31, 2005 and 2004, respectively. The majorityof these loans at December 31, 2006, 2005 and 2004 were commercial loansand leases.

Management reviews delinquent loans frequently toassess problem situations and to quickly address these problems. In the case ofconsumer and commercial loans, the Bank contacts the borrower when a loanbecomes delinquent. When a payment is not made, generally within 10-15days of the due date, a late charge is assessed. After 30 days of delinquency,a notice is sent to the borrower advising that failure to cure the default mayresult in formal demand for payment in full. In the event of furtherdelinquency, the matter is generally referred to legal counsel to commencecivil proceedings to collect all amounts owed. In the case of residentialmortgage loans, delinquency and collection proceedings are conducted by eitherthe Bank, or its mortgage servicers, in accordance with standard servicingguidelines. In any circumstance where the Bank is secured by real property orother collateral, the Bank enforces its rights to the collateral in accordancewith applicable law.

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Thefollowing table sets forth information as to loans delinquent for 30 to 89days.

| ** **                            | ** ** | **2006**                             | ** ** | ** **        | ** ** | **2005**      | ** ** | ** **        | ** ** | **2004**      | ** ** | ** **        | ** ** |
|---------------------------------------|------------|--------------------------------------|------------|-------------------|------------|---------------|------------|-------------------|------------|---------------|------------|-------------------|------------|
| ** **                            | ** ** | ** **                           | ** ** | **Percent**       | ** ** | ** **    | ** ** | **Percent**       | ** ** | ** **    | ** ** | **Percent**       | ** ** |
| ** **                            | ** ** | **Principal**                        | ** ** | **of Total** | ** ** | **Principal** | ** ** | **of Total** | ** ** | **Principal** | ** ** | **of Total** | ** ** |
| ** **                            | ** ** | **Balance**                          | ** ** | **Loans**         | ** ** | **Balance**   | ** ** | **Loans**         | ** ** | **Balance**   | ** ** | **Loans**         | ** ** |
| ** **                            | ** ** | **(Dollars in thousands)** | ** ** |
| Loans delinquent  for 30 to 59 days:  |       |                                 |       |              |       |          |       |              |       |          |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial loans and leases           |       |                                 | $          | 4,671             |       |          |       | 0.47              | %          |          |       | $                 | 4,509      |   |   |   | 0.48 | % |   |   | $ | 3,370 |   |   |   | 0.38 | % |   |
| Residential mortgage loans            |       |                                 | 486        |              |       |          | 0.05       | %                 |       |          | 399        |              |       |   | 0.04 | % |   |   | 951 |   |   |   | 0.11 | % |   |
| Consumer and other loans              |       |                                 | 243        |              |       |          | 0.02       | %                 |       |          | 139        |              |       |   | 0.01 | % |   |   | 549 |   |   |   | 0.06 | % |   |
| Total loans delinquent 30 to 59 days  |       |                                 | 5,400      |              |       |          | 0.54       | %                 |       |          | 5,047      |              |       |   | 0.53 | % |   |   | 4,870 |   |   |   | 0.55 | % |   |
| Loans delinquent for 60 to 89 days:   |       |                                 |       |              |       |          |       |              |       |          |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial loans                      |       |                                 | 476        |              |       |          | 0.05       | %                 |       |          | —     |              |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Residential mortgage loans            |       |                                 | —     |              |       |          | —     |              |       |          | 300        |              |       |   | 0.03 | % |   |   | — |   |   |   | — |   |   |
| Consumer and other loans              |       |                                 | —     |              |       |          | —     |              |       |          | —     |              |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Total loans delinquent 60 to 89 days  |       |                                 | 476        |              |       |          | 0.05       | %                 |       |          | 300        |              |       |   | 0.03 | % |   |   | — |   |   |   | — |   |   |
| Total loans  delinquent 30 to 89 days |       |                                 | $          | 5,876             |       |          |       | 0.59              | %          |          |       | $                 | 5,347      |   |   |   | 0.56 | % |   |   | $ | 4,870 |   |   |   | 0.55 | % |   |

 

*AdverselyClassified Assets—**The***Company’smanagement adversely classifies certain assets as “substandard”, “doubtful” or “loss”based on criteria established under banking regulations. An asset is consideredsubstandard if inadequately protected by the current net worth and payingcapacity of the obligor or of the collateral pledged, if any. Substandardassets include those characterized by the “distinct possibility” that theinsured institution will sustain “some loss” if existing deficiencies are notcorrected. Assets classified as doubtful have all of the weaknesses inherent inthose classified substandard with the added characteristic that the weaknessespresent make “collection or liquidation in full”, on the basis of currentlyexisting facts, conditions, and values, “highly questionable and improbable”.Assets classified as loss are those considered “uncollectible” and of such littlevalue that their continuance as assets without the establishment of a specificloss reserve is not warranted.

At December 31, 2006,the Company had $8.2 million of assets that were classified assubstandard. This compares to $6.8 million and $5.8 million of assetsthat were classified as substandard at December 31, 2005 and 2004,respectively. The Company had no assets that were classified as loss ordoubtful at any of these dates. Performing loans may or may not be adverselyclassified depending upon management’s judgment with respect to each individualloan. At December 31, 2006, included in the $8.2 million of assetsthat were classified as substandard, were $6.8 million of performingloans. This compares to $6.4 million and $5.1 million of adverselyclassified performing assets at December 31, 2005 and 2004, respectively.These amounts constitute assets that, in the opinion of management, couldpotentially migrate to nonperforming or doubtful status. Management believesthat the December 31, 2006 level of adversely classified assets is lowrelative to the size and composition of the Company’s loan portfolio. As theloan and lease portfolio continues to grow and mature, or if economicconditions worsen, management believes it possible that the level of adverselyclassified assets will increase. This in turn may necessitate an increase tothe provision for loan and lease losses in future periods.

*Allowance forCredit Losses*

The allowance for loan and lease losses and reservefor unfunded lending commitments, collectively referred to as the allowance forcredit losses, have been established for credit losses inherent in the loan andlease portfolio and inherent in the unfunded lending commitments through acharge to earnings. The allowance for credit losses is maintained at a levelmanagement considers appropriate to provide for the 

44

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current inherent risk ofloss based upon an evaluation of known and inherent risks in the loan and leaseportfolio, as well as the unfunded lending commitments.

Loans deemed uncollectible are charged against theallowance for loan and lease losses, while recoveries of amounts previouslycharged-off are added to the allowance for loan and lease losses. Amounts arecharged-off once the probability of loss has been established, withconsideration given to such factors as the customer’s financial condition,underlying collateral and guarantees, and general and industry economicconditions.

When an insured institution classifies problem loansas either substandard or doubtful, it is required to establish allowances forloan losses in an amount deemed prudent by management. Additionally, generalallowances represent loss allowances that have been established to recognizethe inherent risk associated with lending activities, and have not beenallocated to particular problem loans.

In addition to the allowance for loan and leaselosses, management also estimates probable losses related to unfunded lendingcommitments. In 2006, the Company reclassified the reserve for unfunded lendingcommitments from the allowance for loan and losses to other liabilities for allperiods presented. Additions to the reserve for unfunded lending commitmentsare made by charges to other expenses.

Thefollowing table represents the allocation of the allowance for loan and leaseslosses as of the dates indicated:

| ** **                  | ** ** | **December 31,**                | ** ** |              |
|-----------------------------|------------|--------------------------------------|------------|-------------------|
| ** **                  | ** ** | **2006**                             | ** ** | **2005**          | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |   |
| ** **                  | ** ** | ** **                           | ** ** | **Percent**       | ** ** | ** ** | ** ** | **Percent** | ** ** | ** ** | ** ** | **Percent** | ** ** | ** ** | ** ** | **Percent** | ** ** | ** ** | ** ** | **Percent** | ** ** |   |
| ** **                  | ** ** | ** **                           | ** ** | **of Loans** | ** ** | ** ** | ** ** | **of Loans** | ** ** | ** ** | ** ** | **of Loans** | ** ** | ** ** | ** ** | **of Loans** | ** ** | ** ** | ** ** | **of Loans** | ** ** |   |
| ** **                  | ** ** | ** **                           | ** ** | **in Each**  | ** ** | ** ** | ** ** | **in Each** | ** ** | ** ** | ** ** | **in Each** | ** ** | ** ** | ** ** | **in Each** | ** ** | ** ** | ** ** | **in Each** | ** ** |   |
| ** **                  | ** ** | ** **                           | ** ** | **Category**      | ** ** | ** ** | ** ** | **Category** | ** ** | ** ** | ** ** | **Category** | ** ** | ** ** | ** ** | **Category** | ** ** | ** ** | ** ** | **Category** | ** ** |   |
| ** **                  | ** ** | ** **                           | ** ** | **to Total** | ** ** | ** ** | ** ** | **to Total** | ** ** | ** ** | ** ** | **to Total** | ** ** | ** ** | ** ** | **to Total** | ** ** | ** ** | ** ** | **to Total** | ** ** |   |
| ** **                  | ** ** | **Amount**                           | ** ** | **Loans**         | ** ** | **Amount** | ** ** | **Loans** | ** ** | **Amount** | ** ** | **Loans** | ** ** | **Amount** | ** ** | **Loans** | ** ** | **Amount** | ** ** | **Loans** | ** ** |   |
| ** **                  | ** ** | **(Dollars in thousands)** | ** ** |              |
| Commercial loans and leases |       | $                                    | 7,944      |              |   | 51.8 | % |   | $ | 7,002 |   |   | 46.1 | % |   | $ | 6,251 |   |   | 45.4 | % |   | $ | 4,529 |   |   | 40.8 | % |   |   | $ | 5,051 |   |   |   | 41.9 | % |   |
| Residential mortgage loans  |       | 1,440                                |       |              | 26.2 | % |   | 1,653 |   |   | 32.2 | % |   | 1,644 |   |   | 35.7 | % |   | 1,922 |   |   | 45.0 | % |   |   | 1,757 |   |   |   | 44.4 | % |   |
| Consumer and other loans    |       | 2,086                                |       |              | 22.0 | % |   | 1,894 |   |   | 21.7 | % |   | 1,545 |   |   | 18.9 | % |   | 1,092 |   |   | 14.2 | % |   |   | 905 |   |   |   | 13.7 | % |   |
| Unallocated                 |       | 907                                  |       |              | NA |   |   | 1,116 |   |   | NA |   |   | 2,014 |   |   | NA |   |   | 3,147 |   |   | NA |   |   |   | 2,071 |   |   |   | NA |   |   |
| Total                       |       | $                                    | 12,377     |              |   | 100.0 | % |   | $ | 11,665 |   |   | 100.0 | % |   | $ | 11,454 |   |   | 100.0 | % |   | $ | 10,690 |   |   | 100.0 | % |   |   | $ | 9,784 |   |   |   | 100.0 | % |   |

 

Assessing the appropriateness of the allowance forloan and leases losses involves substantial uncertainties and is based uponmanagement’s evaluation of the amounts required to meet estimated charge-offsin the loan portfolio after weighing various factors. Management’s methodologyto estimate loss exposure includes an analysis of individual loans deemed to beimpaired, reserve allocations for various loan types based on payment status orloss experience and an unallocated allowance that is maintained based onmanagement’s assessment of many factors including the growth, composition andquality of the loan portfolio, historical loss experiences, general economicconditions and other pertinent factors. These risk factors are continuouslyreviewed and revised by management where conditions indicate that the estimatesinitially applied are different from actual results. Management employs asimilar process with respect to unfunded lending commitments.

A portion of the allowance for loan and lease lossesis not allocated to any specific segment of the loan portfolio. Thisnon-specific allowance is maintained for two primary reasons: (i) thereexists an inherent subjectivity and imprecision to the analytical processesemployed, and (ii) the prevailing business environment, as it is affectedby changing economic conditions and various external factors, may impact theportfolio in ways currently unforeseen. Management, therefore, has establishedand maintains a non-specific allowance for loan and lease losses. The amount ofthis measurement imprecision allocation was $907,000 at December 31, 2006,compared to $1.1 million at December 31, 2005.

45

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While management evaluates currently availableinformation in establishing the allowance for loan and lease losses and thereserve for unfunded lending commitments, future adjustments to the allowancefor credit losses may be necessary if conditions differ substantially from theassumptions used in making the evaluations. Management performs a comprehensivereview of the allowance for loan and lease losses and the reserve for unfundedlending commitments on a quarterly basis. In addition, various regulatoryagencies, as an integral part of their examination process, periodically reviewa financial institution’s allowance for loan and lease losses and carryingamounts of other real estate owned. Such agencies may require the financialinstitution to recognize additions to the allowance based on their judgmentsabout information available to them at the time of their examination.

The factors supporting the allowance for loan andlease losses and the reserve for unfunded lending commitments do not diminishthe fact that the entire allowance for loan and lease losses and the reservefor unfunded lending commitments are available to absorb losses in the loanportfolio and related commitment portfolio, respectively. The Company’s primaryconcern is the appropriateness of the total allowance for loan and lease lossesand reserve for unfunded lending commitments. Based on the evaluation describedabove, management believes that the year-end allowance for loan and leaselosses and reserve for unfunded lending commitments are appropriate.

During 2006, 2005 and 2004, the Bank made additions tothe allowance for loan and lease losses of $1.2 million, $1.4 million and$836,000 and experienced net charge-offs of $490,000, $1.2 million and $72,000,respectively. At December 31, 2006, the allowance for loan and leaseslosses stood at $12.4 million and represented 875.9% of nonperformingloans and 1.23% of total loans outstanding. This compares to an allowance forloan and lease losses of $11.7 million, representing 2810.8% ofnonperforming loans and 1.23% of total loans outstanding at December 31,2005.

During 2006, the Bank made additions to reserve forunfunded lending commitments by $64,000, bringing the balance to $567,000 at December 31,2006. This compares to the December 31, 2005 balance in the reserve forunfunded lending commitments of $503,000.

46

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Ananalysis of the activity in the allowance for credit losses is as follows:

| ** **                                          | ** ** | **Year ended December 31,** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                          | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                          | ** ** | **(In thousands)**                    | ** ** |
| *Allowance for Loan and Lease  Losses*              | * *   | * *                                   | * *   | * * | * * | * * | * * | * * | * * | * * | * * |
| Balance at beginning of year                        |       | $                                          | 11,665     |   | $ | 11,454 |   | $ | 10,690 |   | $ | 9,784 |   | $ | 8,279 |   |
| Loans  charged-off:                                 |       |                                       |       |   |   |   |   |   |   |   |   |
| Commercial loans and leases                         |       | (472                                       | )          | (1,266 | ) | (98 | ) | (565 | ) | (400 | ) |
| Residential mortgage loans                          |       | —                                     |       | — |   | — |   | (17 | ) | — |   |
| Consumer and other loans                            |       | (47                                        | )          | (8 | ) | (52 | ) | (64 | ) | (93 | ) |
| Total loans charged-off                             |       | (519                                       | )          | (1,274 | ) | (150 | ) | (646 | ) | (493 | ) |
| Recoveries of  loans previously charged-off:        |       |                                       |       |   |   |   |   |   |   |   |   |
| Commercial loans and leases                         |       | 19                                         |       | 61 |   | 70 |   | 4 |   | 110 |   |
| Residential mortgage loans                          |       | —                                     |       | — |   | — |   | — |   | 40 |   |
| Consumer and other loans                            |       | 10                                         |       | 1 |   | 8 |   | 24 |   | 40 |   |
| Total recoveries of loans previously charged-off    |       | 29                                         |       | 62 |   | 78 |   | 28 |   | 190 |   |
| Net (charge-offs) recoveries                        |       | (490                                       | )          | (1,212 | ) | (72 | ) | (618 | ) | (303 | ) |
| Provision for  loan losses charged against income   |       | 1,202                                      |       | 1,423 |   | 836 |   | 1,524 |   | 1,808 |   |
| Balance at end of  year                             |       | 12,377                                     |       | 11,665 |   | 11,454 |   | 10,690 |   | 9,784 |   |
| *Reserve  for Unfunded Lending Commitments (1)*     | * *   | * *                                   | * *   | * * | * * | * * | * * | * * | * * | * * | * * |
| Balance at beginning of year                        |       | 503                                        |       | 452 |   | 388 |   | 312 |   | 245 |   |
| (Credit) provision for unfunded lending commitments |       | 64                                         |       | 51 |   | 64 |   | 76 |   | 67 |   |
| Balance at end of year                              |       | 567                                        |       | 503 |   | 452 |   | 388 |   | 312 |   |
| *Allowance for Credit Losses*                       | * *   | * *                                   | * *   | * * | * * | * * | * * | * * | * * | * * | * * |
| Balance at end of year                              |       | $                                          | 12,944     |   | $ | 12,168 |   | $ | 11,906 |   | $ | 11,078 |   | $ | 10,096 |   |

----

(1)          In 2006, the Companyreclassified the reserve for unfunded lending commitments from the allowancefor loan and lease losses to other liabilities for all periods presented.

*Investments*

Total investments (consisting of overnightinvestments, investment securities, MBSs, and FHLB stock) totaled$397.7 million, or 26.9% of total assets, at December 31, 2006. Thiscompares to total investments of $412.2 million, or 28.6% of total assets,as of December 31, 2005. The decrease of $14.5 million, or 3.5%, wascentered in the decline of investment securities of $47.5 million, butpartially offset by an increase in overnight investments of $26.9 million. Allinvestment securities and MBSs at December 31, 2006 and 2005 wereclassified as securities available for sale. At December 31, 2006, theinvestment portfolio carried a total net unrealized loss of $4.6 million,compared to $5.0 million of net unrealized loss at December 31, 2005, withthe primary driver of the change in unrealized gain/loss being the impact ofchanges in interest rates.

The investment portfolio provides the Company a sourceof short-term liquidity and acts as a counterbalance to loan and deposit flows.Excluding the investment portfolio restructuring in September 2006 asreferenced on page 33, the Company made minimal purchases of investmentsecurities and MBSs as the Company’s continued strategy is to target growth ofinternally generated, higher-yielding assets, such as commercial and consumerloans.

47

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Asummary of investment and mortgage-backed securities available for salefollows:

| ** **                             | ** ** | **Amortized**           | ** ** | **Unrealized** | ** ** | **Fair**   | ** ** |
|----------------------------------------|------------|-------------------------|------------|----------------|------------|------------|------------|
| ** **                             | ** ** | **Cost**                | ** ** | **Gains**      | ** ** | **Losses** | ** ** | **Value** | ** ** |
| ** **                             | ** ** | **(In thousands)** | ** ** |
| At December 31,  2006:            |       |                    |       |           |       |       |       |   |   |
| U.S. Agency obligations                |       | $                       | 85,992     |           | $          | 1          |       | $ | (704 | ) | $ | 85,289 |   |
| Corporate debt securities              |       | 12,122                  |       | 7              |       | (105       | )          | 12,024 |   |
| Trust preferred securities             |       | 6,152                   |       | 49             |       | (89        | )          | 6,112 |   |
| U.S. Agency mortgage-backed securities |       | 157,323                 |       | 114            |       | (2,271     | )          | 155,166 |   |
| Collateralized mortgage obligations    |       | 86,935                  |       | 18             |       | (1,657     | )          | 85,296 |   |
| Total                                  |       | $                       | 348,524    |           | $          | 189        |       | $ | (4,826 | ) | $ | 343,887 |   |
| At  December 31, 2005:            |       |                    |       |           |       |       |       |   |   |
| U.S. Agency obligations                |       | $                       | 125,915    |           | $          | —     |       | $ | (1,921 | ) | $ | 123,994 |   |
| Corporate debt securities              |       | 21,214                  |       | 57             |       | (608       | )          | 20,663 |   |
| Trust preferred securities             |       | 6,199                   |       | 108            |       | (5         | )          | 6,302 |   |
| U.S. Agency mortgage-backed securities |       | 174,542                 |       | 404            |       | (1,486     | )          | 173,460 |   |
| Collateralized mortgage obligations    |       | 62,907                  |       | —         |       | (1,509     | )          | 61,398 |   |
| Total                                  |       | $                       | 390,777    |           | $          | 569        |       | $ | (5,529 | ) | $ | 385,817 |   |
| At  December 31, 2004:            |       |                    |       |           |       |       |       |   |   |
| U.S. Agency obligations                |       | $                       | 74,330     |           | $          | 219        |       | $ | (358 | ) | $ | 74,191 |   |
| Corporate debt securities              |       | 25,388                  |       | 528            |       | (43        | )          | 25,873 |   |
| Trust preferred securities             |       | 4,235                   |       | 301            |       | —     |       | 4,536 |   |
| U.S. Agency mortgage-backed securities |       | 97,210                  |       | 1,082          |       | (333       | )          | 97,959 |   |
| Collateralized mortgage obligations    |       | 62,371                  |       | 52             |       | (436       | )          | 61,987 |   |
| Total                                  |       | $                       | 263,534    |           | $          | 2,182      |       | $ | (1,170 | ) | $ | 264,546 |   |

 

48

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Thefollowing table sets forth the contractual maturities of investment andmortgage-backed securities available for sale and the weighted average yieldsof such securities:

| ** **                             | ** ** | ** **                           | ** ** | ** **                      | ** ** | **After one, but**   | ** ** | **After five, but** | ** ** | ** ** | ** ** | ** **   | ** ** |
|----------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|--------------------------------|------------|-------------------------------|------------|------------|------------|--------------|------------|
| ** **                             | ** ** | **Within one year**        | ** ** | **within five years** | ** ** | **within ten years** | ** ** | **After ten years** | ** ** |
| ** **                             | ** ** | ** **                           | ** ** | **Weighted**                    | ** ** | ** **                     | ** ** | **Weighted**                  | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                             | ** ** | **Fair**                             | ** ** | **average**                     | ** ** | **Fair**                       | ** ** | **average**                   | ** ** | **Fair**   | ** ** | **average**  | ** ** | **Fair** | ** ** | **average** | ** ** |
| ** **                             | ** ** | **value**                            | ** ** | **yield**                       | ** ** | **value**                      | ** ** | **yield**                     | ** ** | **value**  | ** ** | **yield**    | ** ** | **value** | ** ** | **yield** | ** ** |
| ** **                             | ** ** | **(Dollars in thousands)** | ** ** |
| At December 31,  2006:            |       |                                 |       |                            |       |                           |       |                          |       |       |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Agency obligations                |       |                                 | $          | 9,959                           |       |                           |       | 2.90                          | %          |       | $          | 75,330       |       |   | 4.78 | % |   | $ | — |   |   | 0.00 | % |   |   | $ | — |   |   |   | 0.00 | % |   |
| Corporate debt securities              |       |                                 | 6,034      |                            |       |                           | 5.33       | %                             |       | 5,990      |       |         | 4.93       | % |   | — |   |   | 0.00 | % |   |   | — |   |   |   | 0.00 | % |   |
| Trust preferred securities             |       |                                 | —     |                            |       |                           | 0.00       | %                             |       | —     |       |         | 0.00       | % |   | — |   |   | 0.00 | % |   |   | 6,112 |   |   |   | 7.63 | % |   |
| U.S. Agency mortgage-backed securities |       |                                 | —     |                            |       |                           | 0.00       | %                             |       | —     |       |         | 0.00       | % |   | 15,136 |   |   | 4.55 | % |   |   | 140,030 |   |   |   | 4.82 | % |   |
| Collateralized mortgage obligations    |       |                                 | —     |                            |       |                           | 0.00       | %                             |       | —     |       |         | 0.00       | % |   | 2,604 |   |   | 4.06 | % |   |   | 82,692 |   |   |   | 5.01 | % |   |
| Total                                  |       |                                 | $          | 15,993                          |       |                           |       | 3.81                          | %          |       | $          | 81,320       |       |   | 4.79 | % |   | $ | 17,740 |   |   | 4.48 | % |   |   | $ | 228,834 |   |   |   | 4.96 | % |   |
| At  December 31, 2005:            |       |                                 |       |                            |       |                           |       |                          |       |       |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Agency obligations                |       |                                 | $          | 14,815                          |       |                           |       | 2.81                          | %          |       | $          | 109,179      |       |   | 4.11 | % |   | $ | — |   |   | 0.00 | % |   |   | $ | — |   |   |   | 0.00 | % |   |
| Corporate debt securities              |       |                                 | 5,045      |                            |       |                           | 4.94       | %                             |       | 15,618     |       |         | 4.86       | % |   | — |   |   | 0.00 | % |   |   | — |   |   |   | 0.00 | % |   |
| Trust preferred securities             |       |                                 | —     |                            |       |                           | 0.00       | %                             |       | —     |       |         | 0.00       | % |   | — |   |   | 0.00 | % |   |   | 6,302 |   |   |   | 7.34 | % |   |
| U.S. Agency mortgage-backed securities |       |                                 | —     |                            |       |                           | 0.00       | %                             |       | —     |       |         | 0.00       | % |   | 18,613 |   |   | 4.55 | % |   |   | 154,847 |   |   |   | 4.62 | % |   |
| Collateralized mortgage obligations    |       |                                 | —     |                            |       |                           | 0.00       | %                             |       | —     |       |         | 0.00       | % |   | — |   |   | 0.00 | % |   |   | 61,398 |   |   |   | 4.52 | % |   |
| Total                                  |       |                                 | $          | 19,860                          |       |                           |       | 3.35                          | %          |       | $          | 124,797      |       |   | 4.21 | % |   | $ | 18,613 |   |   | 4.55 | % |   |   | $ | 222,547 |   |   |   | 4.67 | % |   |
| At  December 31, 2004:            |       |                                 |       |                            |       |                           |       |                          |       |       |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Agency obligations                |       |                                 | $          | —                          |       |                           |       | 0.00                          | %          |       | $          | 74,190       |       |   | 3.66 | % |   | $ | — |   |   | 0.00 | % |   |   | $ | — |   |   |   | 0.00 | % |   |
| Corporate debt securities              |       |                                 | 4,073      |                            |       |                           | 5.68       | %                             |       | 21,801     |       |         | 4.88       | % |   | — |   |   | 0.00 | % |   |   | — |   |   |   | 0.00 | % |   |
| Trust preferred securities             |       |                                 | —     |                            |       |                           | 0.00       | %                             |       | —     |       |         | 0.00       | % |   | — |   |   | 0.00 | % |   |   | 4,536 |   |   |   | 8.40 | % |   |
| U.S. Agency mortgage-backed securities |       |                                 | —     |                            |       |                           | 0.00       | %                             |       | —     |       |         | 0.00       | % |   | — |   |   | 0.00 | % |   |   | 97,959 |   |   |   | 4.46 | % |   |
| Collateralized mortgage obligations    |       |                                 | —     |                            |       |                           | 0.00       | %                             |       | —     |       |         | 0.00       | % |   | — |   |   | 0.00 | % |   |   | 61,987 |   |   |   | 4.41 | % |   |
| Total                                  |       |                                 | $          | 4,073                           |       |                           |       | 5.68                          | %          |       | $          | 95,991       |       |   | 3.94 | % |   | $ | — |   |   | 0.00 | % |   |   | $ | 164,482 |   |   |   | 4.54 | % |   |

 

*Bank-Owned LifeInsurance*

The Bank has purchasedBOLI to protect itself against the loss of key employees due to death and tooffset the Bank’s future obligations to its employees under its retirement andbenefit plans. During 2006, 2005 and 2004, the Bank purchased $3.5 million, $0and $2.0 million of BOLI, respectively. The Bank also conducted a tax-freeexchange of a portion of its BOLI to other life insurance carriers in thefourth quarter of 2006, which should increase income from BOLI in future years.The cash surrender value of these life insurance policies was $23.1 million and$18.8 million at December 31, 2006 and 2005, respectively. The Bankrecorded income from the BOLI policies of $785,000 in 2006, $691,000 in 2005and $641,000 in 2004.

*Deposits andBorrowings*

The Bank continues to concentrate its time and effortstowards its deposit-gathering network. The Bank’s total deposits increased on anet basis by $35.5 million, or 3.6%, during 2006, crossing the $1.0 billionmark at December 31, 2006, from $981.0 million at December 31,2005. This increase in total deposits is summarized as follows: demand depositaccounts were up $15.2 million, or 8.2%, savings accounts were up $15.6million, or 4.6%, and CDs were up $28.7 million, or 8.1%. Meanwhile, NOW and 

49

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money market accounts weredown $18.9 million, or 21.1%, and $5.1 million, or 42.3%, respectively.Included within CD balances at December 31, 2006, were $30.0 million ofbrokered CDs, while the Bank did not have any brokered CDs at December 31,2005. The Bank utilizes brokered CDs if their rates are attractive compared towholesale funding.

In 2006, the Bank was able to achieve highsingle-digit percentage increases in its largest core deposit accounts (demanddeposit accounts and savings accounts). However, in addition to the normallyhigher-yielding term deposit products, the Bank offered higher-yielding savingsaccounts during 2006 in an effort to attract and retain deposits. The consumerdemand for higher-yielding products has gradually increased the cost of fundsand changed the balance sheet mix. Core deposit accounts as percentage of totaldeposits decreased to 62.4% at December 31, 2006 from 64.0% at December 31,2005.

By comparison, total deposits increased $100.3million, or 11.4%, during 2005 and can be summarized as follows:  demand deposit accounts increased $17.4million, or 10.4%, NOW and money market accounts decreased $18.6 million, or17.2%, savings accounts increased $1.3 million, or 0.4%, and CDs increased$104.5 million, or 42.1%, during 2005.

Thefollowing table sets forth certain information regarding deposits:

| ** **                      | ** ** | **December 31,**                | ** ** |
|---------------------------------|------------|--------------------------------------|------------|
| ** **                      | ** ** | **2006**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                      | ** ** | ** **                           | ** ** | **Percent** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Percent** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Percent** | ** ** | **Weighted** | ** ** |
| ** **                      | ** ** | ** **                           | ** ** | **of** | ** ** | **Average** | ** ** | ** ** | ** ** | **of** | ** ** | **Average** | ** ** | ** ** | ** ** | **of** | ** ** | **Average** | ** ** |
| ** **                      | ** ** | **Amount**                           | ** ** | **Total** | ** ** | **Rate** | ** ** | **Amount** | ** ** | **Total** | ** ** | **Rate** | ** ** | **Amount** | ** ** | **Total** | ** ** | **Rate** | ** ** |
| ** **                      | ** ** | **(Dollars in thousands)** | ** ** |
| NOW accounts                    |       | $                                    | 70,736     |   |   | 7.0 | % |   |   | 0.67 | % |   | $ | 89,594 |   |   | 9.1 | % |   |   | 0.54 | % |   | $ | 108,159 |   |   | 12.3 | % |   |   | 0.76 | % |   |
| Money market accounts           |       | 6,991                                |       |   | 0.7 | % |   |   | 2.69 | % |   | 12,122 |   |   | 1.2 | % |   |   | 1.31 | % |   | 16,489 |   |   | 1.9 | % |   |   | 1.22 | % |   |
| Savings accounts                |       | 356,707                              |       |   | 35.1 | % |   |   | 2.81 | % |   | 341,115 |   |   | 34.8 | % |   |   | 1.66 | % |   | 339,836 |   |   | 38.6 | % |   |   | 1.25 | % |   |
| Certificate of deposit accounts |       | 381,707                              |       |   | 37.5 | % |   |   | 4.45 | % |   | 353,049 |   |   | 36.0 | % |   |   | 3.34 | % |   | 248,508 |   |   | 28.2 | % |   |   | 2.55 | % |   |
| Total interest bearing deposits |       | 816,141                              |       |   | 80.3 | % |   |   | 3.40 | % |   | 795,880 |   |   | 81.1 | % |   |   | 2.28 | % |   | 712,992 |   |   | 81.0 | % |   |   | 1.63 | % |   |
| Noninterest bearing accounts    |       | 200,282                              |       |   | 19.7 | % |   |   | 0.00 | % |   | 185,089 |   |   | 18.9 | % |   |   | 0.00 | % |   | 167,682 |   |   | 19.0 | % |   |   | 0.00 | % |   |
| Total deposits                  |       | $                                    | 1,016,423  |   |   | 100.0 | % |   |   | 3.00 | % |   | $ | 980,969 |   |   | 100.0 | % |   |   | 1.85 | % |   | $ | 880,674 |   |   | 100.0 | % |   |   | 1.32 | % |   |

 

At December 31, 2006, CDs with balances greaterthan $100,000 aggregated $144.3 million, compared to $98.0 million and$52.4 million at December 31, 2005 and 2004, respectively.

Total borrowings, excluding subordinated deferrableinterest debentures, decreased $7.7 million, or 2.4%, during 2006, to$318.5 million, from $326.2 million at December 31, 2005. TheCompany had $252.8 million of borrowings outstanding at the end of 2004.Over the past year, the Bank’s customers have increased their utilization ofthe Bank’s cash management product suite. The increase in short-term borrowingshas enabled the Bank to reduce marginally the amount of FHLB borrowings.Through the Bank’s membership in the FHLB, the Company has access to a numberof different funding structures. Wholesale repurchase agreements remainedconstant with the December 31, 2005 level of $20.0 million. The Bank mayutilize wholesale repurchase agreement funding in the future if spreads arefavorable compared to FHLB borrowings.

On a long-term basis, theCompany intends to continue concentrating on increasing its core deposits, andwill utilize FHLB borrowings or wholesale repurchase agreements as cash flowsdictate, as opportunities present themselves and as part of the Bank’s overallstrategy to manage interest rate risk.

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**SubordinatedDeferrable Interest Debentures**

The Company has issued$18.6 million of subordinated deferrable interest debentures to its fourstatutory trust subsidiaries. The statutory trust subsidiaries have thenparticipated in the issuance of pooled trust preferred securities. Theregulatory capital generated from issuing the trust preferred securities helpedsupport the Company’s continued asset growth.

**Liquidity andCapital Resources**

*Liquidity*

Liquidity is defined as the ability to meet currentand future financial obligations of a short-term nature. The Company furtherdefines liquidity as the ability to respond to the needs of depositors andborrowers, as well as to earnings enhancement opportunities, in a changingmarketplace.

The primary source of funds for the payment ofdividends and expenses by the Company is dividends paid to it by the Bank. Bankregulatory authorities generally restrict the amounts available for payment ofdividends if the effect thereof would cause the capital of the Bank to bereduced below applicable capital requirements. These restrictions indirectly affectthe Company’s ability to pay dividends. The primary sources of liquidity forthe Bank consist of deposit inflows, loan repayments, borrowed funds, maturinginvestment securities and sales of securities from the available for saleportfolio. Management believes that these sources are sufficient to fund theBank’s lending and investment activities.

Management is responsiblefor establishing and monitoring liquidity targets as well as strategies andtactics to meet these targets. In general, the Company maintains a high degreeof flexibility with a liquidity target of 10% to 30% of total assets. At December 31,2006, overnight investments, investment securities and mortgage-backedsecurities available for sale amounted to $381.2 million, or 25.8% oftotal assets. This compares to $396.2 million, or 27.5% of total assets,at December 31, 2005. The Bank is a member of the FHLB and, as such, hasaccess to both short- and long-term borrowings. In addition, the Bank maintainsa line of credit at the FHLB as well as a line of credit with a correspondentbank. There have been no adverse trends in the Company’s liquidity or capitalreserves. Management believes that the Company has adequate liquidity to meetits commitments.

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*Commitments andContingent Liabilities*

Thefollowing table sets forth the contractual obligations of the Company:

| ** **                                   | ** ** | **Payments due or commitment expiring—by period** | ** ** |
|----------------------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                                   | ** ** | ** **                                                                      | ** ** | **Less than** | ** ** | **One to** | ** ** | **Four to** | ** ** | **After** | ** ** |
| ** **                                   | ** ** | **Total**                                                                       | ** ** | **one year** | ** ** | **three years** | ** ** | **five years** | ** ** | **five years** | ** ** |
| ** **                                   | ** ** | **(In thousands)**                                                         | ** ** |
| Contractual cash obligations:                |       |                                                                            |       |   |   |   |   |   |   |   |   |   |   |
| FHLB term borrowings                         |       | $                                                                               | 242,198    |   | $ | 34,593 |   |   | $ | 68,389 |   |   | $ | 59,000 |   | $ | 80,216 |   |
| Subordinated deferrable interest debentures  |       | 18,558                                                                          |       | — |   |   | — |   |   | — |   | 18,558 |   |
| Lease obligations                            |       | 11,049                                                                          |       | 1,283 |   |   | 1,984 |   |   | 1,024 |   | 6,758 |   |
| Other:                                       |       |                                                                            |       |   |   |   |   |   |   |   |   |   |   |
| Treasury, Tax and Loan payments              |       | 1,915                                                                           |       | 1,915 |   |   | — |   |   | — |   | — |   |
| Retail repurchase agreements                 |       | 54,426                                                                          |       | 54,426 |   |   | — |   |   | — |   | — |   |
| Wholesale repurchase agreements              |       | 20,000                                                                          |       | — |   |   | — |   |   | — |   | 20,000 |   |
| Total contractual cash obligations           |       | $                                                                               | 348,146    |   | $ | 92,217 |   |   | $ | 70,373 |   |   | $ | 60,024 |   | $ | 125,532 |   |
| Other commitments:                           |       |                                                                            |       |   |   |   |   |   |   |   |   |   |   |
| Commitments to originate or purchase loans   |       | $                                                                               | 35,250     |   | $ | 35,250 |   |   | $ | — |   |   | $ | — |   | $ | — |   |
| Unused lines of credit and other commitments |       | 205,673                                                                         |       | 94,074 |   |   | 19,860 |   |   | 687 |   | 91,052 |   |
| Letters of credit                            |       | 3,353                                                                           |       | 2,744 |   |   | 609 |   |   | — |   | — |   |
| Supplemental retirement benefits             |       | 2,231                                                                           |       | — |   |   | — |   |   | — |   | 2,231 |   |
| Total other  commitments                     |       | $                                                                               | 246,507    |   | $ | 132,068 |   |   | $ | 20,469 |   |   | $ | 687 |   | $ | 93,283 |   |

 

In connection with theMacrolease acquisition, the Company has an obligation to issue up to 18,082 sharesof its common stock over the next two years contingent upon Macrolease reachingspecified performance criteria.

*Capital Resources*

Total shareholders’ equity of the Company at December 31,2006 was $112.1 million, as compared to $104.8 million at December 31,2005. This difference of $7.3 million was primarily attributable to net incomeof $7.7 million, net unrealized gains and losses on securities increasing$210,000, stock option activity (stock option exercises, share-basedcompensation and related tax benefits) of $2.1 million, and dividends paid of$2.9 million.

All FDIC-insured institutions must meet specifiedminimal capital requirements. These regulations require banks to maintain aminimum leverage capital ratio. At December 31, 2006, the Bank’s Tier Ileverage ratio stood at 7.18%. In addition, the FDIC has adopted capitalguidelines based upon ratios of a bank’s capital to total assets adjusted forrisk. The risk-based capital guidelines include both a definition of capitaland a framework for calculating risk-weighted assets by assigning balance sheetassets and off-balance sheet items to broad risk categories. These regulationsrequire banks to maintain minimum capital levels for capital adequacy purposesand higher capital levels to be considered “well capitalized”. According tothese standards, the Bank had a Tier I risk-weighted capital ratio of 10.32%and a Total risk-weighted capital ratio of 11.54% at December 31, 2006.Additionally, at December 31, 2006, the Company had approximately $17million of additional capital (held at the parent company), which is availableto support the Bank’s future growth.

The FRB has also issued capital guidelines for bankholding companies. These guidelines require the Company to maintain minimumcapital levels for capital adequacy purposes. In general, the FRB has adoptedsubstantially identical capital adequacy guidelines as the FDIC. Such standardsare applicable to bank holding companies and their bank subsidiaries on aconsolidated basis. At December 31, 2006, the 

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Company’s Tier I leverageratio was 8.37%, its Tier I Risk-based capital ratio was 12.05% and its TotalRisk-based capital ratio was 13.27%.

As of December 31, 2006, the Company and the Bankmet all applicable minimum capital requirements and were considered “wellcapitalized” by both the FRB and the FDIC.

The Company has issued atotal of $18.0 million of trust preferred securities and utilized theirproceeds as Tier I capital to help support the Company’s growth. If trustpreferred securities are not available as a source of future Tier I capital, inaddition to the available capital referenced above, the Company may use otherforms of additional capital (e.g., common or preferred equity) to support itsgrowth, which, because of less favorable tax treatment, may be a somewhat moreexpensive source of capital than trust preferred securities.

**Impact of Inflationand Changing Prices**

The consolidated financialstatements and related notes thereto, included elsewhere herein, have beenprepared in accordance with U.S. GAAP, which requires the measurement offinancial position and operating results in terms of historical dollars,without considering changes in the relative purchasing power of money over timedue to inflation. Unlike many industrial companies, substantially all of theassets and liabilities of the Company are monetary in nature. As a result,interest rates have a more significant impact on the Company’s performance thanthe general level of inflation. Over short periods of time, interest rates maynot necessarily move in the same direction or in the same magnitude asinflation.

**Recent AccountingDevelopments**

In December 2004, the Financial AccountingStandards Board (“FASB”) issued SFAS 123-R, “*Share-BasedPayment*”, which was subsequently revised in April 2005 bydelaying the implementation date. SFAS 123-R addresses the accounting forshare-based payments to employees and non-employees, including grants ofemployee stock options. Under the new standard, companies will no longer beable to account for share-based compensation transactions using the intrinsicmethod in accordance with APB 25, *“Accounting for StockIssued to Employees*”. Instead, companies are required to account forsuch transactions using a fair-value method and recognize the expense in theconsolidated statements of operations. The Company adopted SFAS 123-R on January 1,2006. The adoption of SFAS 123-R did not have a material impact on theCompany’s statement of operations and is more fully described in Notes 2 and 15to the financial statements.

In February 2006, the FASB issued SFAS 155, *“Accounting for Certain Hybrid Financial Instruments, an amendment ofFASB Statements No. 133 and 140”*, which permits, but does notrequire, fair value accounting for hybrid financial instruments that contain anembedded derivative that would otherwise require bifurcation in accordance withSFAS 133, *“Accounting for Derivative Instruments and HedgingActivities”*. SFAS 155 also eliminated the temporary exemption forinterests in securitized financial assets provided for by SFAS 133, DerivativesImplementation Group (“DIG”) Issue D1, *“Application of Statement133 to Beneficial Interests in Securitized Financial Assets”.*However, in January 2007, the FASB issued interpretive guidance inSFAS 133, DIG Issue B40, *“Application of Paragraph13(b) to Securitized Interests in Prepayable Financial Assets”*,in which the FASB concluded that a securitized interest in prepayable financialassets was not subject to the bifurcation requirements of SFAS 155 providedthat the securitized interest met both the following criteria: (1) theright to accelerate the settlement of the securitized interest cannot becontrolled by the investor; and (2) the securitized interest itself doesnot contain an embedded derivative for which bifurcation would be requiredother than an embedded derivative that results solely from the embedded calloptions in the underlying financial assets. The guidance in DIG Issue B40 iseffective upon the adoption of SFAS 155. SFAS 155 is effective for allfinancial instruments acquired or issued after December 31, 2006, as wellas to those hybrid financial 

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instruments that had beenpreviously bifurcated under SFAS 133. As of December 31, 2006, the Companydid not have any hybrid financial instruments which were previously bifurcatedunder SFAS 133. Additionally, the guidance provided for in DIG Issue B40 isexpected to allow the Company to continue to purchase mortgage-backedsecurities without applying the bifurcation requirements of SFAS 155. TheCompany does not anticipate the adoption of SFAS 155 will have a materialeffect on its financial statements.

In March 2006, the FASB issued SFAS 156, *“Accounting for Servicing of Financial Assets”*, an amendmentof SFAS 140. This standard requires servicing assets and servicingliabilities be initially measured at fair value along with any derivativeinstruments used to mitigate inherent risks. SFAS 156 is effective for fiscalyears beginning after September 15, 2006. The Company does not anticipateSFAS 156 will materially impact its consolidated financial statements uponadoption on January 1, 2007.

In March 2006, the FASB Emerging Issues TaskForce (“EITF”) issued interpretive guidance in Issue 06-4 (“EITF 06-4”),in which agreements by companies to share a portion of the proceeds of lifeinsurance policies with an employee during the postretirement period is apostretirement benefit arrangement that must be accounted for under SFAS 106, *“Employers’ Accountingfor Postretirement Benefits Other Than Pensions”*. Under EITF 06-4, the EITF alsoconcluded the purchase of a split-dollar life insurance policy does notconstitute a settlement of the postretirement benefit as defined in SFAS 106.Thus, companies will be required to record a liability upon adoption of EITF 06-4,which is effective for periods beginning after December 15, 2007. TheCompany is currently evaluating the impact EITF 06-4 will have on itsconsolidated financial statements upon adoption on January 1, 2008.

In July 2006, the FASB issued FinancialAccounting Standards Interpretation No. 48 (“FIN 48”), *“Accounting for Uncertainty in Income Taxes”*. FIN 48clarifies the accounting for uncertainty in income taxes recognized in acompany’s financial statements in accordance with SFAS 109, *“Accounting for Income Taxes”*. FIN 48 prescribes arecognition threshold and measurement attributable for the financial statementrecognition and measurement of a tax position taken or expected to be taken ina tax return. FIN 48 also provides guidance on derecognition, classification,interest and penalties, accounting in interim periods, disclosures andtransitions. FIN 48 is effective for fiscal years beginning after December 15,2006. The Company does not anticipate the adoption of FIN 48 will materiallyimpact its financial statements upon adoption on January 1, 2007.

In September 2006,the SEC issued Staff Accounting Bulletin No. 108 (“SAB 108”), *“Considering the Effects of Prior Year Misstatements when QuantifyingMisstatements in Current Year Financial Statements”.* SAB 108provides guidance regarding the process of quantifying financial statementsmisstatements and dictates that a company should quantify errors using both abalance sheet approach (the “iron curtain” method) and an income statementapproach (the “rollover” approach). The balance sheet approach quantifies amisstatement based on the effects of correcting the misstatement existing inthe balance sheet at the end of the current year, irrespective of themisstatement’s year of origination. The income statement method quantifies amisstatement based on the amount of the error originating in the current yearincome statement, while ignoring the carryover effects of a prior yearmisstatement. SAB 108 indicates that a company should quantify an error underboth methods and evaluate the materiality under both methods. If deemedmaterial, a company is required to adjust its financial statements. SAB 108 waseffective for the first fiscal year ending after November 15, 2006. TheCompany adopted SAB 108 in the fourth quarter of 2006. SAB 108 did not have amaterial impact upon adoption.

In September 2006, the FASB issued SFAS No. 157(“SFAS 157”), *“Fair Value Measurements”*. SFAS157 provides guidance for measuring assets and liabilities at fair value. Thisstandard is applicable whenever other standards require or permit assets andliabilities to be measured at fair value, but does not expand upon the use offair value in any new circumstances. SFAS 157 establishes a fair valuehierarchy that gives the highest priority to quoted prices in active marketsand the lowest priority to unobservable 

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data and requires fairvalue measurements to be disclosed by level within the hierarchy. SFAS 157 iseffective for fiscal years beginning after November 15, 2007. The Companyis currently evaluating the impact SFAS 157 will have on its consolidatedfinancial statements upon adoption on January 1, 2008.

In February 2007, theFASB issued SFAS 159, “The Fair Value Option for Financial Assets and FinancialLiabilities”. SFAS 159 provides companies with an option to report selectedfinancial assets and liabilities at fair value and to provide additionalinformation that will help investors and other users of financial statements tounderstand more easily the effect on earnings of the company’s choice to usefair value. It also requires companies to display the fair value of thoseassets and liabilities for which the company has chosen to use fair value onthe face of the balance sheet. The Company is currently evaluating the impactSFAS 159 will have on its consolidated financial statements upon adoption onJanuary 1, 2008.

**ITEM 7A. QUALITATIVEAND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK**

**Asset and LiabilityManagement**

The principal objective of the Company’s asset andliability management process is to maximize profit potential while minimizingthe vulnerability of its operations to changes in interest rates by managingthe ratio of interest rate sensitive assets to interest rate sensitiveliabilities within specified maturity or repricing periods. The asset andliability management process is dependent on numerous assumptions, many ofwhich require significant judgments by the Company. The Company’s actions inthis regard are taken under the guidance of the Bank’s Asset/LiabilityCommittee (“ALCO”) that is comprised of members of senior management. The ALCOgenerally meets monthly and is actively involved in formulating the economicassumptions that the Company uses in its financial planning and budgetingprocess and establishes policies which control and monitor the sources, usesand pricing of funds.

The ALCO manages the Company’s interest rate riskposition using both income simulation and interest rate sensitivity “gap”analysis. Income simulation is the primary tool for measuring the interest raterisk inherent in the Company’s balance sheet at a given point in time byshowing the effect on net interest income, over a 24-month period, ofinterest rate ramps of up to 200 basis points. These simulations take intoaccount repricing, maturity and prepayment characteristics of individualproducts. The ALCO reviews simulation results to determine whether the exposureto income resulting from changes in market interest rates remains withinestablished tolerance levels over both a 12-month and 24-monthhorizon, and develops appropriate strategies to manage this exposure. TheCompany’s guidelines for interest rate risk specify that if interest rates wereto shift up or down 200 basis points over both a 12-month and 24-monthperiod, estimated net interest income should decline by no more than 10.0%. Asof December 31, 2006, net interest income simulation indicated that theCompany’s exposure to changing interest rates was within these tolerances. TheALCO reviews the methodology utilized for calculating interest rate riskexposure and will adopt changes based upon changing market conditions orindustry standards.

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Thefollowing table presents the estimated impact of interest rate ramps onestimated net interest income over a 24-month period beginning January 1,2007:

| ** **                       | ** ** | **Estimated impact on  net interest income** | ** ** |
|----------------------------------|------------|------------------------------------------------------------------|------------|
| ** **                       | ** ** | **Dollar  change**                                               | ** ** | **Percent  change** | ** ** |
| ** **                       | ** ** | **(Dollars in thousands)**                             | ** ** |
| Initial Twelve Month  Period:    |       |                                                             |       |   |   |   |   |
| Up 200 basis point ramp          |       | $                                                                | (588       | ) |   | (1.37 | )% |   |
| Down 200 basis point ramp        |       | (530                                                             | )          |   | (1.24 | )% |   |
| Subsequent Twelve Month  Period: |       |                                                             |       |   |   |   |   |
| Up 200 basis point ramp          |       | $                                                                | (3,603     | ) |   | (7.98 | )% |   |
| Down 200 basis  point ramp       |       | (1,881                                                           | )          |   | (4.17 | )% |   |

 

The Company also uses interest rate sensitivity “gap”analysis to provide a more general overview of its interest rate risk profile.The interest rate sensitivity gap is defined as the difference betweeninterest-earning assets and interest-bearing liabilities maturing or repricingwithin a given time period. A gap is considered positive when the amount ofinterest rate sensitive assets exceeds the amount of interest rate sensitiveliabilities. A gap is considered negative when the amount of interest ratesensitive liabilities exceeds interest rate sensitive assets. At December 31,2006, the Company’s cumulative one-year gap was a negative $114 million, or7.9% of total assets, compared to a negative $140 million, or 9.7% of totalassets at the end of 2005.

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The following tablepresents the repricing schedule for interest-earning assets andinterest-bearing liabilities at December 31, 2006. To the extentapplicable, amounts of assets and liabilities that mature or reprice within aparticular period were determined in accordance with their contractual terms.Investment securities are allocated based upon expected call dates. Loans andMBSs have been allocated based upon expected amortization and prepayment ratesbased on historical performance and market expectations. Savings, NOW and moneymarket deposit accounts, which have no contractual term and are subject toimmediate repricing, are anticipated to behave more like core accounts andtherefore are presented as spread evenly over the first three years.Nonetheless, this presentation does not reflect lags that may occur in theactual repricing of these deposits.

| ** **                                     | ** ** | **Within  Three  Months**            | ** ** | **Over  Three to  Six months** | ** ** | **Over Six  to Twelve  months** | ** ** | **Over One  Year to  Five Years** | ** ** | **Over  Five Years** | ** ** | **Total** | ** ** |
|------------------------------------------------|------------|--------------------------------------|------------|------------------------------------------|------------|-------------------------------------------|------------|--------------------------------------------------|------------|---------------------------|------------|-----------|------------|
| ** **                                     | ** ** | **(Dollars in thousands)** | ** ** |
| Interest-earning assets:                       |       |                                 |       |                                     |       |                                      |       |                                             |       |                      |       |      |       |   |   |   |   |   |   |
| Overnight investments                          |       | $                                    | 37,295     |                                     |       | $                                         | —     |                                             |       | $                         | —     |      |       | $ | — |   |   |   | $ | — |   |   | $ | 37,295 |   |
| Investment securities                          |       | 7,005                                |       |                                     | 7,000      |                                      |       | 4,005                                            |       |                      | 81,485     |      |       |   | 3,930 |   |   | 103,425 |   |
| Mortgage-backed securities                     |       | 12,222                               |       |                                     | 11,425     |                                      |       | 32,744                                           |       |                      | 112,897    |      |       |   | 71,174 |   |   | 240,462 |   |
| FHLB Stock                                     |       | 16,530                               |       |                                     | —     |                                      |       | —                                           |       |                      | —     |      |       |   | — |   |   | 16,530 |   |
| Commercial loans and leases                    |       | 147,945                              |       |                                     | 40,838     |                                      |       | 68,207                                           |       |                      | 241,124    |      |       |   | 21,676 |   |   | 519,790 |   |
| Residential mortgage loans                     |       | 15,535                               |       |                                     | 15,806     |                                      |       | 33,582                                           |       |                      | 150,098    |      |       |   | 48,924 |   |   | 263,945 |   |
| Consumer and other loans                       |       | 72,823                               |       |                                     | 8,253      |                                      |       | 15,898                                           |       |                      | 80,688     |      |       |   | 42,895 |   |   | 220,557 |   |
| Total interest-earning assets                  |       | 309,355                              |       |                                     | 83,322     |                                      |       | 154,436                                          |       |                      | 666,292    |      |       |   | 188,599 |   |   | 1,402,004 |   |
| Interest-bearing  liabilities:                 |       |                                 |       |                                     |       |                                      |       |                                             |       |                      |       |      |       |   |   |   |   |   |   |
| NOW accounts                                   |       | 5,895                                |       |                                     | 5,895      |                                      |       | 11,789                                           |       |                      | 47,157     |      |       |   | — |   |   | 70,736 |   |
| Money market accounts                          |       | 583                                  |       |                                     | 583        |                                      |       | 1,165                                            |       |                      | 4,660      |      |       |   | — |   |   | 6,991 |   |
| Savings accounts                               |       | 29,800                               |       |                                     | 29,800     |                                      |       | 59,600                                           |       |                      | 237,507    |      |       |   | — |   |   | 356,707 |   |
| Certificate of deposit accounts                |       | 128,205                              |       |                                     | 91,309     |                                      |       | 138,528                                          |       |                      | 23,618     |      |       |   | 47 |   |   | 381,707 |   |
| Overnight & short-term borrowings     |       | 56,341                               |       |                                     | —     |                                      |       | —                                           |       |                      | —     |      |       |   | — |   |   | 56,341 |   |
| FHLB and other borrowings                      |       | 40,022                               |       |                                     | 18,940     |                                      |       | 32,437                                           |       |                      | 122,288    |      |       |   | 48,511 |   |   | 262,198 |   |
| Subordinated deferrable interest debentures    |       | 10,310                               |       |                                     | —     |                                      |       | —                                           |       |                      | 5,155      |      |       |   | 3,093 |   |   | 18,558 |   |
| Total interest-bearing liabilities             |       | 271,156                              |       |                                     | 146,527    |                                      |       | 243,519                                          |       |                      | 440,385    |      |       |   | 51,651 |   |   | 1,153,238 |   |
| Net interest sensitivity gap during the period |       | $                                    | 38,199     |                                     |       | $                                         | (63,205    | )                                                |       | $                         | (89,083    | )         |       | $ | 225,907 |   |   |   | $ | 136,948 |   |   | $ | 248,766 |   |
| Cumulative gap—12/31/06                   |       | $                                    | 38,199     |                                     |       | $                                         | (25,006    | )                                                |       | $                         | (114,089   | )         |       | $ | 111,818 |   |   |   | $ | 248,766 |   |   |   |   |
| Cumulative gap—12/31/05                   |       | $                                    | 21,661     |                                     |       | $                                         | (40,171    | )                                                |       | $                         | (140,494   | )         |       | $ | 78,829 |   |   |   | $ | 222,406 |   |   |   |   |
| Interest-sensitive assets  as a percent of     |       |                                 |       |                                     |       |                                      |       |                                             |       |                      |       |      |       |   |   |   |   |   |   |
| Interest-sensitive liabilities (cumulative)    |       | 114.09                               | %          |                                     | 94.01      | %                                         |       | 82.75                                            | %          |                      | 110.15     | %         |       |   | 121.57 | % |   |   |   |
| Cumulative gap as  a percent of total assets   |       | 2.65                                 | %          |                                     | -1.73      | %                                         |       | -7.91                                            | %          |                      | 7.75       | %         |       |   | 17.25 | % |   |   |   |

 

The preceding table doesnot necessarily indicate the impact of general interest rate movements on theCompany’s net interest income because the repricing of various assets andliabilities is discretionary and is subject to competitive and other factors.As a result, assets and liabilities indicated as repricing within the sameperiod may, in fact, reprice at different times and at different rate levels.

**ITEM 8. FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA**

The index to financialstatements is included on page 61 of this annual report.

**ITEM 9. CHANGES IN ANDDISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING OR FINANCIAL DISCLOSURE**

There were no changes in,or disagreements with, accountants on accounting or financial disclosure asdefined by Item 304 of Regulation S-K.

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**ITEM 9A.**        CONTROLSAND PROCEDURES

As required by Rule 13a-15 under theExchange Act of 1934, the Company carried out an evaluation of theeffectiveness of the design and operation of the Company’s disclosure controlsand procedures as of the end of the period covered by this report. Thisevaluation was carried out under the supervision and with the participation ofthe Company’s management, including the Company’s Chief Executive Officer andthe Company’s Chief Financial Officer. Based upon that evaluation, the ChiefExecutive Officer and the Chief Financial Officer concluded that the Company’sdisclosure controls and procedures are effective as of the end of the periodcovered by this report.

There have been nosignificant changes in the Company’s internal control over financial reportingduring the Company’s most recent fiscal quarter that have materially affected,or are reasonably likely to affect, the Company’s internal control overfinancial reporting. The Company’s management discusses with and disclosesthese matters to the Audit Committee of the Board of Directors and theCompany’s auditors.

**ITEM 9B.**       OTHERINFORMATION

There is no otherinformation to report.

**PART III**

**ITEM 10. DIRECTORS,EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE**

The information concerning directors required by thisitem, including the Audit Committee and the Audit Committee financial expert,is incorporated herein by reference to the sections entitled “Election ofDirectors” and “Section 16(a) Beneficial Ownership ReportingCompliance” in the Company’s Definitive Proxy Statement for the 2007 AnnualMeeting of Shareholders to be filed with the SEC.

Thefollowing table sets forth the executive officers of the Company as of the datehereof.

| **Name**            | ** ** | ** ** | ** ** | **Age** | ** ** | **Position**                           | ** ** |
|---------------------|------------|------------|------------|---------|------------|----------------------------------------|------------|
| Merrill W.  Sherman |       |       | 58         |    |       | President  and Chief Executive Officer |       |
| Linda H. Simmons    |       |       | 47         |    |       | Chief  Financial Officer and Treasurer |       |
| Jeffrey W. Angus    |       |       | 51         |    |       | Vice  President                        |       |
| James V. DeRentis   |       |       | 45         |    |       | Vice President                         |       |

 

*MerrillW. Sherman.*   Ms. Sherman has served asPresident and Chief Executive Officer of the Company and Bank since theirformation. Ms. Sherman is also a director of The Providence JournalCompany, a BELO Corp. subsidiary.

*LindaH. Simmons.**  *Ms. Simmonshas served as Chief Financial Officer and Treasurer of the Company and Banksince July 2005 and served as the Bank’s Executive Vice President—Financeand Treasurer from September 2004 to July 2005. From 1995 untiljoining the Bank, Ms. Simmons was with Fleet Financial Corp.’s TreasuryGroup where she held various positions with responsibilities in theasset/liability management area.

*JeffreyW. Angus.**  *Mr. Angushas served as Vice President of the Company and Executive Vice President andChief Operating Officer of the Bank since December 2005. From 1998 until2004, Mr. Angus served as senior vice president of information systems andas a corporate officer at New England Business Service, Inc.

*James V. DeRentis.*   Mr. DeRentishas served as Vice President of the Company since December 2005 and theBank’s Chief Business Officer since October 2005. Mr. DeRentispreviously served as the Bank’s Executive Vice President—Retail Banking from October 2001through September 2005. Immediately 

58

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prior, Mr. DeRentisserved as the Bank’s Senior Vice President—Retail Banking from December 1998through October 2001.

**Code of Ethics andGovernance Principles**

The Company has adopted aCode of Ethics which applies to all directors, officers and employees of theCompany and the Bank, including the Chief Executive Officer (“CEO”), ChiefFinancial Officer (“CFO”), Controller and Chief Auditor, as supplemented by aCode of Ethical Conduct for Executive Officers and Senior Financial Officers,which meets the requirements of a “code of ethics” as defined in Item 406 ofRegulation S-K. Our Board of Directors has also adopted Corporate GovernanceGuidelines and Principles (“the Guidelines”), which along with the charters ofBoard committees provide the framework for the governance of the Company. TheCompany will provide a copy of the Codes, the Guidelines and/or committeecharters to shareholders, without charge, upon request directed to the InvestorRelations Contact listed on the Company’s website, http://www.bankri.com, under “InvestorRelations”. The Company has posted the Codes, the Guidelines and the committeecharters on the Company’s website under “Investor Relations/Governance Documents”.The Company intends to disclose any amendment to, or waiver of, a provision ofthe Codes for the CEO, CFO, Controller or persons performing similar functionsby posting such information on its website and filing a Form 8-K asrequired by the rules of the Nasdaq Global Select Market SM.

**ITEM 11. EXECUTIVECOMPENSATION**

The information required by this item is incorporatedherein by reference to the sections entitled “Compensation of Directors”, “CompensationDiscussion and Analysis”, “Compensation Committee Report” and “ExecutiveCompensation” in the Company’s Definitive Proxy Statement for the 2007 AnnualMeeting of Shareholders to be filed with the SEC.

The information set forthunder the heading “Compensation Committee Report” in the Company’s DefinitiveProxy Statement is furnished and shall not be deemed as filed for purposes of Section 18of the Securities Exchange Act of 1934, as amended, and is not deemedincorporated by reference in any filing under the Securities Act of 1933, asamended.

59

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**ITEM 12.**         SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS

The information requiredby this item is incorporated herein by reference to the Sections entitled “CommonStock Ownership of Certain Beneficial Owners and Management” in the Company’sDefinitive Proxy Statement for the 2007 Annual Meeting of Shareholders to befiled with the SEC.

**Equity CompensationPlan Information**

The following table setsforth information about the Company’s equity compensation plans as of December 31,2006:

| **Plan category**                                      | ** ** | ** ** | ** ** | **Number of Securities to  be Issued Upon Exercise  of Outstanding Options,  Warrants and Rights** | ** ** | **Weighted-Average  Exercise Price of  Outstanding Options,  Warrants and Rights** | ** ** | **Number of Securities  Remaining Available for  Future Issuance Under  Equity Compensation  Plans** | ** ** |
|-------------------------------------------------------------|------------|------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity Compensation  Plans Approved by Security Holders     |       |       | 456,021    | (1)                                                                                                                                                  |       |                                                                                                        | $          | 24.52                                                                                                                                   |       |   |   | 161,383 | (2) |   |
| Equity Compensation  Plans Not Approved by Security Holders |       |       | 0          |                                                                                                                                                 |       |                                                                                                        | N/A        |                                                                                                                                    |       |   | 0 |   |   |
| Total                                                       |       |       | 456,021    |                                                                                                                                                 |       |                                                                                                        | $          | 24.52                                                                                                                                   |       |   |   | 161,383 |   |   |

----

(1)          Includes 403,021 sharesissuable upon exercise of outstanding awards granted under the Bancorp RhodeIsland, Inc. 2002 Equity Incentive Plan and predecessor plan (Amended andRestated Bancorp Rhode Island, Inc. 1996 Incentive and Nonqualified StockOption Plan) and 53,000 shares issuable upon exercise of outstanding awardsgranted under the Amended and Restated Bancorp Rhode Island, Inc.Non-Employee Directors Stock Plan.

(2)          Includes 142,383 sharesreserved for awards under the Bancorp Rhode Island, Inc. 2002 EquityIncentive Plan and predecessor plan and 19,000 shares reserved for awards underthe Amended and Restated Bancorp Rhode Island, Inc. Non-Employee DirectorsStock Plan.

Additional informationregarding these equity compensation plans is contained in Note 15 to theCompany’s Consolidated Financial Statements included in this annual report.

**ITEM 13.**         CERTAINRELATIONSHIPS, RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE

The information requiredby this item is incorporated herein by reference to the sections entitled “Transactionswith Management” and “Election of Directors” in the Company’s Definitive ProxyStatement for the 2007 Annual Meeting of Shareholders to be filed with the SEC.

**ITEM 14. PRINCIPALACCOUNTANT FEES AND SERVICES**

The information required by this item is incorporatedherein by reference to the Section entitled “Independent Accountant Feesand Services” in the Company’s Definitive Proxy Statement for the 2007 AnnualMeeting of Shareholders to be filed with the SEC.

60

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**PART IV**

**ITEM 15. EXHIBITSAND FINANCIAL STATEMENTS SCHEDULES**

**(a)****          (1)   Financial Statements**

Thefollowing consolidated financial statements appear in response to Item 8 ofthis report commencing on the page numbers specified below:
| Management’s Report on  Internal Control Over Financial Reporting                                                                                          |   | F-1 |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----|--------|
| Report of Independent Registered Public Accounting  Firm on Management’s Assessment of and the Effectiveness of Internal Control  Over Financial Reporting |   | F-2 |   |
| Report of Independent Registered Public Accounting  Firm                                                                                                        |   | F-3 |   |
| Consolidated Balance Sheets as of December 31,  2006 and 2005                                                                                              |   | F-4 |   |
| Consolidated Statements of Operations for the Years  Ended December 31, 2006, 2005 and 2004                                                                |   | F-5 |   |
| Consolidated Statements of Changes in Shareholders’  Equity for the Years Ended December 31, 2006, 2005 and 2004                  |   | F-6 |   |
| Consolidated Statements of Cash Flows for the Years  Ended December 31, 2006, 2005 and 2004                                                                |   | F-7 |   |
| Notes to  Consolidated Financial Statements                                                                                                                     |   | F-8 |   |

 

**(2)****         FinancialStatement Schedules**

All schedules forwhich provision is made in the applicable accounting regulations of theSecurities and Exchange Commission are not required under the relatedinstructions or are inapplicable, and therefore have been omitted.

**(3)****         Exhibits**
| Exhibit No. | ** ** | ** **                                                                                                              | **Description** | ** ** |
|------------------|------------|-------------------------------------------------------------------------------------------------------------------------|-----------------|------------|
| 3.1              |       | Articles of  Incorporation of the Company, as amended(1)                                                                |
| 3.2              |       | By-laws of the  Company, as amended(2)                                                                                  |
| 10.1             |       | Amended and  Restated Employment Agreement of Merrill W. Sherman dated February 20,  2007†                    |
| 10.2             |       | Amended and  Restated Employment Agreement of Linda H. Simmons dated February 20,  2007†                      |
| 10.3             |       | Amended and Restated  Employment Agreement of Jeffrey W. Angus February 20, 2007†                             |
| 10.4             |       | Amended and Restated  Employment Agreement of James V. DeRentis dated February 20, 2007†                      |
| 10.5             |       | Amended and  Restated 1996 Incentive and Nonqualified Stock Option Plan(3)†                                        |
| 10.6             |       | Amended and  Restated Non-Employee Director Stock Plan(4)†                                                         |
| 10.6(a)          |       | Amendment to  Amended and Restated Non-Employee Director Stock Plan(5)†                                            |
| 10.6(b)          |       | Second Amendment  to Amended and Restated Non-Employee Director Stock Plan(6)†                                     |
| 10.7(a)          |       | Bank Rhode Island  Supplemental Executive Retirement Plan, as amended by Amendments No. 1  and No. 2(1)† |

61

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| 10.7(b)  |   | Amendment  No. 3 to Bank Rhode Island Supplemental Executive Retirement Plan(2)†                                                                         |
|----------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.7(c)  |   | Amendment  No. 4 to Bank Rhode Island Supplemental Executive Retirement Plan(7)†                                                                         |
| 10.7(d)  |   | Amendment  No. 5 to Bank Rhode Island Supplemental Executive Retirement Plan(8)†                                                                         |
| 10.7(e)  |   | Amendment  No. 6 to Bank Rhode Island Supplemental Executive Retirement Plan(9)†                                                                         |
| 10.8     |   | Bank Rhode Island  Nonqualified Deferred Compensation Plan, as amended by Amendment  No. 1(1)†                                                           |
| 10.8(a)  |   | Amendment  No. 2 to Bank Rhode Island Nonqualified Deferred Compensation Plan(10)†                                                                       |
| 10.9     |   | Executive  Incentive Bonus Plan(11)†                                                                                                                          |
| 10.10    |   | Bank Rhode Island 2002 Supplemental Executive  Retirement Plan(10)†                                                                                           |
| 10.10(a) |   | Amendment No. 1 to Bank Rhode Island 2002  Supplemental Executive Retirement Plan(12)†                                                                   |
| 10.10(b) |   | Amendment No. 2 to Bank Rhode Island 2002  Supplemental Executive Retirement Plan(13)†                                                                   |
| 10.10(c) |   | Amendment No. 4 to Bank Rhode Island 2002  Supplemental Executive Retirement Plan(2)†                                                                    |
| 10.10(d) |   | Amendment No. 6 to Bank Rhode Island 2002  Supplemental Executive Retirement Plan†                                                                       |
| 10.11    |   | Restricted Stock Agreement by and among Bancorp  Rhode Island, Inc., Bank Rhode Island and Merrill W. Sherman(14)†                                       |
| 10.12    |   | Form of Bank Rhode Island Split Dollar  Agreement(8)†                                                                                                    |
| 10.13    |   | 2002 Equity Incentive Plan(15)†                                                                                                                               |
| 11       |   | Computation of earnings per share(16)                                                                                                                              |
| 21       |   | List of Subsidiaries                                                                                                                                               |
| 23       |   | Consent of KPMG LLP, as independent registered  public accountants for the Company                                                                                 |
| 31.1     |   | Certification of Chief Executive Officer pursuant to  Section 302 of the Sarbanes—Oxley Act of 2002                                                      |
| 31.2     |   | Certification of Chief Financial Officer pursuant to  Section 302 of the Sarbanes—Oxley Act of 2002                                                      |
| 32.1     |   | Certification of Chief Executive Officer pursuant to  18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the  Sarbanes—Oxley Act of 2002. |
| 32.2     |   | Certification of  Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted  pursuant to Section 906 of the Sarbanes—Oxley Act of 2002. |

----

(1)          Incorporated byreference from the Company’s Registration Statement on Form S-4, SECFile No. 333-33182

(2)          Incorporated byreference from the Company’s Annual Report on Form 10-K for the yearended December 31, 2005.

(3)          Incorporated byreference from the Company’s Annual Report on Form 10-K for the yearended December 31, 2000.

(4)          Incorporated byreference from the Company’s Quarterly Report on Form 10-Q for theperiod ended September 30, 2000.

62

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(5)          Incorporated byreference from the Company’s Quarterly Report on Form 10-Q for theperiod ended June 30, 2002.

(6)          Incorporated byreference from the Company’s Quarterly Report on Form 10-Q for theperiod ended June 30, 2006.

(7)          Incorporated byreference from the Company’s Annual Report on Form 10-K for the yearended December 31, 2001.

(8)          Incorporated byreference from the Company’s Quarterly Report on Form 10-Q for theperiod ended March 31, 2002.

(9)          Incorporated byreference from the Company’s Annual Report on Form 10-K for the yearended December 31, 2004.

(10) Incorporated by reference from the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2002.

(11) Incorporated by reference from the Company’s Current Report on Form 8-Kdated February 9, 2005.

(12) Incorporated by reference from the Company’s Quarterly Report on Form 10-Qfor the period ended June 30, 2003.

(13) Incorporated by reference from the Company’s Current Report on Form 8-Kdated January 21, 2005.

(14) Incorporated by reference from the Company’s Quarterly Report on Form 10-Qfor the period ended March 31, 2001.

(15) Incorporated by reference to Appendix B to the Company’s DefinitiveProxy Statement on Schedule 14A filed on April 15, 2005.

(16) The calculation of earnings per share is set forth as Note 20 to theCompany’s audited consolidated financial statements.

†                    Managementcontract or compensatory plan or arrangement.

63

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**BANCORP RHODEISLAND, INC.**

**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.
|                          | BANCORP RHODE ISLAND, INC. |
|--------------------------|----------------------------|
| Date: March 9, 2007 | By:                        | /s/ Merrill W. Sherman |
|                     |                       | Merrill W. Sherman |
|                     |                       | President and Chief Executive Officer |

 

Each person whose signature appears below constitutesand appoints each of Merrill W. Sherman or Linda H. Simmons, or either of them,each acting alone, his or her true and lawful attorneys-in-fact and agents,with full power of substitution and resubstitution, for such person and in hisor her name, place and stead, in any and all capacities in connection with theannual report on Form 10-K of Bancorp Rhode Island, Inc. forthe year ended December 31, 2006, to sign any and all amendments to the Form 10-K,and to file the same, with all exhibits thereto, and other documents in connectiontherewith, with the Securities and Exchange Commission, granting unto saidattorneys-in-fact and agents, each acting alone, full power and authority to doand perform each and every act and thing requisite and necessary to be done inand about the premises, as fully to all intents and purposes as he or she mightor could do in person, hereby ratifying and confirming all that saidattorneys-in-fact and agents, or their substitutes or substitute, may lawfullydo or cause to be done by virtue hereof.

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.
| /s/ Merrill W. Sherman                 |   | /s/ Linda H. Simmons           |   | /s/ Michael J. Hebert            |
|----------------------------------------|--------|--------------------------------|--------|----------------------------------|
| Merrill W. Sherman,                    |   | Linda H. Simmons,              |   | Michael J. Hebert,               |
| President, Chief Executive Officer     |   | Chief Financial Officer and    |   | Controller (Principal Accounting |
| and Director (Principal Executive      |   | Treasurer (Principal Financial |   | Officer)                         |
| Officer)                               |   | Officer)                       |   |                             |
| Date: March 9, 2007               |   | Date: March 9, 2007       |   | Date: March 9, 2007         |
| /s/ Karen Adams                        |   | /s/ Meredith A. Curren         |   | /s/ Bogdan Nowak                 |
| Karen Adams, Director                  |   | Meredith A. Curren, Director   |   | Bogdan Nowak, Director           |
| Date: March 9, 2007               |   | Date: March 9, 2007       |   | Date: March 9, 2007         |
| /s/ Anthony F. Andrade                 |   | /s/ Karl F. Ericson            |   | /s/ Cheryl W. Snead              |
| Anthony F. Andrade, Director           |   | Karl F. Ericson, Director      |   | Cheryl W. Snead, Director        |
| Date: March 9, 2007               |   | Date: March 9, 2007       |   | Date: March 9, 2007         |
| /s/ John R. Berger                     |   | /s/ Mark R. Feinstein          |   | /s/ Pablo Rodriguez              |
| John R. Berger, Director               |   | Mark R. Feinstein, Director    |   | Pablo Rodriguez, Director        |
| Date: March 9, 2007               |   | Date: March 9, 2007       |   | Date: March 9, 2007         |
| /s/ Malcolm G. Chace                   |   | /s/ Edward J. Mack             |   | /s/ John A. Yena                 |
| Malcolm G. Chace, Director and         |   | Edward J. Mack, Director       |   | John A. Yena, Director           |
| Chairman of the Board                  |   | Date: March 9, 2007       |   | Date: March 9, 2007         |
| Date: March 9, 2007               |   |                           |   |                             |
| /s/ Ernest J.  Chornyei, Jr.      |   | /s/ Michael E. McMahon         |   |                             |
| Ernest J. Chornyei, Jr., Director |   | Michael E. McMahon, Director   |   |                             |
| Date: March 9, 2007               |   | Date: March 9, 2007       |   |                             |

 

64

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**BANCORP RHODEISLAND, INC.**

**Management’s Reporton Internal ControlOver Financial Reporting**

The management of Bancorp Rhode Island, Inc. (the“Company”) is responsible for establishing and maintaining adequate internalcontrol over financial reporting. Bancorp Rhode Island Inc.’s internal controlsystem was designed to provide reasonable assurance to the Company’s managementand board of directors regarding the preparation and fair presentation ofpublished financial statements.

All internal control systems, no matter how welldesigned, have inherent limitations. Therefore, even those systems determinedto be effective can provide only reasonable assurance with respect to financialstatement preparation and presentation.

Bancorp Rhode Island, Inc.’s management assessedthe effectiveness of the Company’s internal control over financial reporting asof December 31, 2006. In making this assessment, it used the criteria setforth by the Committee of Sponsoring Organizations of the Treadway Commission(COSO) in Internal Control—Integrated Framework. Based on our assessment webelieve that, as of December 31, 2006, the Company’s internal control overfinancial reporting is effective based on those criteria.

BancorpRhode Island, Inc.’s Independent Registered Public Accounting Firm hasissued an audit report on our assessment of the Company’s internal control overfinancial reporting. This report appears on page F-2 of this annualreport.
| Merrill W. Sherman      | Linda H. Simmons            |
|-------------------------|-----------------------------|
| President and           | Chief Financial Officer and |
| Chief Executive Officer | Treasurer                   |

 

F-1

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**BANCORP RHODE ISLAND, INC.**

**Report of IndependentRegistered Public Accounting Firm on Management’sAssessment of and the Effectiveness of Internal Control Over FinancialReporting**

The Board of Directors and ShareholdersBancorp Rhode Island, Inc.:

We have audited management’s assessment, included inthe accompanying Management’s Report on Internal Control Over FinancialReporting, that Bancorp Rhode Island, Inc. (the “Company”) maintainedeffective internal control over financial reporting as of December 31,2006, based on criteria established in Internal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commissions(COSO). The Company’s management is responsible for maintaining effectiveinternal control over financial reporting and for its assessment of theeffectiveness of internal control over financial reporting. Our responsibilityis to express an opinion on management’s assessment and an opinion on theeffectiveness of the Company’s internal control over financial reporting basedon our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinion.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

In our opinion, management’s assessment that theCompany maintained effective internal control over financial reporting as of December 31,2006, is fairly stated, in all material respects, based on criteria establishedin Internal Control—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commissions (COSO). Also, in our opinion, the Companymaintained, in all material respects, effective internal control over financialreporting as of December 31, 2006, based on criteria established inInternal Control—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commissions (COSO).

We also have audited, in accordance with the standardsof the Public Company Accounting Oversight Board (United States), theconsolidated balance sheets of the Company and subsidiaries as of December 31,2006 and 2005, and the related consolidated statements of operations, changesin shareholders’ equity, and cash flows for each of the years in the three-yearperiod ended December 31, 2006, and our report dated March 9, 2007expressed an unqualified opinion on those consolidated financial statements.
| /s/ KPMG LLP             |
|--------------------------|
| Providence, Rhode Island |
| March 9, 2007       |

 

F-2

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**BANCORP RHODEISLAND, INC.**

**Report ofIndependent Registered Public Accounting Firm**

The Board of Directors and ShareholdersBancorp Rhode Island, Inc.:

We have audited the accompanying consolidated balancesheets of Bancorp Rhode Island, Inc. and subsidiaries as of December 31,2006 and 2005, and the related consolidated statements of operations, changesin shareholders’ equity, and cash flows for each of the years in the three-yearperiod ended December 31, 2006. These consolidated financial statementsare the responsibility of the Company’s management. Our responsibility is toexpress an opinion on these consolidated financial statements based on ouraudits.

We conducted our audits in accordance with generallyaccepted auditing standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An auditalso includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of Bancorp Rhode Island, Inc. and subsidiaries as of December 31,2006 and 2005, and the results of their operations and their cash flows foreach of the years in the three-year period ended December 31, 2006, inconformity with U.S. generally accepted accounting principles.

Wehave also audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the effectiveness of Bancorp RhodeIsland, Inc. and subsidiaries’ internal control over financial reportingas of December 31, 2006, based on criteria established in *Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO), and our report dated March 9, 2007 expressed an unqualifiedopinion on management’s assessment of, and the effective operation of, internalcontrol over financial reporting.
| /s/ KPMG LLP             |
|--------------------------|
| Providence, Rhode Island |
| March 9, 2007       |

 

F-3

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**BANCORP RHODE ISLAND, INC.**

**ConsolidatedBalance Sheets**

| ** **                                                                                                                                    | ** ** | **December 31,**   | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                                                                    | ** ** | **2006**                | ** ** | **2005** | ** ** |
| **Assets**                                                                                                                                    | ** ** | **(In thousands)** | ** ** |
| Assets:                                                                                                                                       | ** ** | ** **              | ** ** | ** ** | ** ** |
| Cash and due from banks                                                                                                                       |       | $                       | 24,469     |   | $ | 30,177 |   |
| Overnight investments                                                                                                                         |       | 37,295                  |       | 10,370 |   |
| Total cash and cash equivalents                                                                                                               |       | 61,764                  |       | 40,547 |   |
| Investment securities available for sale (amortized  cost of $104,266 and $153,328, respectively)                                             |       | 103,425                 |       | 150,959 |   |
| Mortgage-backed securities available for sale  (amortized cost of $244,258 and $237,449, respectively)                                        |       | 240,462                 |       | 234,858 |   |
| Total available for sale securities                                                                                                           |       | 343,887                 |       | 385,817 |   |
| Stock in the Federal Home Loan Bank of Boston                                                                                                 |       | 16,530                  |       | 16,062 |   |
| Loans and leases  receivable:                                                                                                                 |       |                    |       |   |   |
| Commercial loans and leases                                                                                                                   |       | 519,790                 |       | 438,309 |   |
| Residential mortgage loans                                                                                                                    |       | 263,945                 |       | 306,016 |   |
| Consumer and other loans                                                                                                                      |       | 220,557                 |       | 206,481 |   |
| Total loans and leases receivable                                                                                                             |       | 1,004,292               |       | 950,806 |   |
| Allowance for loan and lease losses                                                                                                           |       | (12,377                 | )          | (11,665 | ) |
| Net loans and leases receivable                                                                                                               |       | 991,915                 |       | 939,141 |   |
| Premises and equipment, net                                                                                                                   |       | 13,736                  |       | 14,858 |   |
| Goodwill, net                                                                                                                                 |       | 11,317                  |       | 11,234 |   |
| Accrued interest receivable                                                                                                                   |       | 6,755                   |       | 6,965 |   |
| Investment in bank-owned life insurance                                                                                                       |       | 23,148                  |       | 18,824 |   |
| Prepaid expenses and other assets                                                                                                             |       | 10,047                  |       | 9,334 |   |
| Total assets                                                                                                                                  |       | $                       | 1,479,099  |   | $ | 1,442,782 |   |
| **Liabilities  and Shareholders’ Equity**                                                                                                | ** ** | ** **              | ** ** | ** ** | ** ** |
| Liabilities:                                                                                                                                  |       |                    |       |   |   |
| Deposits:                                                                                                                                     |       |                    |       |   |   |
| Demand deposit accounts                                                                                                                       |       | $                       | 200,282    |   | $ | 185,089 |   |
| NOW accounts                                                                                                                                  |       | 70,736                  |       | 89,594 |   |
| Money market accounts                                                                                                                         |       | 6,991                   |       | 12,122 |   |
| Savings accounts                                                                                                                              |       | 356,707                 |       | 341,115 |   |
| Certificate of deposit accounts                                                                                                               |       | 381,707                 |       | 353,049 |   |
| Total deposits                                                                                                                                |       | 1,016,423               |       | 980,969 |   |
| Overnight and short-term borrowings                                                                                                           |       | 56,341                  |       | 26,238 |   |
| Wholesale repurchase agreements                                                                                                               |       | 20,000                  |       | 20,000 |   |
| Federal Home Loan Bank of Boston borrowings                                                                                                   |       | 242,198                 |       | 279,973 |   |
| Subordinated deferrable interest debentures                                                                                                   |       | 18,558                  |       | 18,558 |   |
| Other liabilities                                                                                                                             |       | 13,494                  |       | 12,212 |   |
| Total liabilities                                                                                                                             |       | 1,367,014               |       | 1,337,950 |   |
| Shareholders’  equity:                                                                                                                   |       |                    |       |   |   |
| Preferred stock, par value $0.01 per share,  authorized 1,000,000 shares: Issued and outstanding: none                                        |       | —                  |       | — |   |
| Common stock, par value $0.01 per share, authorized  11,000,000 shares: Issued and outstanding: 4,792,380 and 4,719,126 shares,  respectively |       | 48                      |       | 47 |   |
| Additional paid-in capital                                                                                                                    |       | 67,960                  |       | 65,768 |   |
| Retained earnings                                                                                                                             |       | 47,091                  |       | 42,241 |   |
| Accumulated other comprehensive loss, net                                                                                                     |       | (3,014                  | )          | (3,224 | ) |
| Total shareholders’ equity                                                                                                               |       | 112,085                 |       | 104,832 |   |
| Total liabilities  and shareholders’ equity                                                                                              |       | $                       | 1,479,099  |   | $ | 1,442,782 |   |

 

See accompanying notes to consolidated financial statements.

F-4

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**BANCORP RHODE ISLAND, INC.**

**ConsolidatedStatements of Operations**

| ** **                                                     | ** ** | **Year Ended December 31,**                         | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **2006**                                                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                     | ** ** | **(In thousands, except per share data)** | ** ** |
| Interest and dividend  income:                                 |       |                                                               |       |   |   |   |   |
| Loans and leases                                               |       | $                                                                  | 62,992     |   | $ | 53,822 |   | $ | 47,112 |   |
| Mortgage-backed securities                                     |       | 10,542                                                             |       | 9,313 |   | 5,709 |   |
| Investment securities                                          |       | 6,245                                                              |       | 5,537 |   | 4,452 |   |
| Overnight investments                                          |       | 517                                                                |       | 201 |   | 138 |   |
| Federal Home Loan Bank of Boston stock dividends               |       | 906                                                                |       | 647 |   | 308 |   |
| Total interest and dividend income                             |       | 81,202                                                             |       | 69,520 |   | 57,719 |   |
| Interest expense:                                              |       |                                                               |       |   |   |   |   |
| Deposits                                                       |       | 22,476                                                             |       | 14,521 |   | 10,922 |   |
| Overnight and short-term borrowings                            |       | 2,124                                                              |       | 652 |   | 157 |   |
| Wholesale repurchase agreements                                |       | 870                                                                |       | 276 |   | — |   |
| Federal Home Loan Bank of Boston borrowings                    |       | 12,044                                                             |       | 9,898 |   | 7,505 |   |
| Subordinated deferrable interest debentures                    |       | 1,460                                                              |       | 1,272 |   | 1,041 |   |
| Total interest expense                                         |       | 38,974                                                             |       | 26,619 |   | 19,625 |   |
| Net interest income                                            |       | 42,228                                                             |       | 42,901 |   | 38,094 |   |
| Provision for loan and lease losses                            |       | 1,202                                                              |       | 1,423 |   | 836 |   |
| Net interest income after provision for loan and lease  losses |       | 41,026                                                             |       | 41,478 |   | 37,258 |   |
| Noninterest income:                                            |       |                                                               |       |   |   |   |   |
| Service charges on deposit accounts                            |       | 5,055                                                              |       | 4,561 |   | 4,514 |   |
| Commissions on nondeposit investment products                  |       | 872                                                                |       | 849 |   | 973 |   |
| Income from bank-owned life insurance                          |       | 785                                                                |       | 691 |   | 641 |   |
| Loan related fees                                              |       | 694                                                                |       | 1,024 |   | 541 |   |
| Commissions on loans originated for others                     |       | 159                                                                |       | 184 |   | 71 |   |
| Net (loss) gain on available for sale securities               |       | (859                                                               | )          | 181 |   | 90 |   |
| Net gain on sales of premises and equipment                    |       | —                                                             |       | — |   | 535 |   |
| Other income                                                   |       | 2,282                                                              |       | 1,784 |   | 1,216 |   |
| Total noninterest income                                       |       | 8,988                                                              |       | 9,274 |   | 8,581 |   |
| Noninterest expense:                                           |       |                                                               |       |   |   |   |   |
| Salaries and employee benefits                                 |       | 20,636                                                             |       | 19,476 |   | 17,072 |   |
| Occupancy                                                      |       | 3,564                                                              |       | 3,126 |   | 2,669 |   |
| Data processing                                                |       | 2,880                                                              |       | 2,759 |   | 2,832 |   |
| Professional services                                          |       | 2,186                                                              |       | 2,017 |   | 1,965 |   |
| Marketing                                                      |       | 1,880                                                              |       | 1,584 |   | 1,429 |   |
| Equipment                                                      |       | 1,407                                                              |       | 1,569 |   | 1,591 |   |
| Loan servicing                                                 |       | 917                                                                |       | 968 |   | 1,092 |   |
| Loan workout and other real estate owned                       |       | 188                                                                |       | 217 |   | 110 |   |
| Other expenses                                                 |       | 5,069                                                              |       | 4,627 |   | 4,169 |   |
| Total noninterest expense                                      |       | 38,727                                                             |       | 36,343 |   | 32,929 |   |
| Income before income taxes                                     |       | 11,287                                                             |       | 14,409 |   | 12,910 |   |
| Income tax expense                                             |       | 3,576                                                              |       | 4,840 |   | 4,296 |   |
| Net income                                                     |       | $                                                                  | 7,711      |   | $ | 9,569 |   | $ | 8,614 |   |
| Weighted average shares outstanding—basic                 |       | 4,766,854                                                          |       | 4,478,081 |   | 3,975,413 |   |
| Weighted average shares outstanding—diluted               |       | 4,920,569                                                          |       | 4,697,134 |   | 4,222,856 |   |
| Per share data:                                                |       |                                                               |       |   |   |   |   |
| Basic earnings per common share                                |       | $                                                                  | 1.62       |   | $ | 2.14 |   | $ | 2.17 |   |
| Diluted earnings per common share                              |       | $                                                                  | 1.57       |   | $ | 2.04 |   | $ | 2.04 |   |
| Cash dividends  declared per common share                      |       | $                                                                  | 0.60       |   | $ | 0.60 |   | $ | 0.58 |   |

 

See accompanying notes to consolidated financial statements.

F-5

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**BANCORP RHODE ISLAND, INC.**

**ConsolidatedStatements of Changes in Shareholders’ EquityFor Years Ended December 31, 2006, 2005 and 2004**

| ** **                                                                          | ** ** | **Preferred  Stock**                                               | ** ** | **Common   Stock** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Retained  Earnings** | ** ** | **Accumulated  Other  Comprehensive  Income/(Loss)** | ** ** | **Total** | ** ** |
|-------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-------------------------|------------|----------------------------------|------------|------------------------|------------|------------------------------------------------------|------------|-----------|------------|
|                                                                                |       | **(In thousands, except per share info)** |       |
| Balance at December 31, 2003                                                   |       |                                                               | $          | —                  |       |                             |       | $                      | 39         |                                                 |       |      | $          | 41,439 |   |   | $ | 29,074 |   |   | $ | 1,555 |   |   | 72,107 |   |
| Net income                                                                          |       |                                                               | —     |                    |       |                             | —     |                   |       |                                                 | —     |      |       | 8,614 |   |   | — |   |   | 8,614 |   |
| Other  comprehensive income:                                                        |       |                                                               |       |                    |       |                             |       |                   |       |                                                 |       |      |       |   |   |   |   |   |   |   |   |
| Unrealized holding losses on securities available for  sale, net of taxes of $432   |       |                                                               |       |                    |       |                             |       |                   |       |                                                 |       |      |       |   |   |   | (838 | ) |   | (838 | ) |
| Reclassification adjustment,  net of taxes of $31                                   |       |                                                               |       |                    |       |                             |       |                   |       |                                                 |       |      |       |   |   |   | (59 | ) |   | (59 | ) |
| Comprehensive income                                                                |       |                                                               |       |                    |       |                             |       |                   |       |                                                 |       |      |       |   |   |   |   |   |   | 7,717 |   |
| Exercise of stock options                                                           |       |                                                               | —     |                    |       |                             | —     |                   |       |                                                 | 566        |      |       | — |   |   | — |   |   | 566 |   |
| Exercise of stock warrants                                                          |       |                                                               | —     |                    |       |                             | 1          |                   |       |                                                 | 699        |      |       | — |   |   | — |   |   | 700 |   |
| Tax benefit from exercise of stock options                                          |       |                                                               | —     |                    |       |                             | —     |                   |       |                                                 | 113        |      |       | — |   |   | — |   |   | 113 |   |
| Share-based compensation                                                            |       |                                                               | —     |                    |       |                             | —     |                   |       |                                                 | 35         |      |       | — |   |   | — |   |   | 35 |   |
| Dividends on common stock  ($0.58 per common share)                                 |       |                                                               | —     |                    |       |                             | —     |                   |       |                                                 | —     |      |       | (2,315 | ) |   | — |   |   | (2,315 | ) |
| Balance at December 31, 2004                                                   |       |                                                               | —     |                    |       |                             | 40         |                   |       |                                                 | 42,852     |      |       | 35,373 |   |   | 658 |   |   | 78,923 |   |
| Net income                                                                          |       |                                                               | —     |                    |       |                             | —     |                   |       |                                                 | —     |      |       | 9,569 |   |   | — |   |   | 9,569 |   |
| Other  comprehensive income:                                                        |       |                                                               |       |                    |       |                             |       |                   |       |                                                 |       |      |       |   |   |   |   |   |   |   |   |
| Unrealized holding losses on securities available for  sale, net of taxes of $2,027 |       |                                                               |       |                    |       |                             |       |                   |       |                                                 |       |      |       |   |   |   | (3,764 | ) |   | (3,764 | ) |
| Reclassification adjustment,  net of taxes of $63                                   |       |                                                               |       |                    |       |                             |       |                   |       |                                                 |       |      |       |   |   |   | (118 | ) |   | (118 | ) |
| Comprehensive income                                                                |       |                                                               |       |                    |       |                             |       |                   |       |                                                 |       |      |       |   |   |   |   |   |   | 5,687 |   |
| Proceeds from stock offering, net                                                   |       |                                                               | —     |                    |       |                             | 7          |                   |       |                                                 | 21,450     |      |       |   |   |   |   |   |   | 21,457 |   |
| Acquisition of Macrolease                                                           |       |                                                               | —     |                    |       |                             | —     |                   |       |                                                 | 250        |      |       |   |   |   |   |   |   | 250 |   |
| Exercise of stock options                                                           |       |                                                               | —     |                    |       |                             | —     |                   |       |                                                 | 825        |      |       | — |   |   | — |   |   | 825 |   |
| Share-based compensation                                                            |       |                                                               | —     |                    |       |                             | —     |                   |       |                                                 | 49         |      |       | — |   |   | — |   |   | 49 |   |
| Tax benefit from exercise of stock options                                          |       |                                                               | —     |                    |       |                             | —     |                   |       |                                                 | 309        |      |       | — |   |   | — |   |   | 309 |   |
| Common stock issued for incentive  stock award, net                                 |       |                                                               | —     |                    |       |                             | —     |                   |       |                                                 | 33         |      |       | — |   |   | — |   |   | 33 |   |
| Dividends on common stock ($0.60 per  common share)                                 |       |                                                               | —     |                    |       |                             | —     |                   |       |                                                 | —     |      |       | (2,701 | ) |   | — |   |   | (2,701 | ) |
| Balance at December 31, 2005                                                   |       |                                                               | —     |                    |       |                             | 47         |                   |       |                                                 | 65,768     |      |       | 42,241 |   |   | (3,224 | ) |   | 104,832 |   |
| Net income                                                                          |       |                                                               | —     |                    |       |                             | —     |                   |       |                                                 | —     |      |       | 7,711 |   |   | — |   |   | 7,711 |   |
| Other  comprehensive income:                                                        |       |                                                               |       |                    |       |                             |       |                   |       |                                                 |       |      |       |   |   |   |   |   |   |   |   |
| Unrealized holding losses on securities available for  sale, net of taxes of $122   |       |                                                               |       |                    |       |                             |       |                   |       |                                                 |       |      |       |   |   |   | (348 | ) |   | (348 | ) |
| Reclassification adjustment,  net of taxes of $(301)                                |       |                                                               |       |                    |       |                             |       |                   |       |                                                 |       |      |       |   |   |   | 558 |   |   | 558 |   |
| Comprehensive income                                                                |       |                                                               |       |                    |       |                             |       |                   |       |                                                 |       |      |       |   |   |   |   |   |   | 7,921 |   |
| Exercise of stock options                                                           |       |                                                               | —     |                    |       |                             | 1          |                   |       |                                                 | 1,662      |      |       | — |   |   | — |   |   | 1,663 |   |
| Acquisition of Macrolease                                                           |       |                                                               | —     |                    |       |                             | —     |                   |       |                                                 | 83         |      |       | — |   |   | — |   |   | 83 |   |
| Share-based compensation                                                            |       |                                                               | —     |                    |       |                             | —     |                   |       |                                                 | 186        |      |       | — |   |   | — |   |   | 186 |   |
| Tax benefit from exercise of stock options                                          |       |                                                               | —     |                    |       |                             | —     |                   |       |                                                 | 261        |      |       | — |   |   | — |   |   | 261 |   |
| Dividends on common stock ($0.60 per  common share)                                 |       |                                                               | —     |                    |       |                             | —     |                   |       |                                                 | —     |      |       | (2,861 | ) |   | — |   |   | (2,861 | ) |
| Balance at  December 31, 2006                                                  |       |                                                               | $          | —                  |       |                             |       | $                      | 48         |                                                 |       |      | $          | 67,960 |   |   | $ | 47,091 |   |   | $ | (3,014 | ) |   | $ | 112,085 |   |
|                                                                                     |            |                                                                    |            |                         |            |                                  |            |                        |            |                                                      |            |           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

See accompanying notes to consolidated financial statements.

F-6

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**BANCORPRHODE ISLAND, INC.Consolidated Statements of Cash Flows**

| ** **                                                                        | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                        | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                        | ** ** | **(In thousands)**                    | ** ** |
| Cash flows from operating  activities:                                            |       |                                       |       |   |   |   |   |
| Net income                                                                        |       | $                                          | 7,711      |   | $ | 9,569 |   | $ | 8,614 |   |
| Adjustment  to reconcile net income to net cash provided by operating activities: |       |                                       |       |   |   |   |   |
| Depreciation, amortization and accretion                                          |       | 550                                        |       | 2,680 |   | 3,656 |   |
| Provision for loan and lease losses                                               |       | 1,202                                      |       | 1,423 |   | 836 |   |
| Net loss/(gain) on sale of available for sale  securities                         |       | 859                                        |       | (181 | ) | (90 | ) |
| Net gain on sales of premises and equipment                                       |       | —                                     |       | — |   | (535 | ) |
| Net gain on other real estate owned                                               |       | —                                     |       | (14 | ) | (2 | ) |
| Income from bank-owned life insurance                                             |       | (785                                       | )          | (691 | ) | (641 | ) |
| Share-based compensation expense                                                  |       | 186                                        |       | 82 |   | 35 |   |
| Tax benefit from exercise of stock options                                        |       | —                                     |       | 309 |   | 113 |   |
| (Increase) decrease in accrued interest receivable                                |       | 210                                        |       | (1,299 | ) | (69 | ) |
| (Increase) in prepaid expenses and other assets                                   |       | (826                                       | )          | (2,445 | ) | (479 | ) |
| Increase in other liabilities                                                     |       | 1,282                                      |       | 3,623 |   | 1,127 |   |
| Other, net                                                                        |       | 28                                         |       | (355 | ) | (101 | ) |
| Net cash provided by operating activities                                         |       | 10,417                                     |       | 12,701 |   | 12,464 |   |
| Cash flows from investing  activities:                                            |       |                                       |       |   |   |   |   |
| Investment  securities available for sale:                                        |       |                                       |       |   |   |   |   |
| Purchases                                                                         |       | (32,990                                    | )          | (63,520 | ) | (63,982 | ) |
| Maturities and principal repayments                                               |       | 20,085                                     |       | 13,999 |   | 46,000 |   |
| Proceeds from sales                                                               |       | 60,982                                     |       | — |   | 10,946 |   |
| Mortgage-backed  securities available for sale:                                   |       |                                       |       |   |   |   |   |
| Purchases                                                                         |       | (51,825                                    | )          | (142,287 | ) | (107,486 | ) |
| Maturities and principal repayments                                               |       | 44,460                                     |       | 50,654 |   | 47,759 |   |
| Proceeds from sales                                                               |       | 445                                        |       | 13,754 |   | 5,572 |   |
| Net (increase) decrease in loans and leases                                       |       | (35,047                                    | )          | 7 |   | (14,165 | ) |
| Purchase of loans and leases, including purchased  interest                       |       | (17,098                                    | )          | (65,755 | ) | (58,720 | ) |
| Purchase of Federal Home Loan Bank of Boston stock                                |       | (468                                       | )          | (2,833 | ) | (3,675 | ) |
| Capital expenditures for premises and equipment                                   |       | (2,259                                     | )          | (5,372 | ) | (2,165 | ) |
| Proceeds from sale of premises and equipment                                      |       | 1,209                                      |       | — |   | 1,206 |   |
| Proceeds from disposition of other real estate owned                              |       | —                                     |       | 261 |   | 2 |   |
| Purchase of bank-owned life insurance                                             |       | (3,539                                     | )          | — |   | (2,000 | ) |
| Net cash used in investing activities                                             |       | (16,045                                    | )          | (201,092 | ) | (140,708 | ) |
| Cash flows from financing  activities:                                            |       |                                       |       |   |   |   |   |
| Net increase in deposits                                                          |       | 35,454                                     |       | 100,295 |   | 69,391 |   |
| Net increase (decrease) in overnight and short-term  borrowings                   |       | 30,103                                     |       | 8,188 |   | 4,590 |   |
| Proceeds from long-term borrowings                                                |       | 200,000                                    |       | 333,908 |   | 204,155 |   |
| Repayment of long-term borrowings                                                 |       | (237,775                                   | )          | (268,713 | ) | (140,981 | ) |
| Proceeds from issuance of common stock                                            |       | 1,663                                      |       | 22,282 |   | 1,266 |   |
| Tax benefit from exercise of stock options                                        |       | 261                                        |       | — |   | — |   |
| Dividends on common stock                                                         |       | (2,861                                     | )          | (2,701 | ) | (2,315 | ) |
| Net cash provided by financing activities                                         |       | 26,845                                     |       | 193,259 |   | 136,106 |   |
| Net increase (decrease) in cash and cash equivalents                              |       | 21,217                                     |       | 4,868 |   | 7,862 |   |
| Cash and cash equivalents at beginning of year                                    |       | 40,547                                     |       | 35,679 |   | 27,817 |   |
| Cash and cash equivalents at end of year                                          |       | $                                          | 61,764     |   | $ | 40,547 |   | $ | 35,679 |   |
| Supplementary  disclosures:                                                       |       |                                       |       |   |   |   |   |
| Cash paid for interest                                                            |       | $                                          | 36,818     |   | $ | 25,137 |   | $ | 19,305 |   |
| Cash paid for income taxes                                                        |       | 3,736                                      |       | 5,592 |   | 4,729 |   |
| Non-cash  transactions:                                                           |       |                                       |       |   |   |   |   |
| Macrolease acquisition                                                            |       | 83                                         |       | 250 |   | — |   |
| Change in  accumulated other comprehensive income, net of taxes                   |       | 210                                        |       | (3,882 | ) | (897 | ) |

 

See accompanying notes to consolidated financial statements

F-7

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**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements**

**(1)**          Organization

Bancorp Rhode Island, Inc. (the “Company”), aRhode Island corporation, is the holding company for Bank Rhode Island (the “Bank”).The Company has no significant assets other than the common stock of the Bank.For this reason, substantially all of the discussion in these ConsolidatedFinancial Statements and accompanying Notes relates to the operations of theBank and its subsidiaries.

The Bank is a commercialbank chartered as a financial institution in the State of Rhode Island. TheBank pursues a community banking mission and is principally engaged inproviding banking products and services to businesses and individuals in RhodeIsland and nearby areas of Massachusetts. The Bank is subject to competitionfrom a variety of traditional and nontraditional financial service providersboth within and outside of Rhode Island. The Bank offers its customers a widerange of business, commercial real estate, consumer and residential loans andleases, deposit products, nondeposit investment products, cash management,private banking and other banking products and services designed to meet thefinancial needs of individuals and small- to mid-sized businesses. The Bankalso offers both commercial and consumer on-line banking products and maintainsa web site at *http://www.bankri.com*.The Company and Bank are subject to the regulations of certain federal andstate agencies and undergo periodic examinations by those regulatoryauthorities. The Bank’s deposits are insured by the Federal Deposit InsuranceCorporation (“FDIC”), subject to regulatory limits. The Bank is also a memberof the Federal Home Loan Bank of Boston (“ FHLB”).

**(2)**          Summaryof Significant Accounting Policies

*Basisof Presentation—**The*accounting and reportingpolicies of the Company conform to U.S. generally accepted accountingprinciples and to prevailing practices within the banking industry. The Companyhas one reportable operating segment. The following is a summary of thesignificant accounting and reporting policies used by management in preparingand presenting the consolidated financial statements.

*Useof Estimates—**In*preparing the consolidatedfinancial statements, management is required to make estimates and assumptionsthat affect the reported amounts of assets and liabilities as of the date ofthe balance sheet and revenues and expenses for the period. Actual resultscould differ from those estimates. Material estimates that are particularlysusceptible to change relate to the determination of the allowance for creditlosses, review of goodwill for impairment and income taxes.

*Principlesof Consolidation—**At*December 31, 2006 and 2005,the consolidated financial statements include the accounts of Bancorp RhodeIsland, Inc., and its wholly-owned subsidiary, Bank Rhode Island, along withthe Bank’s wholly-owned subsidiaries, BRI Investment Corp. (a Rhode Islandpassive investment company), BRI Realty Corp. (a Rhode Island real estateholding company), Acorn Insurance Agency, Inc. (a licensed insuranceagency) and Macrolease Corporation (an equipment leasing company). Allsignificant intercompany accounts and transactions have been eliminated inconsolidation.

*Cash and Cash Equivalents—*Forpurposes of the consolidated statements of cash flows, the Company considerscash, due from banks, and overnight investments to be cash equivalents. Cashflows relating to deposits are presented net in the statements of cash flows.

*Securities—*Debt securities are classified asavailable for sale, held to maturity or trading. Securities are classified as heldto maturity and carried at amortized cost only if the Company has a positiveintent and the ability to hold these securities to maturity. Securities areclassified as trading and carried at fair 

F-8

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**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

value, with unrealizedgains and losses included in earnings, if they are bought and held principallyfor the purpose of selling in the near term. Securities not classified aseither held to maturity or trading are classified as available for sale andreported at fair value, with unrealized gains and losses excluded from earningsand reported as a separate component of shareholders’ equity, net of estimatedincome taxes. As of December 31, 2006 and 2005, all of the Company’sinvestment and mortgage-backed securities were classified as available forsale.

Declines in the fair values of securities below theircost that are deemed to be other-than-temporary are reflected in earnings inthe period that management concludes that other-than-temporary impairmentoccurs. The Company uses various indicators in determining whether a securityis other-than-temporarily impaired, including for debt securities, when it isprobable that the contractual interest and principal will not be collected.

Interest income from debt securities is recorded onthe accrual basis. Premiums and discounts on securities are amortized oraccreted into income by the level yield method. Such amortization and accretionis recorded as an adjustment to interest income. FHLB stock is carried at cost.Dividend income from FHLB stock is recorded on the ex-dividend date. Gains andlosses on the sale of securities are recognized at the time of sale on aspecific identification basis.

*Loans and Leases Receivable*—Loansare stated at the principal amount outstanding, net of unamortized premiums anddiscounts and net of deferred loan fees and/or costs which are amortized as anadjustment to yield over the life of the related loans. When loans and leasesare paid-off, the unamortized portion of premiums, discounts or net fees isrecognized into income. Interest income is accrued on a level yield basis overthe life of the loan.

Leases which meet the appropriate criteria specifiedin Statement of Financial Accounting Standard (“SFAS”) 13, “*Accounting for Leases*”, are classified as direct financeleases. Direct finance leases are recorded upon acceptance of the equipment bythe customer. Unearned lease income represents the excess of the gross leaseinvestment over the cost of the leased equipment, which is recognized over thelease term at a constant rate of return on the net investment in the lease.

Loan and lease origination fees, net of certain directorigination costs, and premiums and discounts on loans purchased are recognizedin interest income over the lives of the loans using a method approximating theinterest method.

Loans on which the accrual of interest has beendiscontinued are designated nonaccrual loans. Accrual of interest income isdiscontinued when concern exists as to the collectibility of principal orinterest, or typically when a loan becomes over 90 days delinquent.Additionally, when a loan is placed on nonaccrual status, all interestpreviously accrued but not collected is reversed against current period income.Loans are removed from nonaccrual when they become less than 90 days past dueand when concern no longer exists as to the collectibility of principal orinterest. Interest collected on nonaccruing loans is either applied againstprincipal or reported as income according to management’s judgment as to thecollectibility of principal.

Impaired loans are loans for which it is probable thatthe Bank will not be able to collect all amounts due according to thecontractual terms of the loan agreements. Impairment is measured on adiscounted cash flow method, or at the loan’s observable market price, or atthe fair value of the collateral if the loan is collateral dependent. Whenforeclosure is probable, impairment is measured based on the fair value of 

F-9

----

**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

the collateral. Inaddition, the Bank classifies a loan as an in-substance foreclosure when the Bankis in possession of the collateral prior to actually foreclosing.

*Allowance for Credit Losses—*Theallowance for loan and lease losses and reserve for unfunded lendingcommitments, collectively referred to as the allowance for credit losses, areestablished for credit losses inherent in the loan and lease portfolio andinherent in the unfunded lending commitments through a charge to earnings. Theallowance for credit losses is maintained at a level management considersappropriate to provide for the current inherent risk of loss based upon anevaluation of known and inherent risks in the loan and lease portfolio, as wellas the unfunded lending commitments.

When management believes that the collectibility of aloan or lease’s principal balance, or portions thereof, is unlikely, theprincipal amount is charged against the allowance for loan and lease losses.Recoveries on loans and leases that have been previously charged off arecredited to the allowance for loan and lease losses as received. Increases tothe allowance for loan and leases are made by charges to provision for loan andlease losses.

In addition to the allowance for loan and leaselosses, management also estimates probable losses related to unfunded lendingcommitments. In the third quarter of 2006, the Company reclassified the reservefor unfunded lending commitments from the allowance for loan and lease lossesto other liabilities for all periods presented. Additions to the reserve forunfunded lending commitments are made by charges to other expenses.

Management’s methodology to estimate loss exposureinherent in the portfolio includes an analysis of individual loans orleases deemed to be impaired, reserve allocations for various loan and leasetypes based on payment status or loss experience and an unallocated allowancethat is maintained based on management’s assessment of many factors including,but not limited to, the growth, composition and quality of the loan and leaseportfolio, historical loss experience, industry loss experience and generaleconomic conditions. Management employs a similar process with respect tounfunded lending commitments. While management evaluates currently availableinformation in establishing the allowance for loan and lease losses and thereserve for unfunded lending commitments, future adjustments to the allowancefor credit losses may be necessary if conditions differ substantially from theassumptions used in making the evaluations. The factors supporting theallowance for loan and lease losses and the reserve for unfunded lendingcommitments do not diminish the fact that the entire allowance for loan andlease losses and the reserve for unfunded lending commitments are available toabsorb losses in the loan portfolio and related commitment portfolio, respectively.The Company’s primary concern is the appropriateness of the total allowance forloan and lease losses and reserve for unfunded lending commitments. Managementperforms a comprehensive review of the allowance for loan and lease losses andthe reserve for unfunded lending commitments on a quarterly basis.

In addition, various regulatory agencies, as anintegral part of their examination process, periodically review a financialinstitution’s allowance for credit losses. Such agencies may require the financialinstitution to recognize additions to the allowance based on their judgmentsabout information available to them at the time of their examination.

*Other Real Estate Owned—*OtherReal Estate Owned (“OREO”) consists of property acquired through foreclosure,real estate acquired through acceptance of a deed in lieu of foreclosure andloans determined to be substantively repossessed. Real estate loans that aresubstantively repossessed include 

F-10

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**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

only those loans for whichthe Company has taken possession of the collateral, but has not completed legalforeclosure proceedings.

OREO, including realestate substantively repossessed, is stated at the lower of cost or fair value,minus estimated costs to sell, at the date of acquisition or classification toOREO status. Fair value of such assets is determined based on independentappraisals and other relevant factors. Any write-down to fair value at the timeof foreclosure is charged to the allowance for loan losses. A valuationallowance is maintained for known specific and potential market declines andfor estimated selling expenses. Increases to the valuation allowance, expensesassociated with ownership of these properties, and gains and losses from theirsale, are reflected in operations as incurred. Realized gains and losses upondisposal are recognized as adjustments to noninterest income or noninterestexpense.

*Premises and Equipment—*Landis carried at cost. Premises and equipment are carried at cost, lessaccumulated depreciation *and*amortization. Depreciation and amortization are computed primarily by thestraight-line method over the estimated useful lives of the assets, or theterms of the leases if shorter.

*Impairment of Long-Lived Assetsexcept Goodwill—*The Company reviews long-lived assets,including premises and equipment and other intangible assets for impairment atleast annually or whenever events or changes in business circumstances indicatethat the remaining useful life may warrant revision or that the carrying amountof the long-lived asset may not be fully recoverable. The Company performsundiscounted cash flow analyses to determine if impairment exists. Ifimpairment is determined to exist, any related impairment loss is calculatedbased on fair value. Impairment losses on assets to be disposed of, if any, arebased on the estimated proceeds to be received, less any costs of disposal.

*Goodwill*—Goodwillrepresents the excess of the cost of an acquisition over the fair value of thetangible and identifiable intangible assets acquired. Goodwill is not amortizedover an estimated life, but rather is tested at least annually for impairmentusing market value comparisons. In the event that the Company was to determinethat its goodwill was impaired, an impairment writedown would be chargedagainst earnings.

*Bank-Owned Life*Insurance*—*Bank-owned life insurance (“BOLI”)represents life insurance on the lives of certain employees who have providedpositive consent allowing the Bank to be the beneficiary of such policies. TheBank utilizes BOLI as tax-efficient financing for the Bank’s benefitobligations to its employees, including the Bank’s obligations under itsSupplemental Executive Retirement Plans. Since the Bank is the primarybeneficiary of the insurance policies, increases in the cash value of the policies,as well as insurance proceeds received, are recorded in noninterest income, andare not subject to income taxes. BOLI is recorded at the cash value of thepolicies, less any applicable cash surrender charges, and is reflected as anasset in the accompanying consolidated balance sheets. The Bank reviews thefinancial strength of the insurance carriers prior to the purchase of BOLI toensure minimum credit ratings of at least investment grade. The financialstrength of the carriers are reviewed at least annually and BOLI with anyindividual carrier is limited to 10% of capital plus reserves.

*Securities Sold Under Agreements toRepurchase—*The Bank enters into sales of securities underagreements to repurchase, with both the Bank’s commercial customers (“retailrepurchase agreements”) and financial institutions (“wholesale repurchaseagreements”). These agreements are treated as financings, and the obligationsto repurchase securities sold are reflected as a liability in the consolidatedbalance sheets. Securities pledged as collateral under agreements to repurchaseare reflected as assets in the accompanying consolidated balance sheets.

F-11

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**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

*Employee Benefits*—TheBank maintains a Section 401(k) savings plan for employees of theBank and its subsidiaries. Under the plan, the Bank makes a matchingcontribution of the amount contributed by each participating employee, up to 4%of the employee’s yearly salary, subject to Internal Revenue Service (“IRS”)limits. The Bank’s contributions are charged against current operations in theyear made.

*Share-*Based*Compensation*—At December 31, 2006, the Company maintained stockoption plans as described more fully in Note 15. Effective January 1,2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”)123-R, *“Share-Based Payment”*, which is a revision to SFAS 123, *“Accounting for Stock-Based Compensation”*.SFAS 123-R focuses primarily on accounting for share-based payments madeto employees. Under SFAS 123-R, the grant date fair value of share-basedawards (primarily stock options for the Company) is recognized as an expense inthe income statement, whereas under SFAS 123, the Company accounted forshare-based awards under the intrinsic value method prescribed by AccountingPrinciples Board (“APB”) Opinion No. 25, *“Accountingfor Stock Issued to Employees”*(“APB 25”).

The Company adopted SFAS 123-R under themodified prospective adoption method. Under that method of adoption, theprovisions of SFAS 123-R are generally only applied to share-based awardsgranted subsequent to adoption and any unvested prior grants. Under SFAS 123-R,share-based awards requiring future service are recognized as compensationexpense over the relevant service period or through the eligible retirementdate if sooner. Share-based awards that do not require future service (“vestedawards”) are expensed immediately. SFAS 123-R also requires the Companyto estimate expected forfeitures in determining compensation expense.Additionally, compensation expense for share-based awards granted toretirement-eligible employees is recognized immediately.

In December 2005, the Executive and CompensationCommittees of the Company’s Board of Directors accelerated the vesting of all89,586 unvested stock options. No other changes were made to the terms andconditions of the options. The Company recorded expenses of $49,000 inconnection with the accelerated vesting. At the time of the vestingacceleration, approximately 79% of the expenses anticipated to be recorded overthe next three years related to stock options that had no intrinsic value, asthe stock options were “out-of-the-money”. Additionally, 73% of the unvestedoptions with a positive intrinsic value, or “in-the-money”, were scheduled tofully vest by April 30, 2006. As a result of this accelerated vesting, theCompany will not be required to recognize anticipated non-cash compensationexpense relating to stock options of approximately $370,000 in 2006, $260,000in 2007 and $70,000 in 2008.

Under SFAS 123, the Company did not recognize compensationexpense for stock options issued prior to January 2006 because the stockoptions had no intrinsic value at grant date, as the exercise price equaled themarket value of the Company’s common stock on the grant date. The Company didrecognize compensation expense related to restricted stock compensation during2005. The relevant service period for this restricted stock award concluded in December 2005.

As indicated above, at the time of adoption of SFAS 123-Ron January 1, 2006, all stock options granted to employees and directorswere fully vested and exercisable. As a result, the transition impact ofadopting SFAS 123-R was not material to the Company’s results ofoperations for the year ended December 31, 2006.

If theCompany had recognized compensation expense for stock options over the relevantservice period, generally 3 to 4 years under the fair value method proscribedby SFAS 123, net income would have 

F-12

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**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

decreased for the prior two years, resulting in proforma net income and earnings per common share (“EPS”) as summarized below:

| ** **                      | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------|------------|--------------------------------------------|------------|
| ** **                      | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| Net income (in  thousands):     |       |                                       |       |   |   |
| As reported                     |       | $                                          | 9,569      |   | $ | 8,614 |   |
| Compensation cost, net of taxes |       | (855                                       | )          | (530 | ) |
| Pro forma                       |       | $                                          | 8,714      |   | $ | 8,084 |   |
| Earnings per common  share:     |       |                                       |       |   |   |
| Basic:                          |       |                                       |       |   |   |
| As reported                     |       | $                                          | 2.14       |   | $ | 2.17 |   |
| Compensation cost, net of taxes |       | (0.19                                      | )          | (0.14 | ) |
| Pro forma                       |       | $                                          | 1.95       |   | $ | 2.03 |   |
| Diluted:                        |       |                                       |       |   |   |
| As reported                     |       | $                                          | 2.04       |   | $ | 2.04 |   |
| Compensation cost, net of taxes |       | (0.18                                      | )          | (0.13 | ) |
| Pro forma                       |       | $                                          | 1.86       |   | $ | 1.91 |   |

 

The compensation cost, net of taxes, for the yearended 2005 reflects the Company’s acceleration of the vesting of alloutstanding options as of December 30, 2005.

*Income Taxes—*TheCompany recognizes income taxes under the asset and liability method. Under thismethod, deferred tax assets and liabilities are established for the future taxconsequences attributable to temporary differences between the financialstatement carrying amounts of existing assets and liabilities and theirrespective tax bases and operatingloss and tax credit carryforwards. Deferred tax assets and liabilities aremeasured using enacted tax rates expected to apply to taxable income in theyears in which those temporary differences are expected to be recovered orsettled. The effect on deferred tax assets and liabilities of a change in taxrates is recognized in income tax expenses during the period that includes theenactment date.

*Revenue Recognition—*Noninterestincome is recognized on theaccrual basis of accounting.

*Comprehensive Income—*Comprehensiveincome is defined as all changes to equity except investments by anddistributions to shareholders. Net income is a component of comprehensiveincome, with all other components referred to in the aggregate as ‘other comprehensive income.’

*Earnings Per Share—*Basicearnings per share (“EPS”) excludes dilution and is computed by dividing incomeavailable to commonshareholders by the weighted average number of common shares outstanding forthe period. Diluted EPS reflects the potential dilution that could occur ifsecurities or other contracts to issue common stock were exercised or convertedinto common stock or resulted in the issuance of common stock that then sharein the earnings of the entity.

*Segment Reporting*—Anoperating segment is defined as a component of a business for which separatefinancial information is available that is evaluated regularly by the chiefoperating decision-maker in deciding how to allocate resources and evaluate performance. The Company’s primarybusiness is banking, which provided substantially all of its total revenues andpre-tax income in 2006, 2005 and 2004. Accordingly, disaggregated segmentinformation is not presented in the notes to the financial statements.

F-13

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**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

*Guarantees*—FASBInterpretation (“FIN”) 45, “*Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others*”, considers standby letters ofcredit, excluding commercial letters of credit and other lines of credit, a guarantee of the Bank. The Bankenters into a standby letter of credit to guarantee performance of a customerto a third party. The credit risk involved is represented by the contractualamounts of those instruments. Under the standby letters of credit, the Bank isrequired to make payments to the beneficiary of the standby letters of creditupon request by the beneficiary so long as all performance criteria have beenmet. Most guarantees extend up to one year.

Pledged collateral including cash, accountsreceivable, inventory, property, plant, equipment and real estate supported allstandby letters of credit outstanding at December 31, 2006 and 2005. Thecollateral obtained is determined based on management’s credit evaluation ofthe customer. Should the Bank be required to make payments to the beneficiaryof a letter of credit, repayment to the Bank is required. When cash collateralis present the recourse provisions of the agreements allow the Bank to collectthe cash used to collateralize the agreement. If any other business assets areused as collateral and cash is not available, the Bank creates a loan for thecustomer with the same criteria as its other lending activities. The standbyletters of credit and the fair value of customer guarantees and cash collateralsupporting the standby letters of credit are not reflected on the balancesheet.

*Reclassifications—*Certainamounts in the prior years’ financial statements may have been reclassified toconform with the current year’s presentation.

*Recent Accounting Developments*—InFebruary 2006, the FASB issued SFAS 155, *“Accountingfor Certain Hybrid Financial Instruments, an amendment of FASB Statements No. 133and 140”*, which permits, but does not require, fair value accountingfor hybrid financial instruments that contain an embedded derivative that wouldotherwise require bifurcation in accordance with SFAS 133, *“Accountingfor Derivative Instruments and Hedging Activities”*. SFAS 155 alsoeliminated the temporary exemption for interests in securitized financialassets provided for by SFAS 133, Derivatives Implementation Group (“DIG”) IssueD1, *“Application of Statement 133 to BeneficialInterests in Securitized Financial Assets”.* However, in January 2007,the FASB issued interpretive guidance in SFAS 133, DIG Issue B40, *“Application of Paragraph 13(b) to Securitized Interests inPrepayable Financial Assets”*, in which the FASB concluded that asecuritized interest in prepayable financial assets was not subject to thebifurcation requirements of SFAS 155 provided that the securitized interest metboth the following criteria: (1) the right to accelerate the settlement ofthe securitized interest cannot be controlled by the investor; and (2) thesecuritized interest itself does not contain an embedded derivative for whichbifurcation would be required other than an embedded derivative that resultssolely from the embedded call options in the underlying financial assets. Theguidance in DIG Issue B40 is effective upon the adoption of SFAS 155. SFAS155 is effective for all financial instruments acquired or issued after December 31,2006, as well as to those hybrid financial instruments that had been previouslybifurcated under SFAS 133. As of December 31, 2006, the Company did nothave any hybrid financial instruments which were previously bifurcated underSFAS 133. Additionally, the guidance provided for in DIG Issue B40 is expectedto allow the Company to continue to purchase mortgage-backed securities withoutapplying the bifurcation requirements of SFAS 155. The Company does notanticipate the adoption of SFAS 155 will have a material effect on itsfinancial statements.

In March 2006, the FASB issued SFAS 156, *“Accounting for Servicing of Financial Assets”*, an amendmentof SFAS 140. This standard requires servicing assets and servicingliabilities be initially 

F-14

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**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

measured at fair valuealong with any derivative instruments used to mitigate inherent risks. SFAS 156is effective for fiscal years beginning after September 15, 2006. TheCompany does not anticipate SFAS 156 will materially impact its consolidatedfinancial statements upon adoption on January 1, 2007.

In March 2006, the FASB Emerging Issues TaskForce (“EITF”) issued interpretive guidance in Issue 06-4 (“EITF 06-4”),in which agreements by companies to share a portion of the proceeds of lifeinsurance policies with an employee during the postretirement period is apostretirement benefit arrangement that must be accounted for under SFAS 106, *“Employers’ Accountingfor Postretirement Benefits Other Than Pensions”*. Under EITF 06-4, the EITF alsoconcluded the purchase of a split-dollar life insurance policy does notconstitute a settlement of the postretirement benefit as defined in SFAS 106.Thus, companies will be required to record a liability upon adoption of EITF 06-4,which is effective for periods beginning after December 15, 2007. TheCompany is currently evaluating the impact EITF 06-4 will have on itsconsolidated financial statements upon adoption on January 1, 2008.

In July 2006, the FASB issued FinancialAccounting Standards Interpretation No. 48 (“FIN 48”), *“Accounting for Uncertainty in Income Taxes”*. FIN 48clarifies the accounting for uncertainty in income taxes recognized in acompany’s financial statements in accordance with SFAS 109, *“Accounting for Income Taxes”*. FIN 48 prescribes arecognition threshold and measurement attributable for the financial statementrecognition and measurement of a tax position taken or expected to be taken ina tax return. FIN 48 also provides guidance on derecognition, classification,interest and penalties, accounting in interim periods, disclosures andtransitions. FIN 48 is effective for fiscal years beginning after December 15,2006. The Company does not anticipate the adoption of FIN 48 will materiallyimpact its consolidated financial statements upon adoption on January 1,2007.

In September 2006, the SEC issued StaffAccounting Bulletin No. 108 (“SAB 108”), *“Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements”*. SAB 108 provides guidanceregarding the process of quantifying financial statements misstatements anddictates that a company should quantify errors using both a balance sheetapproach (the “iron curtain” method) and an income statement approach (the “rollover”approach). The balance sheet approach quantifies a misstatement based on theeffects of correcting the misstatement existing in the balance sheet at the endof the current year, irrespective of the misstatement’s year of origination.The income statement method quantifies a misstatement based on the amount ofthe error originating in the current year income statement, while ignoring thecarryover effects of a prior year misstatement. SAB 108 indicates that acompany should quantify an error under both methods and by evaluating themateriality under both methods. If deemed material, a company is required toadjust their financial statements. SAB 108 was effective for the first fiscalyear ending after November 15, 2006. The Company adopted SAB 108 in thefourth quarter of 2006. SAB 108 did not have a material impact upon adoption.

In September 2006, the FASB issued SFAS No. 157(“SFAS 157”), *“Fair Value Measurements”*. SFAS157 provides guidance for measuring assets and liabilities at fair value. Thisstandard is applicable whenever other standards require or permit assets andliabilities to be measured at fair value, but does not expand upon the use offair value in any new circumstances. SFAS 157 establishes a fair valuehierarchy that gives the highest priority to quoted prices in active marketsand the lowest priority to unobservable data and requires fair valuemeasurements to be disclosed by level within the hierarchy. SFAS 157 iseffective for fiscal years beginning after November 15, 2007. The Companyis currently evaluating the impact SFAS 157 will have on its consolidatedfinancial statements upon adoption on January 1, 2008.

F-15

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**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

In February 2007, theFASB issued SFAS 159, *“The Fair Value Option forFinancial Assets and Financial Liabilities”*. SFAS 159 provides companieswith an option to report selected financial assets and liabilities at fairvalue and to provide additional information that will help investors and otherusers of financial statements to understand more easily the effect on earningsof the company’s choice to use fair value. It also requires companies todisplay the fair value of those assets and liabilities for which the companyhas chosen to use fair value on the face of the balance sheet. The Company iscurrently evaluating the impact SFAS 159 will have on its consolidatedfinancial statements upon adoption on January 1, 2008.

**(3)**          BusinessCombinations

On March 1, 1996, the Bank acquired certainassets and assumed certain liabilities from Fleet Financial Group, Inc.and other related entities. This acquisition was accounted for utilizing thepurchase method of accounting and generated $17.5 million of goodwill. Thisgoodwill was amortized in the years prior to 2002, resulting in a net balanceof $10.8 million.

On May 1, 2005, theBank acquired certain operating assets from Macrolease InternationalCorporation. This acquisition was accounted for utilizing the purchase methodof accounting and has generated $551,000 of goodwill. In connection with thisacquisition, the Company has issued 9,040 shares of its common stock,which were valued at $333,000. In addition, 18,082 shares of the Company’scommon stock may be issued over the next two years contingent upon Macroleasereaching specified performance criteria.

**(4)**          Restrictionson Cash and Due from Banks

The Bank is required tomaintain average reserve balances in a noninterest bearing account with theFederal Reserve Bank based upon a percentage of certain deposits. As of December 31,2006 and 2005, the average daily amount required to be held was $1.0 millionand $774,000, respectively.

**(5)**          InvestmentSecurities Available for Sale

TheCompany categorizes obligations issued by the Federal Home Loan Bank, FederalHome Loan Mortgage Corporation and Federal National Mortgage Association asU.S. Agency obligations. A summary of investment securities available for salefollows:

| ** **                  | ** ** | **Amortized**           | ** ** | **Unrealized** | ** ** | **Fair**   | ** ** |
|-----------------------------|------------|-------------------------|------------|----------------|------------|------------|------------|
| ** **                  | ** ** | **Cost**                | ** ** | **Gains**      | ** ** | **Losses** | ** ** | **Value** | ** ** |
| ** **                  | ** ** | **(In thousands)** | ** ** |
| At December 31,  2006: |       |                    |       |           |       |       |       |   |   |   |   |
| U.S. Agency obligations     |       | $                       | 85,992     |           |       | $          | 1          |   |   | $ | (704 | ) | $ | 85,289 |   |
| Corporate debt securities   |       | 12,122                  |       |           | 7          |       |       | (105 | ) | 12,024 |   |
| Trust preferred securities  |       | 6,152                   |       |           | 49         |       |       | (89 | ) | 6,112 |   |
| Total                       |       | $                       | 104,266    |           |       | $          | 57         |   |   | $ | (898 | ) | $ | 103,425 |   |
| At  December 31, 2005: |       |                    |       |           |       |       |       |   |   |   |   |
| U.S. Agency obligations     |       | $                       | 125,915    |           |       | $          | —     |   |   | $ | (1,921 | ) | $ | 123,994 |   |
| Corporate debt securities   |       | 21,214                  |       |           | 57         |       |       | (608 | ) | 20,663 |   |
| Trust preferred securities  |       | 6,199                   |       |           | 108        |       |       | (5 | ) | 6,302 |   |
| Total                       |       | $                       | 153,328    |           |       | $          | 165        |   |   | $ | (2,534 | ) | $ | 150,959 |   |

 

F-16

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**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

The following table sets forth certain informationregarding temporarily impaired investment securities:

| ** **                  | ** ** | **Less than One Year** | ** ** | **One Year or Longer** | ** **                   | **Total** | ** ** |
|-----------------------------|------------|---------------------------------------|------------|---------------------------------------|------------------------------|-----------|------------|
| ** **                  | ** ** | **Fair**                              | ** ** | **Unrealized**                        | ** **                   | **Fair**  | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                  | ** ** | **Value**                             | ** ** | **Losses**                            | ** **                   | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** |
| ** **                  | ** ** | **(In thousands)**               | ** ** |
| At December 31,  2006: |       |                                  |       |                                  |                         |      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| US Agency obligations       |       | $   29,927             |       |                                  | $    (63 | )         |       | $ 52,361 |   |   | $  (641 | ) |   | $   82,288 |   |   | $   (704 | ) |   |
| Corporate debt securities   |       | 3,995                                 |       |                                  | (9                           | )         |       | 5,990 |   |   | (96 | ) |   | 9,985 |   |   | (105 | ) |   |
| Trust preferred securities  |       | —                                |       |                                  | —                       |      |       | 1,911 |   |   | (89 | ) |   | 1,911 |   |   | (89 | ) |   |
| Total                       |       | $   33,922             |       |                                  | $    (72 | )         |       | $ 60,262 |   |   | $  (826 | ) |   | $   94,184 |   |   | $   (898 | ) |   |
| At  December 31, 2005: |       |                                  |       |                                  |                         |      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| US Agency obligations       |       | $   71,938             |       |                                  | $ (1,077                | )         |       | $ 52,056 |   |   | $  (844 | ) |   | $ 123,994 |   |   | $ (1,921 | ) |   |
| Corporate debt securities   |       | 10,724                                |       |                                  | (352                         | )         |       | 1,799 |   |   | (256 | ) |   | 12,523 |   |   | (608 | ) |   |
| Trust preferred securities  |       | —                                |       |                                  | —                       |      |       | 1,995 |   |   | (5 | ) |   | 1,995 |   |   | (5 | ) |   |
| Total                       |       | $   82,662             |       |                                  | $ (1,429                | )         |       | $ 55,850 |   |   | $ (1,105 | ) |   | $ 138,512 |   |   | $ (2,534 | ) |   |

 

The above securities were deemed to be not other-than-temporarilyimpaired after considering that substantially all of the above securities wererated “investment grade” with unrealized losses primarily caused by marketinterest rate changes. In addition, the Company has the intent and ability to holdall securities with unrealized losses until recovery or maturity.

In making these other-than-temporary impairmentdeterminations, management considers, among other things, the length of timeand extent to which the fair value has been less than cost and the creditworthiness and near-term prospects of the issuer. Also, management considerscapital adequacy, interest rate risk, liquidity and business plans in assessingthe intent and ability to hold all securities with unrealized losses untilrecovery or maturity.

F-17

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**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

Thefollowing table sets forth the contractual maturities of investment securitiesavailable for sale and the weighted average yields of such securities:

|            | ** ** | ** **                    | ** **                 | **After One, But**    | ** ** | **After Five, But**  | ** ** | ** **                    | ** ** |
|------------|------------|-------------------------------|----------------------------|---------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** ** | ** ** | **Within One Year** | ** **                 | **Within Five Years** | ** ** | **Within Ten Years** | ** ** | **After Ten Years** | ** ** |
| ** ** | ** ** | ** **                    | ** **                 | ** **                      | ** ** | **Weighted**                   | ** ** | ** **                    | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** ** | ** ** | **Amortized**                 | ** **                 | **Fair**                        | ** ** | **Average**                    | ** ** | **Amortized**                 | ** ** | **Fair** | ** ** | **Average** | ** ** | **Amortized** | ** ** | **Fair** | ** ** | **Average** | ** ** | **Amortized** | ** ** | **Fair** | ** ** | **Average** | ** ** |
| ** ** | ** ** | **Cost**                      | ** **                 | **Value**                       | ** ** | **Yield**                      | ** ** | **Cost**                      | ** ** | **Value** | ** ** | **Yield** | ** ** | **Cost** | ** ** | **Value** | ** ** | **Yield** | ** ** | **Cost** | ** ** | **Value** | ** ** | **Yield** | ** ** |
| ** ** |       |                          | **(Dollars in thousands)** |                            |       |
|            |            |                               |                            |                                 |            |                                |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

| At December 31, 2006:       |   |   |    |   |   |    |   |   |   |   |   |   |     |   |   |     |   |   |   |   |   |   |          |   |   |   |          |   |   |   |   |   |   |   |                      |   |   |                      |   |   |   |   |   |
|-----------------------------|--------|--------|---------|--------|--------|---------|--------|--------|--------|--------|--------|--------|----------|--------|--------|----------|--------|--------|--------|--------|--------|--------|---------------|--------|--------|--------|---------------|--------|--------|--------|--------|--------|--------|--------|---------------------------|--------|--------|---------------------------|--------|--------|--------|--------|--------|
| U.S. Agency  obligations    |   |   | $9,998  |   |   | $9,959  |   |   | 2.90   | %      |   |   | 75,994   |   |   | $75,330  |   |   | 4.78   | %      |   |   | $ — |   |   |   | $ — |   |   |   | 0.00   | %      |   |   | $   — |   |   | $   — |   |   | 0.00   | %      |   |
| Corporate debt  securities  |   |   | 6,037   |   |   | 6,034   |   |   | 5.33   | %      |   |   | 6,085    |   |   | 5,990    |   |   | 4.93   | %      |   |   | —        |   |   |   | —        |   |   |   | 0.00   | %      |   |   | —                    |   |   | —                    |   |   | 0.00   | %      |   |
| Trust preferred  securities |   |   | —  |   |   | —  |   |   | 0.00   | %      |   |   | —   |   |   | —   |   |   | 0.00   | %      |   |   | —        |   |   |   | —        |   |   |   | 0.00   | %      |   |   | 6,152                     |   |   | 6,112                     |   |   | 7.63   | %      |   |
| Total                       |   |   | $16,035 |   |   | $15,993 |   |   | 3.81   | %      |   |   | $82,079  |   |   | $81,320  |   |   | 4.79   | %      |   |   | $ — |   |   |   | $ — |   |   |   | 0.00   | %      |   |   | $6,152                    |   |   | $6,112                    |   |   | 7.63   | %      |   |
| At December 31, 2005:       |   |   |    |   |   |    |   |   |   |   |   |   |     |   |   |     |   |   |   |   |   |   |          |   |   |   |          |   |   |   |   |   |   |   |                      |   |   |                      |   |   |   |   |   |
| U.S. Agency  obligations    |   |   | $14,992 |   |   | $14,815 |   |   | 2.81   | %      |   |   | $110,923 |   |   | $109,179 |   |   | 4.11   | %      |   |   | $ — |   |   |   | $ — |   |   |   | 0.00   | %      |   |   | $   — |   |   | $   — |   |   | 0.00   | %      |   |
| Corporate debt  securities  |   |   | 5,047   |   |   | 5,045   |   |   | 4.94   | %      |   |   | 16,167   |   |   | 15,618   |   |   | 4.86   | %      |   |   | —        |   |   |   | —        |   |   |   | 0.00   | %      |   |   | —                    |   |   | —                    |   |   | 0.00   | %      |   |
| Trust preferred  securities |   |   | —  |   |   | —  |   |   | 0.00   | %      |   |   | —   |   |   | —   |   |   | 0.00   | %      |   |   | —        |   |   |   | —        |   |   |   | 0.00   | %      |   |   | 6,199                     |   |   | 6,302                     |   |   | 7.34   | %      |   |
| Total                       |   |   | $20,039 |   |   | $19,860 |   |   | 3.35   | %      |   |   | $127,090 |   |   | $124,797 |   |   | 4.21   | %      |   |   | $ — |   |   |   | $ — |   |   |   | 0.00   | %      |   |   | $6,199                    |   |   | $ 6,302              |   |   | 7.34   | %      |   |

 

The weighted average remaining life of investmentsecurities available for sale at December 31, 2006 and 2005 was 2.9 yearsand 2.5 years, respectively. Included in the weighted average remaining lifecalculation at December 31, 2006 and 2005, were $77.1 million and $84.2million, respectively, of securities that are callable at the discretion of theissuer. These call dates were not utilized in computing the weighted averageremaining life.

In September 2006, the Company restructured aportion of its investment portfolio to improve earnings in future periods bycapitalizing on a temporary increase in security valuations due to movements inthe yield curve. The Company sold $62 million of its available for salesecurities and reinvested the sales proceeds into higher-yielding securities.This investment portfolio restructuring resulted in losses of $859,000($852,000 of investment securities and $7,000 of mortgage-backed securities);however, the effect of these security losses on shareholders’ equity wasminimal as the securities had been carried at market value on the balancesheet. As a result of this investment portfolio repositioning, the Companyanticipates an increase of future investment income of over $900,000 by the endof 2007.

The following table presents the sale of investmentsecurities available for sale and the resulting gains and losses from suchsales:

| ** **                                                 | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                 | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                 | ** ** | **(In thousands)**                    | ** ** |
| Amortized cost of  investment securities sold              |       | $ 61,834                              |       |   | $ — |   |   | $ 10,596 |   |
| Gains (losses)  realized on sales of investment securities |       | (852                                       | )          |   | — |   |   | 350 |   |
| Net proceeds from  sales of investment securities          |       | $ 60,982                              |       |   | $ — |   |   | $ 10,946 |   |

 

F-18

----

**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

**(6)**          Mortgage-BackedSecurities Available for Sale

Asummary of mortgage-backed securities available for sale by issuer follows:

| ** **                               | ** ** | **Amortized**                                                       | ** ** | **Unrealized**                     | ** ** | **Fair**                                                                | ** ** |
|------------------------------------------|------------|---------------------------------------------------------------------|------------|------------------------------------|------------|-------------------------------------------------------------------------|------------|
| ** **                               | ** ** | **Cost**                                                            | ** ** | **Gains**                          | ** ** | **Losses**                                                              | ** ** | **Value** | ** ** |
| ** **                               | ** ** | **(In thousands)**                                             | ** ** |
| At  December 31, 2006:              |       |                                                                |       |                               |       |                                                                    |       |   |   |
| Government National Mortgage Association |       | $ 17,432                                                       |       | $ 15                          |       | $  (102                                                       | )          | $ 17,345 |   |
| Federal National Mortgage Association    |       | 109,480                                                             |       | 57                                 |       | (1,645                                                                  | )          | 107,892 |   |
| Federal Home Loan Mortgage Corporation   |       | 30,411                                                              |       | 42                                 |       | (524                                                                    | )          | 29,929 |   |
| Collateralized Mortgage Obligations      |       | 86,935                                                              |       | 18                                 |       | (1,657                                                                  | )          | 85,296 |   |
| Total                                    |       | $       244,258                  |       | $     132 |       | $        (3,928                 | )          | $       240,462 |   |
| At December 31, 2005:               |       |                                                                |       |                               |       |                                                                    |       |   |   |
| Government National Mortgage Association |       | $          23,762 |       | $     160 |       | $           (103 | )          | $          23,819 |   |
| Federal National Mortgage Association    |       | 113,252                                                             |       | 191                                |       | (1,062                                                                  | )          | 112,381 |   |
| Federal Home Loan Mortgage Corporation   |       | 37,528                                                              |       | 53                                 |       | (321                                                                    | )          | 37,260 |   |
| Collateralized Mortgage Obligations      |       | 62,907                                                              |       | —                             |       | (1,509                                                                  | )          | 61,398 |   |
| Total                                    |       | $       237,449                  |       | $     404 |       | $        (2,995                 | )          | $       234,858 |   |

 

Thefollowing table sets forth certain information regarding temporarily impairedinvestment securities:

| ** **                               | ** ** | **Less than One Year** | ** ** | **One Year or Longer** | ** **                   | **Total** | ** ** |
|------------------------------------------|------------|---------------------------------------|------------|---------------------------------------|------------------------------|-----------|------------|
| ** **                               | ** ** | **Fair**                              | ** ** | **Unrealized**                        | ** **                   | **Fair**  | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                               | ** ** | **Value**                             | ** ** | **Losses**                            | ** **                   | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** |
| ** **                               | ** ** | **(In thousands)**               | ** ** |
| At December 31,  2006:              |       |                                  |       |                                  |                         |      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Government National Mortgage Association |       | $   4,655              |       |                                  | $    (16 | )         |       | $   3,123 |   |   | $    (86 | ) |   | $   7,778 |   |   | $  (102 | ) |   |
| Federal National Mortgage Association    |       | 25,041                                |       |                                  | (96                          | )         |       | 77,853 |   |   | (1,549 | ) |   | 102,894 |   |   | (1,645 | ) |   |
| Federal Home Loan Mortgage Corporation   |       | 299                                   |       |                                  | (1                           | )         |       | 26,603 |   |   | (523 | ) |   | 26,902 |   |   | (524 | ) |   |
| Collateralized Mortgage Obligations      |       | 23,752                                |       |                                  | (62                          | )         |       | 52,051 |   |   | (1,595 | ) |   | 75,803 |   |   | (1,657 | ) |   |
| Total                                    |       | $ 53,747                         |       |                                  | $  (175            | )         |       | $ 159,630 |   |   | $ (3,753 | ) |   | $ 213,377 |   |   | $ (3,928 | ) |   |
| At December 31,  2005:              |       |                                  |       |                                  |                         |      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Government National Mortgage Association |       | $   3,913              |       |                                  | $    (52 | )         |       | $   6,953 |   |   | $    (51 | ) |   | $ 10,866 |   |   | $  (103 | ) |   |
| Federal National Mortgage Association    |       | 55,008                                |       |                                  | (676                         | )         |       | 16,225 |   |   | (386 | ) |   | 71,233 |   |   | (1,062 | ) |   |
| Federal Home Loan Mortgage Corporation   |       | 32,901                                |       |                                  | (317                         | )         |       | 412 |   |   | (4 | ) |   | 33,313 |   |   | (321 | ) |   |
| Collateralized Mortgage Obligations      |       | 29,623                                |       |                                  | (555                         | )         |       | 31,775 |   |   | (954 | ) |   | 61,398 |   |   | (1,509 | ) |   |
| Total                                    |       | $ 121,445                        |       |                                  | $ (1,600                | )         |       | $ 55,365 |   |   | $ (1,395 | ) |   | $ 176,810 |   |   | $ (2,995 | ) |   |

 

F-19

----

**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

The above securities were deemed to be not other-than-temporarilyimpaired after considering that all of the above securities were rated “investmentgrade” with unrealized losses caused by market interest rate changes. Inaddition, the Company is able and intends to hold all securities withunrealized losses until recovery or maturity.

In making these other-than-temporary impairmentdeterminations, management considers, among other things, the length of timeand extent to which the fair value has been less than cost and the creditworthiness and near-term prospects of the issuer. Also, management considerscapital adequacy, interest rate risk, liquidity and business plans in assessingthe intent and ability to hold all securities with unrealized losses untilrecovery or maturity.

Thefollowing table sets forth the maturities of mortgage-backed securitiesavailable for sale and the weighted average yields of such securities*:*

| ** **                               | ** ** | **After Five, But Within Ten Years** | ** **                                  | **After Ten Years** | ** ** |
|------------------------------------------|------------|---------------------------------------------------------------|---------------------------------------------|-------------------------------|------------|
| ** **                               | ** ** | ** **                                                    | ** **                                  | ** **                    | ** ** | **Weighted** | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                               | ** ** | **Amortized**                                                 | ** **                                  | **Fair**                      | ** ** | **Average** | ** ** | **Amortized** | ** ** | **Fair** | ** ** | **Average** | ** ** |
| ** **                               | ** ** | **Cost**                                                      | ** **                                  | **Value**                     | ** ** | **Yield** | ** ** | **Cost** | ** ** | **Value** | ** ** | **Yield** | ** ** |
| ** **                               | ** ** | **(Dollars in thousands)**                          | ** **                                  |
| At December 31,  2006:              |       |                                                          |                                        |                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Government National Mortgage Association |       |                                                          | $      — |                          |       | $      — |   |   | — |   |   |   | $ 17,432 |   |   | $ 17,345 |   |   | 4.31 | % |   |
| Federal National Mortgage Association    |       |                                                          | 15,515                                      |                          |       | 15,136 |   |   | 4.55 | % |   |   | 93,965 |   |   | 92,756 |   |   | 4.94 | % |   |
| Federal Home Loan Mortgage Corporation   |       |                                                          | —                                      |                          |       | — |   |   | — |   |   |   | 30,411 |   |   | 29,929 |   |   | 4.73 | % |   |
| Collateralized Mortgage Obligations      |       |                                                          | 2,680                                       |                          |       | 2,604 |   |   | 4.06 | % |   |   | 84,255 |   |   | 82,692 |   |   | 5.01 | % |   |
| Total                                    |       |                                                          | $ 18,195                               |                          |       | $ 17,740 |   |   | 4.48 | % |   |   | $ 226,063 |   |   | $ 222,722 |   |   | 4.89 | % |   |
| At December 31,  2005:              |       |                                                          |                                        |                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Government National Mortgage Association |       |                                                          | $      — |                          |       | $      — |   |   | — |   |   |   | $ 23,762 |   |   | $ 23,819 |   |   | 4.32 | % |   |
| Federal National Mortgage Association    |       |                                                          | 18,939                                      |                          |       | 18,613 |   |   | 4.55 | % |   |   | 94,313 |   |   | 93,768 |   |   | 4.69 | % |   |
| Federal Home Loan Mortgage Corporation   |       |                                                          | —                                      |                          |       | — |   |   | — |   |   |   | 37,528 |   |   | 37,260 |   |   | 4.65 | % |   |
| Collateralized Mortgage Obligations      |       |                                                          | —                                      |                          |       | — |   |   | — |   |   |   | 62,907 |   |   | 61,398 |   |   | 4.52 | % |   |
| Total                                    |       |                                                          | $ 18,939                               |                          |       | $ 18,613 |   |   | 4.55 | % |   |   | $ 218,510 |   |   | $ 216,245 |   |   | 4.59 | % |   |

 

Maturities on mortgage-backed securities are based oncontractual maturities and do not take into consideration scheduledamortization or prepayments. Actual maturities will differ from contractualmaturities due to scheduled amortization and prepayments. The weighted averageremaining contractual term of mortgage-backed securities available for sale at December 31,2006 and 2005 was 20.0 years and 20.2 years, respectively.

F-20

----

**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

Withrespect to sales of mortgage-backed securities in 2006, refer to page F-18for a full description of the investment portfolio restructuring in September 2006.The following table presents the sale of mortgage-backed securities availablefor sale and the resulting gains and losses from such sales:

| ** **                                                   | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                   | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                   | ** ** | **(In thousands)**                    | ** ** |
| Amortizedcost of  mortgage-backed securities sold            |       | $ 452                                 |       | $ 13,573 |   | $ 5,832 |   |
| Gain/(Loss)  realized on sales of mortgage-backed securities |       | (7                                         | )          | 181 |   | (260 | ) |
| Net proceeds from  sales of mortgage-backed securities       |       | $ 445                                 |       | $ 13,754 |   | $ 5,572 |   |

 

F-21

----

**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

**(7)**          Loansand Leases Receivable

The following is a summary of loans and leasesreceivable:

| ** **                                    | ** ** | **December 31,**   | ** ** |
|-----------------------------------------------|------------|-------------------------|------------|
| ** **                                    | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                                    | ** ** | **(In thousands)** | ** ** |
| Commercial loans and  leases:                 |       |                    |       |   |   |
| Commercial real estate—owner occupied    |       | $                       | 140,812    |   | $ | 112,987 |   |
| Commercial real estate—nonowner occupied |       | 102,390                 |       | 95,779 |   |
| Commercial and industrial                     |       | 106,017                 |       | 73,620 |   |
| Small business                                |       | 41,785                  |       | 38,641 |   |
| Multi-family                                  |       | 34,294                  |       | 33,725 |   |
| Construction                                  |       | 37,237                  |       | 37,772 |   |
| Leases and other                              |       | 62,979                  |       | 48,745 |   |
| Subtotal                                      |       | 525,514                 |       | 441,269 |   |
| Unearned lease income                         |       | (6,651                  | )          | (3,366 | ) |
| Net deferred loan origination costs           |       | 927                     |       | 406 |   |
| Total commercial loans and leases             |       | 519,790                 |       | 438,309 |   |
| Residential mortgage  loans:                  |       |                    |       |   |   |
| One- to four-family adjustable rate           |       | 165,140                 |       | 202,223 |   |
| One- to four-family fixed rate                |       | 96,880                  |       | 101,598 |   |
| Subtotal                                      |       | 262,020                 |       | 303,821 |   |
| Premium on loans acquired                     |       | 1,979                   |       | 2,257 |   |
| Net deferred loan origination fees            |       | (54                     | )          | (62 | ) |
| Total residential mortgage loans              |       | 263,945                 |       | 306,016 |   |
| Consumer and other  loans:                    |       |                    |       |   |   |
| Home equity—term loans                   |       | 152,484                 |       | 134,932 |   |
| Home equity—lines of credit              |       | 64,208                  |       | 67,959 |   |
| Automobile                                    |       | 178                     |       | 157 |   |
| Installment                                   |       | 506                     |       | 365 |   |
| Savings secured                               |       | 587                     |       | 358 |   |
| Unsecured and other                           |       | 1,088                   |       | 1,271 |   |
| Subtotal                                      |       | 219,051                 |       | 205,042 |   |
| Premium on loans acquired                     |       | —                  |       | 2 |   |
| Net deferred loan origination costs           |       | 1,506                   |       | 1,437 |   |
| Total consumer and other loans                |       | 220,557                 |       | 206,481 |   |
| Total loans and  leases receivable            |       | $                       | 1,004,292  |   | $ | 950,806 |   |

 

The Bank’s commercial and consumer lending activitiesare conducted principally in the State of Rhode Island and, to a lesser extent,in nearby areas of Massachusetts. The Bank’s equipment lease financingsubsidiary, Macrolease, is based in Long Island, NY, with borrowers locatedthroughout the United States. The Bank originates commercial real estate loans,commercial and industrial loans, multi-family residential loans, equipmentleases, residential mortgage loans and consumer loans (principally home equityloans and lines of credit) for its portfolio.

F-22

----

**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

The Bank purchases one- to four-family residentialmortgage loans and commercial leases from third party originators. These loansand leases may have been originated from areas outside of New England. Mostloans made by the Bank are secured by borrowers’ personal or business assets.The Bank considers a concentration of credit to a particular industry to existwhen the aggregate credit exposure to a borrower or group of borrowers in thatindustry exceeds 25% of the Bank’s capital plus reserves. At December 31,2006, no concentrations of credit to a particular industry existed as definedby these parameters. The ability of the Bank’s residential and consumerborrowers to honor their repayment commitments is generally dependent on thelevel of overall economic activity within the area they reside.

Commercial borrowers’ ability to repay is generallydependent upon the general health of the economy and in cases of real estateloans, the real estate sector in particular. Accordingly, the ultimatecollectibility of a substantial portion of the Bank’s loan portfolio issusceptible to changing conditions in the Rhode Island economy in particular,and the New England and Northeast and national economies, in general.

The Bank’s lending limit to any single borrowingrelationship is limited by law to approximately $18.7 million. At December 31,2006, the Bank had no outstanding commitments to any single borrowingrelationship that were in excess of $10.0 million.

At December 31, 2006, the risk elements containedwithin the loan portfolio were centered in $1.4 million of nonaccrual loans.There were $476,000 of loans past due 60 to 89 days at December 31, 2006.At December 31, 2006, the Bank had no commitments to lend additional fundsto borrowers whose loans were on nonaccrual. This compares to $415,000 ofnonaccrual loans and $300,000 of loans past due 60 to 89 days as of December 31,2005. There are no impaired loans at December 31, 2006, and thus nospecific impairment reserves, while included in nonaccrual loans as of December 31,2005 and 2004, were $141,000 and $671,000 of impaired loans, respectively. At December 31,2005, specific reserves of $71,000 were maintained against impaired loanscompared to $170,000 at December 31, 2004. The average balance of impairedloans was $1.0 million during 2006, $741,000 during 2005 and $1.2 millionduring 2004.

Thereduction in interest income associated with nonaccrual loans was as follows:

| ** **                                | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                | ** ** | **(In thousands)**                    | ** ** |
| Income in  accordance with original terms |       | $                                          | 99         |   | $ | 36 |   | $ | 63 |   |
| Income recognized                         |       | (49                                        | )          | (13 | ) | (34 | ) |
| Foregone interest  income                 |       | $                                          | 50         |   | $ | 23 |   | $ | 29 |   |

 

F-23

----

**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

Loansoutstanding to executive officers and directors of the Company, including theirimmediate families and affiliated companies (“related parties”), are made inthe ordinary course of business under normal credit terms, including interestrates and collateral, prevailing at the time of origination for comparabletransactions with other persons, and do not represent more than normal creditrisk. These loans comply with the provisions of Regulation O under the FederalReserve Act and, accordingly, are permissible under Section 402 of theSarbanes-Oxley Act of 2002. An analysis of the activity of these loans is asfollows:

| ** **                    | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------|------------|--------------------------------------------|------------|
| ** **                    | ** ** | **2006**                                   | ** ** | **2005** | ** ** |
| ** **                    | ** ** | **(In thousands)**                    | ** ** |
| Balance at  beginning of year |       | $                                          | 5,561      |   | $ | 5,019 |   |
| Additions                     |       | 525                                        |       | 10,854 |   |
| Repayments                    |       | (672                                       | )          | (10,312 | ) |
| Balance at end of year        |       | $                                          | 5,414      |   | $ | 5,561 |   |

 

**(8)**          Allowancefor Credit Losses

An analysis of the activity in the allowance forcredit losses is as follows:

| ** **                                     | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                     | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                     | ** ** | **(In thousands)**                    | ** ** |
| *Allowance  for Loan and Lease Losses*         |       |                                       |       |   |   |   |   |
| Balance at beginning of year                   |       | $                                          | 11,665     |   | $ | 11,454 |   | $ | 10,690 |   |
| Provision for loan and lease losses            |       | 1,202                                      |       | 1,423 |   | 836 |   |
| Loans charged-off                              |       | (519                                       | )          | (1,274 | ) | (150 | ) |
| Recoveries of loans previously charged-off     |       | 29                                         |       | 62 |   | 78 |   |
| Balance at end of  year                        |       | 12,377                                     |       | 11,665 |   | 11,454 |   |
| *Reserve for Unfunded Lending Commitments (1)* |       |                                       |       |   |   |   |   |
| Balance at  beginning of year                  |       | 503                                        |       | 452 |   | 388 |   |
| Provision for unfunded lending commitments     |       | 64                                         |       | 51 |   | 64 |   |
| Balance at end of  year                        |       | 567                                        |       | 503 |   | 452 |   |
| *Allowance for Credit Losses*                  |       |                                       |       |   |   |   |   |
| Balance at end of year                         |       | $                                          | 12,944     |   | $ | 12,168 |   | $ | 11,906 |   |

----

(1)          In 2006, the Companyreclassified the reserve for unfunded lending commitments from the allowancefor loan and lease losses to other liabilities for all periods presented.

F-24

----

**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

Thefollowing table represents the allocation of the allowance for loan and leaselosses as of the dates indicated:

| ** **                  | ** ** | **December 31,**   | ** ** |
|-----------------------------|------------|-------------------------|------------|
| ** **                  | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                  | ** ** | **(In thousands)** | ** ** |
| Loan category:              |       |                    |       |   |   |
| Commercial loans and leases |       | $                       | 7,944      |   | $ | 7,002 |   |
| Residential mortgage loans  |       | 1,440                   |       | 1,653 |   |
| Consumer and other loans    |       | 2,086                   |       | 1,894 |   |
| Unallocated                 |       | 907                     |       | 1,116 |   |
| Total                       |       | $                       | 12,377     |   | $ | 11,665 |   |

 

**(9)**          Premisesand Equipment

Premisesand equipment consisted of the following:

| ** **                                      | ** ** | **December 31,**   | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|
| ** **                                      | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                                      | ** ** | **(In thousands)** | ** ** |
| Land                                            |       | $                       | 1,412      |   | $ | 2,620 |   |
| Office buildings  and improvements              |       | 2,931                   |       | 2,631 |   |
| Leasehold  improvements                         |       | 9,996                   |       | 8,692 |   |
| Data processing  equipment and software         |       | 6,726                   |       | 6,429 |   |
| Furniture,  fixtures and other equipment        |       | 5,808                   |       | 5,463 |   |
| Subtotal                                        |       | 26,873                  |       | 25,835 |   |
| Less accumulated  depreciation and amortization |       | (13,137                 | )          | (10,977 | ) |
| Total premises and equipment                    |       | $                       | 13,736     |   | $ | 14,858 |   |

 

The Company utilizes a useful life of 40 years forbuildings and 15 years for building improvements. Leasehold improvements areamortized over their respective lease terms. Data processing equipment andsoftware’s useful life varies but is primarily three years. Furniture, fixturesand other equipment’s useful life varies but is primarily five years.Depreciation expense totaled $2.2 million, $2.4 million and $2.3 million forthe years ended December 31, 2006, 2005 and 2004, respectively.

In November 2004, the Bank sold its SouthBroadway, East Providence, RI office building, leasing back its branch officespace, for a gross selling price of $1.2 million. This transaction generated atotal gain of $755,000 from the sale of the premises, $511,000 of which wasrecognized in 2004’s earnings and $244,000 was deferred, to be recognized overthe term of the branch office space lease.

F-25

----

**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

Rentexpense for the years ended December 31, 2006, 2005 and 2004 was $1.5million, $1.3 million and $1.0 million, respectively. In connection with theacquisition of branches from Fleet Financial Group, Inc. and relatedentities, the Bank assumed the liability for lease payments on seven bankingoffices previously occupied by Shawmut Bank Connecticut, N.A. The Bank hasrenegotiated some of these leases and has also entered into agreements to leaseadditional space. Under the terms of these noncancellable operating leases, theBank is currently obligated to minimum annual rents as follows:

| ** ** | ** ** | **Minimum**             | ** ** |
|------------|------------|-------------------------|------------|
| ** ** | ** ** | **Lease**               | ** ** |
| ** ** | ** ** | **Payments**            | ** ** |
| ** ** | ** ** | **(In thousands)** | ** ** |
| 2007       |       |                    | $          | 1,283 |   |   |
| 2008       |       |                    | 1,172      |   |   |
| 2009       |       |                    | 812        |   |   |
| 2010       |       |                    | 509        |   |   |
| 2011       |       |                    | 515        |   |   |
| Thereafter |       |                    | 6,758      |   |   |
|       |       |                    | $          | 11,049 |   |   |

 

**(10)**   Deposits

Certificate of deposit accounts had the followingschedule of maturities:

| ** **                              | ** ** | **December 31,**   | ** ** |
|-----------------------------------------|------------|-------------------------|------------|
| ** **                              | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                              | ** ** | **(In thousands)** | ** ** |
| 1 year or less  remaining               |       | $                       | 358,041    |   | $ | 293,053 |   |
| More than 1 year  to 2 years remaining  |       | 10,206                  |       | 36,378 |   |
| More than 2 years  to 3 years remaining |       | 7,965                   |       | 6,071 |   |
| More than 3 years  to 4 years remaining |       | 4,196                   |       | 9,020 |   |
| More than 4 years  remaining            |       | 1,299                   |       | 8,527 |   |
| Total                                   |       | $                       | 381,707    |   | $ | 353,049 |   |

 

At December 31, 2006,certificate of deposit accounts included $30.0 million obtained throughbrokers, compared to none at December 31, 2005. At December 31, 2006and 2005, certificate of deposit accounts with balances of $100,000 or more aggregated$144.3 million and $98.0 million, respectively.

**(11)**   Short-TermBorrowings and Repurchase Agreements

Overnightand short-term borrowings are comprised of the following:

| ** **                       | ** ** | **December 31,**   | ** ** |
|----------------------------------|------------|-------------------------|------------|
| ** **                       | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                       | ** ** | **(In thousands)** | ** ** |
| Treasury tax and  loan notes     |       | $                       | 1,915      |   | $ | 2,387 |   |
| FHLB Ideal Way  advances         |       | —                  |       | — |   |
| Retail repurchase  agreements    |       | 54,426                  |       | 23,851 |   |
| Wholesale  repurchase agreements |       | 20,000                  |       | 20,000 |   |
| Total                            |       | $                       | 76,341     |   | $ | 46,238 |   |

 

F-26

----

**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

The Bank utilizes the NoteOption for remitting Treasury Tax and Loan payments to the Federal ReserveBank. Under this option the U.S. Treasury invests in obligations of the Bank,as evidenced by open-ended interest-bearing notes. These notes arecollateralized by U.S. Agency securities owned by the Bank. Informationconcerning these treasury tax and loan notes is as follows:

| ** **                                      | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                      | ** ** | **2006**                                   | ** ** | **2005** | ** ** |
| ** **                                      | ** ** | **(Dollars in thousands)**       | ** ** |
| Outstanding at  end of year                     |       | $                                          | 1,915      |   | $ | 2,387 |   |
| Outstanding  collateralized by securities with: |       |                                       |       |   |   |
| Par value                                       |       | 5,000                                      |       | 5,000 |   |
| Market value                                    |       | 4,966                                      |       | 4,897 |   |
| Average  outstanding for the year               |       | 776                                        |       | 739 |   |
| Maximum  outstanding at any month end           |       | 1,915                                      |       | 2,387 |   |
| Weighted average  rate at end of year           |       | 4.26                                       | %          | 3.95 | % |
| Weighted average rate  paid for the year        |       | 4.77                                       | %          | 2.98 | % |
|                                                 |            |                                            |            |  |  |  |  |

 

The Bank has a short-term line of credit with theFHLB. All borrowings from the FHLB are secured by the Bank’s stock in the FHLBand a blanket lien on “qualified collateral” defined principally as 90% of themarket value of U.S. Government and Agency obligations and 75% of the carryingvalue of certain residential mortgage loans. Unused borrowing capacity underthis line at December 31, 2006, 2005 and 2004 was $25.0 million, $25.0million and $15.0 million, respectively.

Informationconcerning this short-term line of credit is as follows:

| ** **                               | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------|------------|--------------------------------------------|------------|
| ** **                               | ** ** | **2006**                                   | ** ** | **2005** | ** ** |
| ** **                               | ** ** | **(Dollars in thousands)**       | ** ** |
| Outstanding at  end of year              |       | $                                          | —     |   | $ | — |   |
| Maturity date                            |       | NA                                         |       | NA |   |
| Average  outstanding for the year        |       | $                                          | 616        |   | $ | 295 |   |
| Maximum  outstanding at any month end    |       | 3,718                                      |       | 773 |   |
| Weighted average  rate at end of year    |       | NA                                         |       | NA |   |
| Weighted average rate  paid for the year |       | 5.48                                       | %          | 3.36 | % |

 

The Bank utilizes retail repurchase agreements inconnection with a cash management product that the Bank offers its commercialcustomers and wholesale repurchase agreements with financial institutions.Sales of repurchase agreements are treated as financings. The obligations torepurchase the identical securities that were sold are reflected as liabilitiesand the securities remain in the asset accounts. All of these agreements arecollateralized by U.S. Agency securities owned by the Bank. The securitiesunderlying the agreements were held by the Bank in a special custody accountand remained under the Bank’s control.

F-27

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**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

Informationconcerning retail repurchase agreements is as follows:

| ** **                                      | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                      | ** ** | **2006**                                   | ** ** | **2005** | ** ** |
| ** **                                      | ** ** | **(Dollars in thousands)**       | ** ** |
| Outstanding at  end of year                     |       | $                                          | 54,426     |   | $ | 23,851 |   |
| Maturity date                                   |       | 1/2/07                                     |       | 1/3/06 |   |
| Outstanding  collateralized by securities with: |       |                                       |       |   |   |
| Par value                                       |       | $                                          | 103,605    |   | $ | 55,769 |   |
| Market value                                    |       | 101,807                                    |       | 55,609 |   |
| Average  outstanding for the year               |       | 42,963                                     |       | 22,280 |   |
| Maximum  outstanding at any month end           |       | 54,426                                     |       | 23,851 |   |
| Weighted average  rate at end of year           |       | 5.13                                       | %          | 3.69 | % |
| Weighted average rate  paid for the year        |       | 4.78                                       | %          | 2.80 | % |

 

Informationconcerning wholesale repurchase agreements is as follows:

| ** **                                      | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                      | ** ** | **2006**                                   | ** ** | **2005** | ** ** |
| ** **                                      | ** ** | **(Dollars in thousands)**       | ** ** |
| Outstanding at  end of year                     |       | $                                          | 20,000     |   | $ | 20,000 |   |
| Maturity date                                   |       | 11/2010 and  6/2011                        |       | 3/2010 and  11/2010 |   |
| Outstanding  collateralized by securities with: |       |                                       |       |   |   |
| Par value                                       |       | $                                          | 21,085     |   | $ | 22,076 |   |
| Market value                                    |       | 20,895                                     |       | 21,946 |   |
| Average  outstanding for the year               |       | 20,000                                     |       | 9,417 |   |
| Maximum  outstanding at any month end           |       | 20,000                                     |       | 20,000 |   |
| Weighted average  rate at end of year           |       | 4.84                                       | %          | 3.45 | % |
| Weighted average rate  paid for the year        |       | 4.35                                       | %          | 2.93 | % |

 

Additionally, at December 31, 2006, the Bank hada $3.0 million line of credit with a correspondent bank to facilitate theissuance of letters of credit by the Bank and the conducting of foreignexchange transactions for the Bank’s customers. Since inception, there havebeen no outstanding balances under this line of credit.

F-28

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**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

**(12)**   FederalHome Loan Bank of Boston Borrowings

FHLBborrowings are comprised of the following:

| ** **               | ** ** | **December 31, 2006**      | ** ** | **December 31, 2005** | ** ** |
|--------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **               | ** ** | **Scheduled**                        | ** ** | **First**                       | ** ** | **Weighted** | ** ** | **Scheduled** | ** ** | **First** | ** ** | **Weighted** | ** ** |
| ** **               | ** ** | **Final**                            | ** ** | **Call**                        | ** ** | **Average** | ** ** | **Final** | ** ** | **Call** | ** ** | **Average** | ** ** |
| ** **               | ** ** | **Maturity**                         | ** ** | **Date (1)**               | ** ** | **Rate (2)** | ** ** | **Maturity** | ** ** | **Date (1)** | ** ** | **Rate (2)** | ** ** |
| ** **               | ** ** | **(Dollars in thousands)** | ** ** |
| Within 1 year            |       | $                                    | 34,593     |                            | $          | 153,593 |   |   | 3.57 | % |   | $ | 79,250 |   | $ | 196,250 |   |   | 3.79 | % |   |
| Over 1 year to 2  years  |       | 27,058                               |       | 57,058                          |       |   | 4.18 | % |   | 38,880 |   | 38,880 |   |   | 3.60 | % |   |
| Over 2 years to 3  years |       | 41,331                               |       | 21,331                          |       |   | 4.57 | % |   | 30,917 |   | 30,917 |   |   | 4.16 | % |   |
| Over 3 years to 5  years |       | 59,000                               |       | —                          |       |   | 4.97 | % |   | 63,702 |   | 13,702 |   |   | 3.87 | % |   |
| Over 5 years             |       | 80,216                               |       | 10,216                          |       |   | 4.31 | % |   | 67,224 |   | 224 |   |   | 4.46 | % |   |
| Total                    |       | $                                    | 242,198    |                            | $          | 242,198 |   |   | 4.40 | % |   | $ | 279,973 |   | $ | 279,973 |   |   | 3.98 | % |   |

----

(1)          Callable FHLB advancesof $149 million are shown in the respective periods assuming that the callabledebt is redeemed at the next call date while all other advances are shown inthe periods corresponding to their scheduled maturity date.

(2)          Weighted average ratebased on scheduled maturity dates.

All borrowings from theFHLB are secured by the Bank’s stock in the FHLB and a blanket lien on “qualifiedcollateral” defined principally as 90% of the market value of U.S. Governmentand Agency obligations and 75% of the carrying value of certain residentialmortgage loans. Unused term borrowing capacity with the FHLB at December 31,2006 and 2005 was $40.9 million and $26.9 million, respectively. As onerequirement of its borrowings, the Bank is required to invest in the commonstock of the FHLB in an amount at least equal to five percent of itsoutstanding borrowings from the FHLB. As and when such stock is redeemed, theBank would receive from the FHLB an amount equal to the par value of the stock.As of December 31, 2006 and 2005, the Bank’s FHLB stock holdings, recordedat cost, were $16.5 million and $16.1 million, respectively.

**(13)**   Company-ObligatedMandatorily Redeemable Capital Securities and Subordinated Deferrable InterestDebentures

On January 23, 2001, the Company sponsored thecreation of BRI Statutory Trust I (the “Trust I”), a Connecticut statutorytrust. The Company is the owner of all of the common securities of Trust I. OnFebruary 22, 2001, Trust I issued $3.0 million of its 10.20%Company-Obligated Mandatorily Redeemable Capital Securities (“CapitalSecurities”) through a pooled trust preferred securities offering. The proceedsfrom this issuance, along with the Company’s $93,000 capital contribution forTrust I’s common securities (which is included in prepaid expenses and otherassets), were used to acquire $3.1 million of the Company’s 10.20% SubordinatedDeferrable Interest Debentures (“Junior Subordinated Notes”) dueFebruary 22, 2031, and constitute the primary asset of Trust I. TheCompany has, through the Declaration of Trust, the Guarantee Agreement, theNotes and the related Indenture, taken together, fully irrevocably andunconditionally guaranteed all of Trust I’s obligations under the CapitalSecurities, to the extent Trust I has funds available therefor.

F-29

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**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

On June 4, 2002, the Company sponsored thecreation of BRI Statutory Trust II (the “Trust II”), a Connecticut statutorytrust. The Company is the owner of all of the common securities of Trust II. OnJune 26, 2002, Trust II issued $5.0 million of its floating rate(quarterly reset to 3 month LIBOR plus 3.45%) Capital Securities through apooled trust preferred securities offering. At December 31, 2006, the rateof the Capital Securities was 8.82%. The proceeds from this issuance, alongwith the Company’s $155,000 capital contribution for Trust II’s commonsecurities (which is included in prepaid expenses and other assets), were usedto acquire $5.2 million of the Company’s floating rate (quarterly reset to 3month LIBOR plus 3.45%) Junior Subordinated Notes due June 26, 2032, andconstitute the primary asset of Trust II. The Company has, through theDeclaration of Trust, the Guarantee Agreement, the Notes and the relatedIndenture, taken together, fully irrevocably and unconditionally guaranteed allof Trust II’s obligations under the Capital Securities, to the extent Trust IIhas funds available therefor.

On June 5, 2003, the Company sponsored thecreation of BRI Statutory Trust III (the “Trust III”), a Connecticut statutorytrust. The Company is the owner of all of the common securities of Trust III.On June 26, 2003, Trust III issued $5.0 million of its 5.55% (quarterlyreset to 3 month LIBOR plus 3.10% beginning June 26, 2008) CapitalSecurities through a pooled trust preferred securities offering. The proceedsfrom this issuance, along with the Company’s $155,000 capital contribution forTrust III’s common securities (which is included in prepaid expenses and otherassets), were used to acquire $5.2 million of the Company’s 5.55% (quarterlyreset to 3 month LIBOR plus 3.10% beginning June 26, 2008) JuniorSubordinated Notes due June 26, 2033, and constitute the primary asset ofTrust III. The Company has, through the Declaration of Trust, the GuaranteeAgreement, the Notes and the related Indenture, taken together, fullyirrevocably and unconditionally guaranteed all of Trust III’s obligations underthe Capital Securities, to the extent Trust III has funds available therefor.

On February 24, 2004, the Company sponsored thecreation of BRI Statutory Trust IV (the “Trust IV”), a Connecticut statutorytrust. The Company is the owner of all of the common securities of Trust IV. OnMarch 17, 2004, Trust IV issued $5.0 million of its floating rate(quarterly reset to 3 month LIBOR plus 2.79%) Capital Securities through apooled trust preferred securities offering. At December 31, 2006, the rateof the Capital Securities was 8.15%. The proceeds from this issuance, alongwith the Company’s $155,000 capital contribution for Trust IV’s commonsecurities (which is included in prepaid expenses and other assets), were usedto acquire $5.2 million of the Company’s floating rate (quarterly reset to 3month LIBOR plus 2.79%) Junior Subordinated Notes due March 17, 2034, andconstitute the primary asset of Trust IV. The Company has, through theDeclaration of Trust, the Guarantee Agreement, the Notes and the relatedIndenture, taken together, fully irrevocably and unconditionally guaranteed allof Trust IV’s obligations under the Capital Securities, to the extent Trust IVhas funds available therefor.

As of December 31,2006, the Company’s investments in its statutory trust subsidiaries aggregated$649,000 and are included within prepaid expenses and other assets.

F-30

----

**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

**(14) Income Taxes**

Thecomponents of income tax expense are as follows:

| ** **                | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------|------------|--------------------------------------------|------------|
| ** **                | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                | ** ** | **(In thousands)**                    | ** ** |
| Current expense:          |       |                                       |       |   |   |   |   |
| Federal                   |       | $                                          | 5,056      |   | $ | 4,763 |   | $ | 4,873 |   |
| State                     |       | 51                                         |       | 92 |   | 66 |   |
| Total current expense     |       | 5,107                                      |       | 4,855 |   | 4,939 |   |
| Deferred benefit:         |       |                                       |       |   |   |   |   |
| Federal                   |       | (1,531                                     | )          | (15 | ) | (643 | ) |
| State                     |       | —                                     |       | — |   | — |   |
| Total deferred benefit    |       | (1,531                                     | )          | (15 | ) | (643 | ) |
| Total income tax  expense |       | $                                          | 3,576      |   | $ | 4,840 |   | $ | 4,296 |   |

 

Thedifference between the statutory federal income tax rate and the effectivefederal income tax rate is as follows:

| ** **                                            | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Statutory federal  income tax rate                    |       | 35.0     | %          | 35.0     | %          | 35.0     | %          |
| Increase  resulting from:                             |       |     |       |     |       |     |       |
| State income tax, net of federal tax benefit          |       | 0.3      |       | 0.4      |       | 0.3      |       |
| Bank-owned life insurance                             |       | (2.4     | )          | (1.7     | )          | (1.7     | )          |
| Other, net                                            |       | (1.2     | )          | (0.1     | )          | (0.3     | )          |
| Effective combined  federal and state income tax rate |       | 31.7     | %          | 33.6     | %          | 33.3     | %          |

 

Thesignificant components of gross deferred tax assets and gross deferred taxliabilities are as follows:

| ** **                          | ** ** | **December 31,**   | ** ** |
|-------------------------------------|------------|-------------------------|------------|
| ** **                          | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                          | ** ** | **(In thousands)** | ** ** |
| Gross deferred  tax assets:         |       |                    |       |   |   |
| Allowance for loan and lease losses |       | $                       | 4,348      |   | $ | 4,103 |   |
| Securities available for sale       |       | 1,623                   |       | 1,736 |   |
| Depreciation                        |       | 1,299                   |       | 479 |   |
| Accrued retirement                  |       | 785                     |       | 632 |   |
| Loss on investments                 |       | 273                     |       | — |   |
| Other                               |       | 579                     |       | 193 |   |
| Total gross deferred tax assets     |       | 8,907                   |       | 7,143 |   |
| Gross deferred  tax liabilities:    |       |                    |       |   |   |
| Goodwill                            |       | (2,556                  | )          | (2,210 | ) |
| Net deferred tax  asset             |       | $                       | 6,351      |   | $ | 4,933 |   |

 

Thenet balance of deferred tax assets and liabilities is included in prepaidexpenses and other assets. It is management’s belief that it is more likelythan not that the reversal of deferred tax liabilities and 

F-31

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**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

results of future operations will generate sufficienttaxable income to realize the deferred tax assets. In addition, the Company’snet deferred tax asset is supported by recoverable income taxes. Therefore, novaluation allowance was deemed necessary at December 31, 2006 or 2005. Itshould be noted, however, that factors beyond management’s control, such as thegeneral state of the economy and real estate values, can affect future levelsof taxable income and that no assurance can be given that sufficient taxableincome will be generated to fully absorb gross deductible temporarydifferences.

**(15) Employee andDirector Benefits**

*Employee401(k) Plan—**The*Bank maintains a 401(k) Plan(the “Plan”) which qualifies as a tax exempt plan and trust under Sections 401and 501 of the Internal Revenue Code. Generally, Bank employees who are atleast twenty-one (21) years of age are eligible to participate in the Plan.Expenses associated with the Plan were $450,000, $388,000 and $352,000 for theyears ended December 31, 2006, 2005 and 2004, respectively.

*NonqualifiedDeferred Compensation Plan—**The* Bank alsomaintains a Nonqualified Deferred Compensation Plan (the “Nonqualified Plan”)under which certain participants may contribute the amounts they are precludedfrom contributing to the Bank’s 401(k) Plan because of the qualified planlimitations, and additional compensation deferrals that may be advantageous forpersonal income tax or other planning reasons. Expenses associated with theNonqualified Plan were $40,000, $43,000 and $39,000 for the years ended December 31,2006, 2005 and 2004, respectively. Accrued liabilities associated with theNonqualified Plan were $644,000 and $770,000 for December 31, 2006 and2005, respectively.

*SupplementalExecutive Retirement Plans—**The* Bank maintainsSupplemental Executive Retirement Plans (the “SERPs”) for certain of its seniorexecutives under which participants designated by the Board of Directors areentitled to an annual retirement benefit. Expenses associated with the SERPswere $436,000, $578,000 and $391,000 for the years ended December 31,2006, 2005 and 2004, respectively. Accrued liabilities associated with theSERPs were $2.2 million and $1.8 million for December 31, 2006 and 2005,respectively.

*RestrictedStock Agreement—**During**2*001,the Company entered into a Restricted Stock Agreement with its CEO, pursuant towhich she was awarded 7,700 shares of restricted stock, subject to achievement ofcertain performance goals spanning a three year period, which have beenachieved. The restricted shares vested 50% on January 1, 2005 and 50% on January 1,2006. The restricted shares were subject to forfeiture in the event oftermination of the CEO’s employment prior to the applicable vesting dates forcause by the Company or without good reason by the executive. In addition, theCompany made a “gross-up” payment sufficient to pay any taxes of the CEO(including those on the “gross-up” payment) arising as a result of the vestingof the restricted stock. The relevant service period for this restricted stockconcluded in December 2005. Expenses associated with the Restricted StockAgreement were $97,000 and $129,000 for the years ended December 31, 2005and 2004, respectively.

*EmployeeStock Plans—**The***Companymaintains a 1996 Incentive and Nonqualified Stock Option Plan and a 2002 EquityIncentive Plan (collectively the “Employee Stock Plans”) under which it maygrant awards of its common stock to officers and key employees. The 1996Incentive and Nonqualified Stock Option Plan has no remaining shares availablefor issuance as it expired in March 2006. At December 31, 2006, thetotal remaining shares available for issuance under the 2002 Equity IncentivePlan is 142,383. The 2002 Equity Incentive Plan also provides for automaticincremental increases each year in the number of shares authorized for issuanceunder such plan on the date of the annual shareholders meeting equal to 

F-32

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**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

the least of (i) 2%of total issued and outstanding common stock on the date of the shareholdersmeeting, (ii) 75,000 shares and (iii) such lesser number asdetermined by the Board of Directors of the Company. The Employee Stock Plans,which are shareholder approved, allow grants of options, restricted stock,stock appreciation rights (“SARs”), performance shares or units and otherstock-based awards. To date, the Company has only awarded options under theEmployee Stock Plans, which have been granted at an exercise price equal to themarket value of the stock on the date of the grant with vesting terms of threeto five years. Unless exercised, options granted under the Employee Stock Planshave a 10-year contractual term. Certain stock option awards provide foraccelerated vesting if there is a change in control (as defined in the EmployeeStock Plans).

Thefair value of each employee stock option award has been estimated on the grantdate using the Black-Scholes option-pricing model utilizing the followingpricing assumptions, summarized on a weighted-average basis in the table below:

| ** **                     | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------|------------|--------------------------------------------|------------|
| ** **                     | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Expected term                  |       | 7 years                                    |       | 7 years |   | 7 years |   |
| Expected  volatility           |       | 23                                         | %          | 25 | % | 25 | % |
| Risk-free  interest rate       |       | 4.73                                       | %          | 3.90 | % | 3.73 | % |
| Dividend yield                 |       | 1.71                                       | %          | 1.70 | % | 1.66 | % |
| Fair value of options  granted |       | $                                          | 10.01      |   | $ | 9.27 |   | $ | 9.38 |   |
|                                |            |                                            |            |  |  |  |  |  |  |  |

 

Theactivity related to these employee stock options is summarized below:

| ** **                           | ** ** | ** **      | ** ** | **Weighted** | ** ** | ** **               | ** ** | **Weighted**                  | ** ** |
|--------------------------------------|------------|-----------------|------------|--------------|------------|--------------------------|------------|-------------------------------|------------|
| ** **                           | ** ** | ** **      | ** ** | **Average**  | ** ** | ** **               | ** ** | **Average**                   | ** ** |
| ** **                           | ** ** | **Options**     | ** ** | **Exercise** | ** ** | **Aggregate**            | ** ** | **Contractual**               | ** ** |
| **Employee Stock Options** | ** ** | **Outstanding** | ** ** | **Price**    | ** ** | **Intrinsic Value** | ** ** | **Term (in years)** | ** ** |
| Outstanding,  December 31, 2003 |       |            | 399,538    |         |       |                     | $          | 14.65                         |       |   |   |   |   |   |   |   |   |   |
| Granted                              |       |            | 106,650    |         |       |                     | $          | 33.79                         |       |   |   |   |   |   |   |   |   |   |
| Exercised                            |       |            | (53,308    | )            |       |                     | $          | 13.70                         |       |   |   |   |   |   |   |   |   |   |
| Forfeited/Canceled                   |       |            | (7,575     | )            |       |                     | $          | 23.21                         |       |   |   |   |   |   |   |   |   |   |
| Outstanding,  December 31, 2004 |       |            | 445,305    |         |       |                     | $          | 19.21                         |       |   |   |   |   |   |   |   |   |   |
| Granted                              |       |            | 68,000     |         |       |                     | $          | 37.05                         |       |   |   |   |   |   |   |   |   |   |
| Exercised                            |       |            | (73,374    | )            |       |                     | $          | 18.29                         |       |   |   |   |   |   |   |   |   |   |
| Forfeited/Canceled                   |       |            | (10,951    | )            |       |                     | $          | 33.18                         |       |   |   |   |   |   |   |   |   |   |
| Outstanding,  December 31, 2005 |       |            | 428,980    |         |       |                     | $          | 21.27                         |       |   |   |   |   |   |   |   |   |   |
| Granted                              |       |            | 60,850     |         |       |                     | $          | 35.18                         |       |   |   |   |   |   |   |   |   |   |
| Exercised                            |       |            | (74,059    | )            |       |                     | $          | 18.57                         |       |   |   |   |   |   |   |   |   |   |
| Forfeited/Canceled                   |       |            | (12,750    | )            |       |                     | $          | 33.26                         |       |   |   |   |   |   |   |   |   |   |
| Outstanding,  December 31, 2006 |       |            | 403,021    |         |       |                     | $          | 24.57                         |       |   |   | $ | 7,527,000 |   |   |   | 5.8 |   |   |
| Exercisable,  December 31, 2006 |       |            | 342,171    |         |       |                     | $          | 22.69                         |       |   |   | $ | 7,036,000 |   |   |   | 5.2 |   |   |

 

The total intrinsic value of options by employeesexercised during 2006, 2005 and 2004 was $1.3 million, $1.6 million and $1.1million, respectively.

F-33

----

**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

Theoptions outstanding as of December 31, 2006 are set forth below:

| ** **                           | ** ** | ** **      | ** ** | **Weighted** | ** ** | **Weighted**                  | ** ** |
|--------------------------------------|------------|-----------------|------------|--------------|------------|-------------------------------|------------|
| ** **                           | ** ** | ** **      | ** ** | **Average**  | ** ** | **Average**                   | ** ** |
| ** **                           | ** ** | **Options**     | ** ** | **Exercise** | ** ** | **Contractual**               | ** ** |
| **Exercise Price**              | ** ** | **Outstanding** | ** ** | **Price**    | ** ** | **Term (in years)** | ** ** |
| $10.00—$19.99                   |       |            | 161,171    |         |       |                          | $          | 12.56 |   |   |   | 2.8 |   |   |
|   20.00—29.99         |       |            | 51,700     |         |       |                          | $          | 23.09 |   |   |   | 6.0 |   |   |
|   30.00—39.99         |       |            | 187,650    |         |       |                          | $          | 35.03 |   |   |   | 8.3 |   |   |
|   40.00—49.99         |       |            | 2,500      |         |       |                          | $          | 44.93 |   |   |   | 9.8 |   |   |
| Outstanding,  December 31, 2006 |       |            | 403,021    |         |       |                          | $          | 24.57 |   |   |   | 5.8 |   |   |

 

Thefollowing table summarizes share-based compensation and the related tax benefitfor the periods indicated:

| ** **                                                 | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                 | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                 | ** ** | **(in thousands)**                    | ** ** |
| Share-based  compensation(1)                               |       |                                       | $          | 97 |   |   | $ | 146 |   | $ | 129 |   |
| Excess tax benefit  related to share-based compensation(2) |       |                                       | 244        |   |   | 309 |   | 104 |   |
|                                                            |            |                                            |            |  |  |  |  |  |  |  |  |  |

----

(1)          Expensesfor 2005 and 2004 include expenses relating to the Restricted Stock Agreement,as described on page F-32, for which the relevant service periodconcluded in December 2005.

(2)          Representsthe tax benefits on stock options exercised and share-based compensation.

As of December 31, 2006, there was $455,000 oftotal unrecognized compensation cost related to nonvested employee compensationarrangements. This cost is expected to be recognized over a weighted averageperiod of 3.9 years.

*DirectorStock Plan—**The***Companyestablished a Non-Employee Director Stock Plan (the “Director Stock Plan”)under which it may grant up to 90,000 options to acquire its Common Stock tonon-employee directors. At December 31, 2006, the total remaining sharesavailable for issuance under the Director Stock Plan is 19,000. Eachnon-employee director elected at the 1998 shareholders meeting received anoption for 1,500 shares and each new non-employee director elected subsequentlyreceives an option for 1,000 shares. Non-employee directors also receive anannual option grant for 500 shares as of the date of each annual meeting ofshareholders. Options are granted at an exercise price equal to the marketvalue of the stock on the date of the grant and vest six months after the grantdate. Options granted under the Director Stock Plan have a 10-yearcontractual term, subject to earlier of expiration on the second anniversary ofa director’s termination of service.

F-34

----

**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

Thefair value of each non-employee director stock option award has been estimatedon the grant date using the Black-Scholes option-pricing model utilizing thefollowing pricing assumptions, summarized on a weighted-average basis in thetable below:

| ** **                     | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------|------------|--------------------------------------------|------------|
| ** **                     | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Expected term                  |       | 8 years                                    |       | 7 years |   | 7 years |   |
| Expected  volatility           |       | 28                                         | %          | 25 | % | 25 | % |
| Risk-free  interest rate       |       | 5.05                                       | %          | 3.83 | % | 4.25 | % |
| Dividend yield                 |       | 1.66                                       | %          | 1.58 | % | 1.66 | % |
| Fair value of options  granted |       | $                                          | 12.73      |   | $ | 10.89 |   | $ | 9.76 |   |
|                                |            |                                            |            |  |  |  |  |  |  |  |

 

Theactivity related to these director stock options is summarized below:

| ** **                           | ** ** | ** **      | ** ** | **Weighted** | ** ** | ** **               | ** ** | **Weighted**                  | ** ** |
|--------------------------------------|------------|-----------------|------------|--------------|------------|--------------------------|------------|-------------------------------|------------|
| ** **                           | ** ** | ** **      | ** ** | **Average**  | ** ** | ** **               | ** ** | **Average**                   | ** ** |
| ** **                           | ** ** | **Options**     | ** ** | **Exercise** | ** ** | **Aggregate**            | ** ** | **Contractual**               | ** ** |
| **Employee Stock Options** | ** ** | **Outstanding** | ** ** | **Price**    | ** ** | **Intrinsic Value** | ** ** | **Term (in years)** | ** ** |
| Outstanding,  December 31, 2003 |       |            | 37,000     |         |       |                     | $          | 17.82                         |       |   |   |   |   |   |   |   |   |   |
| Granted                              |       |            | 7,000      |         |       |                     | $          | 33.43                         |       |   |   |   |   |   |   |   |   |   |
| Exercised                            |       |            | (1,500     | )            |       |                     | $          | 22.60                         |       |   |   |   |   |   |   |   |   |   |
| Forfeited/Canceled                   |       |            | —     |         |       |                     | —     |                          |       |   |   |   |   |   |   |   |   |
| Outstanding,  December 31, 2004 |       |            | 42,500     |         |       |                     | $          | 20.22                         |       |   |   |   |   |   |   |   |   |   |
| Granted                              |       |            | 7,000      |         |       |                     | $          | 38.07                         |       |   |   |   |   |   |   |   |   |   |
| Exercised                            |       |            | —     |         |       |                     | —     |                          |       |   |   |   |   |   |   |   |   |
| Forfeited/Canceled                   |       |            | —     |         |       |                     | —     |                          |       |   |   |   |   |   |   |   |   |
| Outstanding,  December 31, 2005 |       |            | 49,500     |         |       |                     | $          | 22.75                         |       |   |   |   |   |   |   |   |   |   |
| Granted                              |       |            | 8,000      |         |       |                     | $          | 36.19                         |       |   |   |   |   |   |   |   |   |   |
| Exercised                            |       |            | (4,000     | )            |       |                     | $          | 30.15                         |       |   |   |   |   |   |   |   |   |   |
| Forfeited/Canceled                   |       |            | (500       | )            |       |                     | $          | 35.24                         |       |   |   |   |   |   |   |   |   |   |
| Outstanding,  December 31, 2006 |       |            | 53,000     |         |       |                     | $          | 24.09                         |       |   |   | $ | 1,015,000 |   |   |   | 5.1 |   |   |
| Exercisable,  December 31, 2006 |       |            | 52,000     |         |       |                     | $          | 23.73                         |       |   |   | $ | 1,015,000 |   |   |   | 5.0 |   |   |

 

The total intrinsic value of options exercised bydirectors during 2006, 2005 and 2004 was $49,000, $0 and $25,000, respectively.

Thedirector options outstanding as of December 31, 2006 are set forth below:

| ** **                           | ** ** | ** **      | ** ** | **Weighted** | ** ** | **Weighted**        | ** ** |
|--------------------------------------|------------|-----------------|------------|--------------|------------|---------------------|------------|
| ** **                           | ** ** | ** **      | ** ** | **Average**  | ** ** | **Average**         | ** ** |
| ** **                           | ** ** | **Options**     | ** ** | **Exercise** | ** ** | **Contractual**     | ** ** |
| **Exercise Price**                   | ** ** | **Outstanding** | ** ** | **Price**    | ** ** | **Term (in years)** | ** ** |
| $10.00—$19.99                   |       | 25,000          |       | $15.32       |       | 2.8                 |       |
|   20.00—29.99         |       | 9,500           |       | $24.03       |       | 5.6                 |       |
|   30.00—39.99         |       | 17,500          |       | $35.59       |       | 8.0                 |       |
|   40.00—49.99         |       | 1,000           |       | $42.85       |       | 9.8                 |       |
| Outstanding,  December 31, 2006 |       | 53,000          |       | $24.09       |       | 5.1                 |       |

 

F-35

----

**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

Thefollowing table summarizes share-based compensation and the related tax benefitfor the periods indicated:

| ** **                                                 | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                 | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                 | ** ** | **(in thousands)**                    | ** ** |
| Share-based  compensation                                  |       |                                       | $          | 89 |   |   |   | $ | — |   |   |   | $ | — |   |   |
| Excess tax benefit related  to share-based compensation(1) |       |                                       | 17         |   |   |   | — |   |   |   | 9 |   |   |

----

(1)          Representsthe tax benefits on stock options exercised and share-based compensation.

F-36

----

**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

As of December 31, 2006, there was $7,000 oftotal unrecognized compensation cost related to nonvested director compensationarrangements. This cost is expected to be recognized over the next threemonths.

*Change of ControlAgreements—**The* Bank has entered intoEmployment Agreements with its President and Chief Executive Officer, ChiefFinancial Officer, Chief Operating Officer and Chief Business Officer. Theseagreements generally provide for the continued payment of specifiedcompensation and benefits for the remainder of the term of the agreement upontermination without cause. The agreements also provide that if the executive isterminated (or in the case of the Chief Executive Officer, resigns) inconjunction with a Change in Control, they are entitled to a severance payment,which is equal to 2.99 times base salary plus target bonus for the Presidentand Chief Executive Officer and 2.00 times base salary plus target bonus forthe Chief Financial Officer, Chief Operating Officer, and Chief Business Officer.Except in the case of the Chief Operating Officer, payments under theemployment agreements following a Change in Control are subject to the “goldenparachute” excise tax, the Company will make a “gross-up” payment sufficient toensure that the net after-tax amount retained by the executive (taking intoaccount all taxes, including those on the “gross-up” payment) is the same as ifsuch excise tax had not applied.

**(16) Other Expenses**

Majorcomponents of other expenses are as follows:

| ** **                        | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------|------------|--------------------------------------------|------------|
| ** **                        | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                        | ** ** | **(In thousands)**                         | ** ** |
| Postage and  mailing              |       | $                                          | 603        |   | $ | 566 |   | $ | 582 |   |
| Forms and  supplies               |       | 560                                        |       | 583 |   | 578 |   |
| Telephone                         |       | 538                                        |       | 584 |   | 507 |   |
| Director fees                     |       | 434                                        |       | 346 |   | 241 |   |
| Credit card and  interchange fees |       | 266                                        |       | 289 |   | 323 |   |
| Charitable contributions          |       | 231                                        |       | 246 |   | 268 |   |
| Insurance                         |       | 227                                        |       | 207 |   | 221 |   |
| Correspondent  bank fees          |       | 155                                        |       | 154 |   | 202 |   |
| Recruiting                        |       | 63                                         |       | 130 |   | 176 |   |
| Other                             |       | 1,992                                      |       | 1,522 |   | 1,069 |   |
| Total                             |       | $                                          | 5,069      |   | $ | 4,627 |   | $ | 4,167 |   |

 

In December 2006,the Company recorded insurance recovery proceeds of $803,000 relating to a lossthe Company incurred in the first quarter of 2006 of $868,000. These amountsare recorded net within other expenses in the table above and on theConsolidated Statement of Operations for the year ended December 31, 2006.

**(17) Commitmentsand Contingent Liabilities**

The Bank is party to financial instruments withoff-balance sheet risk in the normal course of business to meet the financingneeds of its customers. These financial instruments include commitments tooriginate loans and letters of credit. The instruments involve, to varyingdegrees, elements of credit and interest rate 

F-37

----

**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

risk in excess of theamount recognized in the balance sheet. The contract or notional amounts ofthose instruments reflect the extent of involvement the Bank has in particularclasses of financial instruments.

The Bank’s exposure to credit loss in the event ofnonperformance by the other party to the financial instrument for loancommitments and letters of credit is represented by the contractual amount ofthose instruments. The Bank uses the same credit policies in making commitmentsand conditional obligations as it does for on-balance sheet instruments.

Financialinstruments with off-balance sheet risk are summarized as follows:

| ** **                                             | ** ** | **December 31,**   | ** ** |
|--------------------------------------------------------|------------|-------------------------|------------|
| ** **                                             | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                                             | ** ** | **(In thousands)** | ** ** |
| Commitments to  originate or purchase loans and leases |       | $                       | 35,250     |   | $ | 37,623 |   |
| Unused lines of  credit and other commitments          |       | 205,673                 |       | 177,317 |   |
| Letters of credit                                      |       | 3,353                   |       | 1,895 |   |
|                                                        |            |                         |            |  |  |  |  |

 

Commitments to originate loans and unused lines ofcredit are agreements to lend to a customer provided there is no violation ofany condition established in the contract. Commitments generally have fixedexpiration dates or other termination clauses and may require payment of a fee.Since certain commitments may expire without being drawn upon, the totalcommitment amounts do not necessarily represent future cash requirements. TheBank evaluates each customer’s creditworthiness on a case-by-case basis. Theamount of collateral obtained, if deemed necessary by the Bank upon extensionof credit, is based on management’s credit evaluation of the borrower.

Lettersof credit are conditional commitments issued by the Bank to guarantee theperformance by a customer to a third party. The credit risk involved in issuingletters of credit is essentially the same as that involved in extending loanfacilities to customers. At December 31, 2006 and 2005, the maximumpotential amount of future payments under letters of credit was $3.2 millionand $1.5 million, respectively. At December 31, 2006 and 2005, cashcollateral supported $1.1 million and $1.0 million, respectively, of theoutstanding standby letters of credit. The fair value of the guarantees was$24,000 and $11,000, respectively, and is not reflected on the balance sheet.

**(18) Fair Value ofFinancial Instruments**

The following disclosure of the estimated fair valueof financial instruments is made in accordance with the requirements of SFAS107, “*DisclosuresAbout Fair Value of Financial Instruments*”. The estimatedfair value amounts have been determined by using available quoted marketinformation or other appropriate valuation methodologies. The aggregate fairvalue amounts presented are in accordance with SFAS 107 guidelines but do notrepresent the underlying value of the Bank taken as a whole.

The fair value estimates provided are made at aspecific point in time, based on relevant market information and thecharacteristics of the financial instrument. The estimates do not provide forany premiums or discounts that could result from concentrations of ownership ofa financial instrument. Because no active market exists for some of the Bank’sfinancial instruments, certain fair value estimates are based on subjectivejudgments regarding current economic conditions, risk characteristics of thefinancial instruments, future expected loss experience, prepayment assumptionsand other factors. The resulting estimates involve uncertainties and thereforecannot be determined with precision. Changes made to any of the underlyingassumptions could significantly affect the estimates.

F-38

----

**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

Thebook values and estimated fair values for the Company’s financial instrumentsare as follows:

| ** **                                                                | ** ** | **December 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|---------------------------------------------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                                                                | ** ** | **Book**                        | ** ** | **Estimated**                   | ** ** | **Book** | ** ** | **Estimated** | ** ** |
| ** **                                                                | ** ** | **Value**                       | ** ** | **Fair Value**             | ** ** | **Value** | ** ** | **Fair Value** | ** ** |
| ** **                                                                | ** ** | **(In thousands)**              | ** ** | **(In thousands)**              | ** ** |
| Assets:                                                                   |       |                            |       |                            |       |   |   |   |   |
| Cash and due from banks                                                   |       | $                               | 24,469     |                            | $          | 24,469 |   | $ | 30,177 |   | $ | 30,177 |   |
| Overnight investments                                                     |       | 37,295                          |       | 37,295                          |       | 10,370 |   | 10,370 |   |
| Investment securities                                                     |       | 103,425                         |       | 103,425                         |       | 150,959 |   | 150,959 |   |
| Mortgage-backed securities                                                |       | 240,462                         |       | 240,462                         |       | 234,858 |   | 234,858 |   |
| Stock in the FHLB                                                         |       | 16,530                          |       | 16,530                          |       | 16,062 |   | 16,062 |   |
| Loans and leases  receivable, net of allowance for loan and lease losses: |       |                            |       |                            |       |   |   |   |   |
| Commercial loans and leases                                               |       | 511,218                         |       | 509,636                         |       | 430,337 |   | 429,892 |   |
| Residential mortgage loans                                                |       | 262,391                         |       | 262,158                         |       | 304,197 |   | 292,703 |   |
| Consumer and other loans                                                  |       | 218,306                         |       | 216,418                         |       | 204,104 |   | 204,524 |   |
| Accrued interest receivable                                               |       | 6,755                           |       | 6,755                           |       | 6,965 |   | 6,965 |   |
| Liabilities:                                                              |       |                            |       |                            |       |   |   |   |   |
| Deposits:                                                                 |       |                            |       |                            |       |   |   |   |   |
| Demand deposit accounts                                                   |       | $                               | 200,282    |                            | $          | 200,282 |   | $ | 185,089 |   | $ | 185,089 |   |
| NOW accounts                                                              |       | 70,736                          |       | 70,736                          |       | 89,594 |   | 89,594 |   |
| Money market accounts                                                     |       | 6,991                           |       | 6,991                           |       | 12,122 |   | 12,122 |   |
| Savings accounts                                                          |       | 356,707                         |       | 356,707                         |       | 341,115 |   | 341,115 |   |
| Certificate of deposit accounts                                           |       | 381,707                         |       | 382,403                         |       | 353,049 |   | 353,755 |   |
| Overnight and short-term borrowings                                       |       | 56,341                          |       | 56,341                          |       | 26,238 |   | 26,238 |   |
| Wholesale repurchase agreements                                           |       | 20,000                          |       | 20,151                          |       | 20,000 |   | 20,014 |   |
| FHLB borrowings                                                           |       | 242,198                         |       | 242,918                         |       | 279,973 |   | 280,009 |   |
| Subordinated deferrable interest debentures                               |       | 18,558                          |       | 18,708                          |       | 18,558 |   | 20,564 |   |
| Accrued interest  payable                                                 |       | 5,084                           |       | 5,084                           |       | 2,928 |   | 2,928 |   |

 

*Cashand due from banks—**The* carrying values reported in thebalance sheet for cash and due from banks approximate the fair values becauseof the short maturity of these instruments.

*Overnightinvestments—**The* carrying values reported in thebalance sheet for federal funds sold and overnight investments approximate thefair values because of the short maturity of these instruments.

*Investmentand mortgage-backed securities—**The* fair valuespresented for investment and mortgage-backed securities are based on quoted bidprices received from securities dealers.

*Stockin the Federal Home Loan Bank of Boston—**The*fair value ofstock in the FHLB equals the carrying value reported in the balance sheet. Thisstock is redeemable at full par value only by the FHLB.

*Loansand leases receivable—**Fair* value estimates are based onloans and leases with similar financial characteristics. Loans and leases havebeen segregated by homogenous groups into residential mortgage, commercial, andconsumer and other loans. Fair values are estimated by discounting contractualcash flows, adjusted for prepayment estimates, using discount ratesapproximately equal to current market rates 

F-39

----

**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

on loans with similarcharacteristics and maturities. The incremental credit risk for nonperformingloans has been considered in the determination of the fair value of loans.

*Deposits—**The* fair valuesreported for demand deposit, NOW, money market, and savings accounts are equalto their respective book values reported on the balance sheet. The fair valuesdisclosed are, by definition, equal to the amount payable on demand at thereporting date. The fair values reported for certificate of deposit accountsare based on the discounted value of contractual cash flows. The discount ratesused are representative of approximate rates currently offered on certificateof deposit accounts with similar remaining maturities.

*Overnight and short-term borrowings*—Thecarrying values reported in the balance sheet for overnight and short-termborrowings approximate the fair values because of the short maturity of theseinstruments.

*Wholesalerepurchase agreements—**The*fair values reported forwholesale repurchase agreements are based on the discounted value ofcontractual cash flows. The discount rates used are representative ofapproximate rates currently offered on borrowings with similar remainingmaturities.

*FederalHome Loan Bank of Boston borrowings—**The* fair valuesreported for FHLB borrowings are based on the discounted value of contractualcash flows. The discount rates used are representative of approximate ratescurrently offered on borrowings with similar remaining maturities.

*Subordinateddeferrable interest debentures—**The*fair valuesreported for Subordinated deferrable interest debentures are based on thediscounted value of contractual cash flows. The discount rates used arerepresentative of approximate rates currently offered on instruments withsimilar terms and remaining maturities.

*Accruedinterest receivable and payable—**The*carrying valuesfor accrued interest receivable and payable approximate fair values because ofthe short-term nature of these financial instruments.

*Financial instruments withoff-balance sheet risk—**Since*the Bank’scommitments to originate or purchase loans, and for unused lines andoutstanding letters of credit, are primarily at market interest rates, there isno significant fair value adjustment.

**(19) Shareholders’Equity**

Capital guidelines issued by the Federal Reserve Board(“FRB”) require the Company to maintain minimum capital levels for capitaladequacy purposes. Tier I capital is defined as common equity and retainedearnings, less certain intangibles. The risk-based capital guidelines includeboth a definition of capital and a framework for calculating risk-weightedassets by assigning assets and off-balance-sheet items to one of four riskcategories, each with an appropriate weight. The risk-based capital rules aredesigned to make regulatory capital more sensitive to differences in riskprofiles among banks and bank holding companies, to account for off-balancesheet exposure and to minimize disincentives for holding liquid assets. TheBank is also subject to FDIC regulations regarding capital requirements. Theseregulations require banks to maintain minimum capital levels for capitaladequacy purposes and higher capital levels to be considered “well capitalized”.

As of December 31,2006 and 2005, the Company and the Bank met all applicable minimum capitalrequirements and were considered “well capitalized” by both the FRB and theFDIC. There have been no events or conditions since the end of the year thatmanagement believes would cause a change in either the 

F-40

----

**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

Company’s or the Bank’s categorization. The Company’sand the Bank’s actual and required capital amounts and ratios are as follows:

| ** **                               | ** ** | **Actual**                 | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Considered  “Well Capitalized”** | ** ** |
|------------------------------------------|------------|----------------------------|------------|----------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                               | ** ** | **Amount**                 | ** ** | **Ratio**                                    | ** ** | **Amount**                                                        | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| ** **                               | ** ** | **(Dollars in thousands)** | ** ** |
| At  December 31, 2006:              |       |                       |       |                                         |       |                                                              |       |   |   |   |   |   |   |   |   |
| Bancorp Rhode Island, Inc.:         |       |                       |       |                                         |       |                                                              |       |   |   |   |   |   |   |   |   |
| Tier I capital (to average assets)       |       | $                          | 121,782    |                                         | 8.37       | %                                                                 | $          | 43,658 |   |   | 3.00 | % |   | $ | 72,763 |   | 5.00 | % |
| Tier I capital (to risk-weighted assets) |       | 121,782                    |       | 12.05                                        | %          | 40,428                                                            |       |   | 4.00 | % |   | 60,642 |   | 6.00 | % |
| Total capital (to risk-weighted assets)  |       | 134,159                    |       | 13.27                                        | %          | 80,856                                                            |       |   | 8.00 | % |   | 101,070 |   | 10.00 | % |
| Bank Rhode Island:                       |       |                       |       |                                         |       |                                                              |       |   |   |   |   |   |   |   |   |
| Tier I capital (to average assets)       |       | $                          | 104,213    |                                         | 7.18       | %                                                                 | $          | 43,540 |   |   | 3.00 | % |   | $ | 72,567 |   | 5.00 | % |
| Tier I capital (to risk-weighted assets) |       | 104,213                    |       | 10.32                                        | %          | 40,405                                                            |       |   | 4.00 | % |   | 60,607 |   | 6.00 | % |
| Total capital (to risk-weighted assets)  |       | 116,590                    |       | 11.54                                        | %          | 80,809                                                            |       |   | 8.00 | % |   | 101,011 |   | 10.00 | % |
| At December 31, 2005:               |       |                       |       |                                         |       |                                                              |       |   |   |   |   |   |   |   |   |
| Bancorp Rhode Island, Inc.:         |       |                       |       |                                         |       |                                                              |       |   |   |   |   |   |   |   |   |
| Tier I capital (to average assets)       |       | $                          | 114,822    |                                         | 8.21       | %                                                                 | $          | 41,933 |   |   | 3.00 | % |   | $ | 69,889 |   | 5.00 | % |
| Tier I capital (to risk-weighted assets) |       | 114,822                    |       | 12.62                                        | %          | 36,394                                                            |       |   | 4.00 | % |   | 54,592 |   | 6.00 | % |
| Total capital (to risk-weighted assets)  |       | 126,200                    |       | 13.87                                        | %          | 72,789                                                            |       |   | 8.00 | % |   | 90,986 |   | 10.00 | % |
| Bank Rhode Island:                       |       |                       |       |                                         |       |                                                              |       |   |   |   |   |   |   |   |   |
| Tier I capital (to average assets)       |       | $                          | 93,339     |                                         | 6.67       | %                                                                 | $          | 41,965 |   |   | 3.00 | % |   | $ | 69,941 |   | 5.00 | % |
| Tier I capital (to risk-weighted assets) |       | 93,339                     |       | 10.26                                        | %          | 36,378                                                            |       |   | 4.00 | % |   | 54,566 |   | 6.00 | % |
| Total capital (to  risk-weighted assets) |       | 104,717                    |       | 11.51                                        | %          | 72,755                                                            |       |   | 8.00 | % |   | 90,944 |   | 10.00 | % |

 

F-41

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**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

**(20) Earnings PerShare**

Thefollowing table is a reconciliation of basic EPS and diluted EPS:

| ** **                          | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------|------------|--------------------------------------------|------------|
| ** **                          | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Basic EPS Computation:              |       |                                       |       |   |   |   |   |
| Numerator:                          |       |                                       |       |   |   |   |   |
| Net income (in thousands)           |       | $                                          | 7,711      |   | $ | 9,569 |   | $ | 8,614 |   |
| Denominator:                        |       |                                       |       |   |   |   |   |
| Weighted average shares outstanding |       | 4,766,854                                  |       | 4,478,081 |   | 3,975,413 |   |
| Basic EPS                           |       | $                                          | 1.62       |   | $ | 2.14 |   | $ | 2.17 |   |
| Diluted EPS  Computation:           |       |                                       |       |   |   |   |   |
| Numerator:                          |       |                                       |       |   |   |   |   |
| Net income (in thousands)           |       | $                                          | 7,711      |   | $ | 9,569 |   | $ | 8,614 |   |
| Denominator:                        |       |                                       |       |   |   |   |   |
| Common shares outstanding           |       | 4,766,854                                  |       | 4,478,081 |   | 3,975,413 |   |
| Stock options                       |       | 153,715                                    |       | 214,174 |   | 238,281 |   |
| Restricted stock                    |       | —                                     |       | 3,372 |   | 6,199 |   |
| Contingent shares                   |       | —                                     |       | 1,507 |   | — |   |
| Warrants                            |       | —                                     |       | — |   | 2,963 |   |
| Total shares                        |       | 4,920,569                                  |       | 4,697,134 |   | 4,222,856 |   |
| Diluted EPS                         |       | $                                          | 1.57       |   | $ | 2.04 |   | $ | 2.04 |   |

 

**(21) Regulation andLitigation**

The Company and the Bank are subject to extensiveregulation and examination by the FRB, the Rhode Island Division of Banking andthe FDIC, which insures the Bank’s deposits to the maximum extent permitted bylaw. The federal and state laws and regulations which are applicable to banksregulate, among other things, the scope of their business, their investments,their reserves against deposits, the timing of the availability of depositedfunds and the nature and amount of and collateral for certain loans. The lawsand regulations governing the Bank generally have been promulgated to protectdepositors and not for the purpose of protecting shareholders. Among otherthings, bank regulatory authorities have the right to restrict the payment ofdividends by banks and bank holding companies to shareholders.

The Company is involved inroutine legal proceedings occurring in the ordinary course of business. In theopinion of management, final disposition of these lawsuits will not have amaterial adverse effect on the consolidated financial condition or results ofoperations of the Company.

F-42

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**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

**(22) Parent CompanyStatements**

The following are condensed financial statements forBancorp Rhode Island, Inc. (the “Parent Company”):

**BalanceSheets**

| ** **                                                                                                                                                                                           | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                           | ** ** | **2006**              | ** ** | **2005** | ** ** |
| ** **                                                                                                                                                                                           | ** ** | **(In thousands)**    | ** ** |
| **Assets**                                                                                                                                                                                           |       |                  |       |   |   |
| Assets:                                                                                                                                                                                              |       |                  |       |   |   |
| Cash and due from banks                                                                                                                                                                              |       | $                     | —     |   | $ | 20 |   |
| Overnight investments                                                                                                                                                                                |       | 17,120                |       | 21,237 |   |
| Investment in subsidiaries                                                                                                                                                                           |       | 113,165               |       | 101,973 |   |
| Prepaid expenses and other assets                                                                                                                                                                    |       | 437                   |       | 381 |   |
| Total assets                                                                                                                                                                                         |       | $                     | 130,722    |   | $ | 123,611 |   |
| **Liabilities and Shareholders’ Equity**                                                                                                                                                        | ** ** | ** **            | ** ** | ** ** | ** ** |
| Liabilities:                                                                                                                                                                                         |       |                  |       |   |   |
| Subordinated deferrable interest debentures                                                                                                                                                          |       | $                     | 18,558     |   | $ | 18,558 |   |
| Other liabilities                                                                                                                                                                                    |       | 79                    |       | 221 |   |
| Total liabilities                                                                                                                                                                                    |       | 18,637                |       | 18,779 |   |
| Shareholders’ equity:                                                                                                                                                                           |       |                  |       |   |   |
| Preferred stock: par value $0.01 per share,  authorized 1,000,000 shares. Issued and outstanding: none                                                                                          |       | —                |       | — |   |
| Common stock: par value $0.01 per share, authorized  11,000,000 shares. Issued and outstanding: 4,792,380 shares at  December 31, 2006 and 4,719,126 shares in December 31, 2005 |       | 48                    |       | 47 |   |
| Additional paid-in capital                                                                                                                                                                           |       | 67,960                |       | 65,768 |   |
| Retained earnings                                                                                                                                                                                    |       | 47,091                |       | 42,241 |   |
| Accumulated other comprehensive loss, net                                                                                                                                                            |       | (3,014                | )          | (3,224 | ) |
| Total shareholders’ equity                                                                                                                                                                      |       | 112,085               |       | 104,832 |   |
| Total liabilities  and shareholders’ equity                                                                                                                                                     |       | $                     | 130,722    |   | $ | 123,611 |   |

 

F-43

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**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

**Statementsof Operations**

| ** **                                                             | ** ** | **Year Ended December 31,**                         | ** ** |
|------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                             | ** ** | **2006**                                                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                             | ** ** | **(In thousands, except per share data)** | ** ** |
| Income:                                                                |       |                                                               |       |   |   |   |   |
| Dividends received from subsidiaries                                   |       | $                                                                  | 700        |   | $ | 3,750 |   | $ | 3,500 |   |
| Interest on overnight investments                                      |       | 945                                                                |       | 486 |   | 30 |   |
| Total income                                                           |       | 1,645                                                              |       | 4,236 |   | 3,530 |   |
| Expenses:                                                              |       |                                                               |       |   |   |   |   |
| Interest on notes payable                                              |       | 1,460                                                              |       | 1,272 |   | 1,041 |   |
| Compensation expense                                                   |       | 98                                                                 |       | 97 |   | 130 |   |
| Directors’ fees                                                   |       | 261                                                                |       | 118 |   | 103 |   |
| Professional services                                                  |       | 550                                                                |       | 253 |   | 254 |   |
| Other expenses                                                         |       | 3                                                                  |       | 1 |   | 1 |   |
| Total expenses                                                         |       | 2,372                                                              |       | 1,741 |   | 1,529 |   |
| Income (loss) before income taxes                                      |       | (727                                                               | )          | 2,495 |   | 2,001 |   |
| Income tax expense (benefit)                                           |       | (540                                                               | )          | (423 | ) | (504 | ) |
| Income (loss) before equity in undistributed earnings  of subsidiaries |       | (187                                                               | )          | 2,918 |   | 2,505 |   |
| Equity in undistributed earnings of subsidiaries                       |       | 7,898                                                              |       | 6,651 |   | 6,109 |   |
| Net income                                                             |       | $                                                                  | 7,711      |   | $ | 9,569 |   | $ | 8,614 |   |

 

F-44

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**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

**Statementsof Cash Flow**

| ** **                                                                        | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                        | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                        | ** ** | **(In  thousands)**                        | ** ** |
| Cash flows from  operating activities:                                            |       |                                       |       |   |   |   |   |
| Net income                                                                        |       | $                                          | 7,711      |   | $ | 9,569 |   | $ | 8,614 |   |
| Adjustment to  reconcile net income to net cash provided by operating activities: |       |                                       |       |   |   |   |   |
| Equity in undistributed earnings of subsidiaries                                  |       | (7,898                                     | )          | (6,651 | ) | (6,109 | ) |
| Share-based compensation expense                                                  |       | 186                                        |       | 82 |   | 35 |   |
| Tax benefit from stock option exercises                                           |       | —                                     |       | 309 |   | 113 |   |
| (Increase) decrease in other assets                                               |       | (56                                        | )          | 107 |   | (91 | ) |
| Increase (decrease) in other liabilities                                          |       | (142                                       | )          | 8 |   | 110 |   |
| Other, net                                                                        |       | (1                                         | )          | — |   | 1 |   |
| Net cash provided by operating activities                                         |       | (200                                       | )          | 3,424 |   | 2,673 |   |
| Cash flows from  financing activities:                                            |       |                                       |       |   |   |   |   |
| Proceeds from notes payable                                                       |       | —                                     |       | — |   | 5,155 |   |
| Investment in subsidiaries                                                        |       | (3,000                                     | )          | (5,250 | ) | (5,155 | ) |
| Proceeds from issuance of common stock                                            |       | 1,663                                      |       | 22,532 |   | 1,266 |   |
| Tax benefit from stock option exercises                                           |       | 261                                        |       | — |   | — |   |
| Dividends on common stock                                                         |       | (2,861                                     | )          | (2,701 | ) | (2,315 | ) |
| Net cash used by financing activities                                             |       | (3,937                                     | )          | 14,581 |   | (1,049 | ) |
| Net increase  (decrease) in cash and due from banks                               |       | (4,137                                     | )          | 18,005 |   | 1,624 |   |
| Cash and cash  equivalents at beginning of year                                   |       | 21,257                                     |       | 3,252 |   | 1,628 |   |
| Cash and cash  equivalents at end of year                                         |       | $                                          | 17,120     |   | $ | 21,257 |   | $ | 3,252 |   |
| Supplementary  disclosures:                                                       |       |                                       |       |   |   |   |   |
| Cash paid  (received) for income taxes                                            |       | $                                          | (1,011     | ) | $ | (542 | ) | $ | (508 | ) |
| Non-cash  transactions:                                                           |       |                                       |       |   |   |   |   |
| Change in other  comprehensive income, net of taxes                               |       | 210                                        |       | (3,882 | ) | (897 | ) |

 

The Parent Company’sStatements of Changes in Shareholders’ Equity is identical to the ConsolidatedStatements of Changes in Shareholders’ Equity and therefore is not presentedhere.

F-45

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**BANCORP RHODE ISLAND, INC. Notes to Consolidated Financial Statements (Continued)**

**(23) Quarterly Results of Operations (unaudited)**

| ** **                                                     | ** ** | **2006 Quarter Ended**           | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                     | ** ** | **March 31**                          | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** |
| ** **                                                     | ** ** | **(In  thousands, except per share data)** | ** ** |
| Interest and  dividend income                                  |       |                                       | $          | 19,395 |   |   | $ | 19,762 |   |   | $ | 21,017 |   |   |   | $ | 21,028 |   |   |
| Interest expense                                               |       |                                       | 8,345      |   |   | 9,433 |   |   | 10,341 |   |   |   | 10,855 |   |   |
| Net interest income                                            |       |                                       | 11,050     |   |   | 10,329 |   |   | 10,676 |   |   |   | 10,173 |   |   |
| Provision for  loan and lease losses                           |       |                                       | 267        |   |   | 435 |   |   | 400 |   |   |   | 100 |   |   |
| Net interest income after provision for loan and  lease losses |       |                                       | 10,783     |   |   | 9,894 |   |   | 10,276 |   |   |   | 10,073 |   |   |
| Noninterest  income                                            |       |                                       | 2,305      |   |   | 2,815 |   |   | 1,544 |   |   |   | 2,324 |   |   |
| Noninterest  expense                                           |       |                                       | 10,824     |   |   | 9,725 |   |   | 9,504 |   |   |   | 8,674 |   |   |
| Income before taxes                                            |       |                                       | 2,264      |   |   | 2,984 |   |   | 2,316 |   |   |   | 3,723 |   |   |
| Income taxes                                                   |       |                                       | 739        |   |   | 978 |   |   | 673 |   |   |   | 1,186 |   |   |
| Net income                                                     |       |                                       | $          | 1,525 |   |   | $ | 2,006 |   |   | $ | 1,643 |   |   |   | $ | 2,537 |   |   |
| Basic EPS                                                      |       |                                       | $          | 0.32 |   |   | $ | 0.42 |   |   | $ | 0.34 |   |   |   | $ | 0.53 |   |   |
| Diluted EPS                                                    |       |                                       | $          | 0.31 |   |   | $ | 0.41 |   |   | $ | 0.33 |   |   |   | $ | 0.51 |   |   |

 

| ** **                                                     | ** ** | **2005 Quarter Ended**          | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                     | ** ** | **March 31**                         | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** |
| ** **                                                     | ** ** | **(In thousands, except per share data)** | ** ** |
| Interest and  dividend income                                  |       |                                      | $          | 15,745 |   |   | $ | 17,068 |   |   | $ | 17,862 |   |   |   | $ | 18,845 |   |   |
| Interest expense                                               |       |                                      | 5,374      |   |   | 6,298 |   |   | 7,095 |   |   |   | 7,852 |   |   |
| Net interest income                                            |       |                                      | 10,371     |   |   | 10,770 |   |   | 10,767 |   |   |   | 10,993 |   |   |
| Provision for  loan and lease losses                           |       |                                      | 300        |   |   | 354 |   |   | 415 |   |   |   | 377 |   |   |
| Net interest income after provision for loan and  lease losses |       |                                      | 10,071     |   |   | 10,416 |   |   | 10,352 |   |   |   | 10,616 |   |   |
| Noninterest  income                                            |       |                                      | 2,075      |   |   | 2,445 |   |   | 2,581 |   |   |   | 2,173 |   |   |
| Noninterest  expense                                           |       |                                      | 8,512      |   |   | 9,125 |   |   | 9,156 |   |   |   | 9,527 |   |   |
| Income before taxes                                            |       |                                      | 3,634      |   |   | 3,736 |   |   | 3,777 |   |   |   | 3,262 |   |   |
| Income taxes                                                   |       |                                      | 1,227      |   |   | 1,276 |   |   | 1,310 |   |   |   | 1,027 |   |   |
| Net income                                                     |       |                                      | $          | 2,407 |   |   | $ | 2,460 |   |   | $ | 2,467 |   |   |   | $ | 2,235 |   |   |
| Basic EPS                                                      |       |                                      | $          | 0.60 |   |   | $ | 0.55 |   |   | $ | 0.53 |   |   |   | $ | 0.47 |   |   |
| Diluted EPS                                                    |       |                                      | $          | 0.57 |   |   | $ | 0.52 |   |   | $ | 0.50 |   |   |   | $ | 0.46 |   |   |

 

F-46

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