Exhibit 13

**INTERNATIONALBANCSHARES CORPORATION AND SUBSIDIARIES(Consolidated)**

Thefollowing consolidated selected financial data is derived from the Corporation’saudited financial statements as of and for the five years ended December 31,2006. The following consolidated financial data should be read in conjunctionwith Management’s Discussion and Analysis of Financial Condition and Results ofOperations and the Consolidated Financial Statements and related notes in thisreport.

**SELECTEDFINANCIAL DATA**

| ** **                                                                  | ** ** | **AS OF OR FOR THE YEARS ENDED DECEMBER 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| ** **                                                                  | ** ** | **2006**                                                                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                  | ** ** | **(Dollars in Thousands, Except Per Share Data)**       | ** ** |
| **STATEMENT  OF CONDITION**                                                 | ** ** | ** **                                                                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Assets                                                                      |       | 10,911,454                                                                            |       | $ | 10,391,853 |   | $ | 9,921,505 |   | $ | 6,580,560 |   | $ | 6,497,638 |   |
| Net loans                                                                   |       | 4,970,273                                                                             |       | 4,547,896 |   | 4,807,623 |   | 2,700,354 |   | 2,725,349 |   |
| Deposits                                                                    |       | 6,989,918                                                                             |       | 6,656,426 |   | 6,571,104 |   | 4,435,699 |   | 4,239,899 |   |
| Other borrowed funds                                                        |       | 2,095,576                                                                             |       | 1,870,075 |   | 1,670,199 |   | 845,276 |   | 1,185,857 |   |
| Junior subordinated deferrable  interest  Debentures (Note 1)               |       | 210,908                                                                               |       | 236,391 |   | 235,395 |   | 172,254 |   | — |   |
| Shareholders’ equity                                                   |       | 842,056                                                                               |       | 792,867 |   | 753,090 |   | 577,383 |   | 547,264 |   |
| **INCOME STATEMENT**                                                        |       |                                                                                  |       |   |   |   |   |   |   |   |   |
| Interest income                                                             |       | $                                                                                     | 609,073    |   | $ | 508,705 |   | $ | 352,378 |   | $ | 318,051 |   | $ | 353,928 |   |
| Interest expense                                                            |       | 319,588                                                                               |       | 206,830 |   | 108,602 |   | 94,725 |   | 116,415 |   |
| Net interest income                                                         |       | 289,485                                                                               |       | 301,875 |   | 243,776 |   | 223,326 |   | 237,513 |   |
| Provision for possible loan  losses                                         |       | 3,849                                                                                 |       | 960 |   | 5,196 |   | 8,044 |   | 8,253 |   |
| Non-interest income                                                         |       | 176,971                                                                               |       | 167,222 |   | 134,816 |   | 127,273 |   | 85,645 |   |
| Non-interest expense                                                        |       | 288,677                                                                               |       | 255,988 |   | 196,484 |   | 160,001 |   | 155,131 |   |
| Income before income taxes and  cumulative  change in accounting  principle |       | 173,930                                                                               |       | 212,149 |   | 176,912 |   | 182,554 |   | 159,774 |   |
| Minority interest in  consolidated  subsidiary                              |       | 40                                                                                    |       | — |   | — |   | — |   | — |   |
| Income taxes                                                                |       | 56,889                                                                                |       | 71,370 |   | 57,880 |   | 60,426 |   | 54,013 |   |
| Cumulative effect of a change  in  accounting principle, net of taxes       |       | —                                                                                |       | — |   | — |   | — |   | (5,130 | ) |
| Net income                                                                  |       | $                                                                                     | 117,001    |   | $ | 140,779 |   | $ | 119,032 |   | $ | 122,128 |   | $ | 100,631 |   |
| Adjusted net income                                                         |       | $                                                                                     | 117,001    |   | $ | 140,779 |   | $ | 119,032 |   | $ | 122,128 |   | $ | 100,631 |   |
| Per common share (Note 2):                                                  |       |                                                                                  |       |   |   |   |   |   |   |   |   |
| Basic                                                                       |       | $                                                                                     | 1.85       |   | $ | 2.21 |   | $ | 1.92 |   | $ | 2.02 |   | $ | 1.61 |   |
| Diluted                                                                     |       | $                                                                                     | 1.83       |   | $ | 2.18 |   | $ | 1.88 |   | $ | 1.98 |   | $ | 1.58 |   |

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Note 1:   See note 1 of notes to the consolidatedfinancial statements regarding the adoption of FIN 46, as revised. The Companyearly-adopted the provisions of FIN 46, as revised, as of December 31,2003 and thus deconsolidated its investment in eight special purpose businesstrusts established for the issuance of trust preferred securities.

Note 2:   Per share information has been re-statedgiving retroactive effect to stock dividends distributed.

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**MANAGEMENT’SDISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OFOPERATIONS**

Management’s discussionand analysis represents an explanation of significant changes in the financialposition and results of operations of International Bancshares Corporation andsubsidiaries (the “Company” or the “Corporation”) on a consolidated basis forthe three-year period ended December 31, 2006. The following discussionshould be read in conjunction with the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2006, and the Selected Financial Data andConsolidated Financial Statements included elsewhere herein.

**Special Cautionary Notice Regarding Forward Looking Information**

Certain matters discussed in this report, excludinghistorical information, include forward-looking statements, within the meaningof Section 27A of the Securities Act of 1933, as amended, and Section 21Eof the Securities Exchange Act of 1934, as amended, and are subject to the safeharbor created by these sections. Although the Company believes suchforward-looking statements are based on reasonable assumptions, no assurancecan be given that every objective will be reached. The words “estimate,” “expect,”“intend,” “believe” and “project,” as well as other words or expressions of asimilar meaning are intended to identify forward-looking statements. Readersare cautioned not to place undue reliance on forward-looking statements, whichspeak only as of the date of this report. Such statements are based on currentexpectations, are inherently uncertain, are subject to risks and should beviewed with caution. Actual results and experience may differ materially fromthe forward-looking statements as a result of many factors.

Factors that couldcause actual results to differ materially from any results that are projected,forecasted, estimated or budgeted by the Company in forward-looking statementsinclude, among others, the following possibilities:

·       Changesin interest rates and market prices, which could reduce the Company’s netinterest margins, asset valuations and expense expectations.

·       Changesin the capital markets utilized by the Company and its subsidiaries, includingchanges in the interest rate environment that may reduce margins.

·       Changesin state and/or federal laws and regulations to which the Company and itssubsidiaries, as well as their customers, competitors and potentialcompetitors, are subject, including, without limitation, changes in theaccounting, tax and regulatory treatment of trust preferred securities, as wellas changes in banking, tax, securities, insurance and employment laws andregulations.

·       Changesin U.S.—Mexico trade, including, without limitation, reductions in bordercrossings and commerce resulting from the Homeland Security Programs called “US-VISIT,”which is derived from Section 110 of the Illegal Immigration Reform andImmigrant Responsibility Act of 1996.

·       Theloss of senior management or operating personnel.

·       Increasedcompetition from both within and outside the banking industry.

·       Changesin local, national and international economic business conditions thatadversely affect the Company’s customers and their ability to transactprofitable business with the Company, including the ability of its borrowers torepay their loans according to their terms or a change in the value of therelated collateral.

·       Thetiming, impact and other uncertainties of the Company’s potential futureacquisitions including the Company’s ability to identify suitable potentialfuture acquisition candidates, the success or 

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failure in the integrationof their operations and the Company’s ability to maintain its current branchnetwork and to enter new markets successfully and capitalize on growthopportunities.

·       Changesin the Company’s ability to pay dividends on its Common Stock.

·       Theeffects of the litigation and proceedings pending with the Internal RevenueService regarding the Company’s lease financing transactions.

·       Additionsto the Company’s loan loss allowance as a result of changes in local, nationalor international conditions which adversely affect the Company’s customers.

·       Politicalinstability in the United States or Mexico.

·       Technologicalchanges.

·       Actsof war or terrorism.

·       Theeffect of changes in accounting policies and practices as may be adopted by theregulatory agencies, as well as the Public Company Accounting Oversight Board,the Financial Accounting Standards Board and other accounting standardssetters.

It is not possible toforesee or identify all such factors. The Company makes no commitment to updateany forward-looking statement, or to disclose any facts, events orcircumstances after the date hereof that may affect the accuracy of anyforward-looking statement, unless required by law.

**Overview**

The Company, which isheadquartered in Laredo, Texas, with more than 230 facilities and more than 360ATMs, provides banking services for commercial, consumer and internationalcustomers of South, Central and Southeast Texas and the State of Oklahoma. TheCompany is one of the largest independent commercial bank holding companiesheadquartered in Texas. The Company, through its bank subsidiaries, is in thebusiness of gathering funds from various sources and investing those funds inorder to earn a return. The Company either directly or through a banksubsidiary owns two insurance agencies, a broker/dealer and a majority interestin an investment banking unit that owns a broker/dealer. The Company’s primaryearnings come from the spread between the interest earned on interest-bearingassets and the interest paid on interest-bearing liabilities. In addition, theCompany generates income from fees on products offered to commercial, consumerand international customers.

A primary goal of the Company isto grow net interest income and non-interest income while adequately managingcredit risk, interest rate risk and expenses. Effective management of capitalis a critical objective of the Company. A key measure of the performance of abanking institution is the return on average common equity (“ROE”). The Company’sROE for the year ended December 31, 2006 was 14.02% as compared to 17.97%for the year ended December 31, 2005.

The Company is very active infacilitating trade along the United States border with Mexico. The Company doesa large amount of business with customers domiciled in Mexico. Deposits frompersons and entities domiciled in Mexico comprise a large and stable portion ofthe deposit base of the Company’s bank subsidiaries. The Company also servesthe growing Hispanic population through the Company’s facilities locatedthroughout South, Central and Southeast Texas and the State of Oklahoma.

Expensecontrol is an essential element in the Company’s long-term profitability. As aresult, one of the key ratios the Company monitors is the efficiency ratio,which is a measure of non-interest expense to net-interest income plusnon-interest income. The Company’s efficiency ratio has been under 55% for eachof the last five years except 2006, which the Company’s review indicates isbetter than average compared to its national peer group. The Company’sefficiency ratio has increased over the last few years because of the Company’saggressive branch expansion which has added 64 branches during 2006 and 2005.The efficiency 

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ratio during 2006 was negatively affected by the $8.9million, net of tax, expense recognized in connection with the tax litigation.During rapid expansion periods, the Company’s efficiency ratio will suffer butthe long term benefits of the expansion should be realized in future periodsand benefits should positively impact the efficiency ratio in future periods.The Company believes that the de novo branching will help in attracting new lowcost deposits and loans and also help with the retention of current customersas more out of market banks expand their branching activities in Texas;however, the Company realizes that there is a certain amount of time beforeeach branch becomes profitable and thus negatively impacts earnings in theshort term. The Company has continued to foster the growth of loans to improvenet interest income; however, this process of expanding quality loan balancestakes a certain amount of time and also increases the provision for loan lossesin periods of expansion. The Company believes the de novo branch expansion isimportant to the future long term expansion of the Company.

**Results ofOperations**

**Summary**

**Consolidated Statements ofCondition Information**

| ** **                                          | ** ** | **December 31, 2006**      | ** ** | **December 31, 2005** | ** ** | **Percent Increase  (Decrease)** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|---------------------------------------|------------|
| ** **                                          | ** ** | **(Dollars in Thousands)** | ** ** |
| Assets                                              |       |                                 | 10,911,454 |                            |       |                                  | $          | 10,391,853 |   |   |   | 5.0 | % |   |
| Net loans                                           |       |                                 | 4,970,273  |                            |       |                                  | 4,547,896  |   |   |   | 9.3 |   |   |
| Deposits                                            |       |                                 | 6,989,918  |                            |       |                                  | 6,656,426  |   |   |   | 5.0 |   |   |
| Other borrowed funds                                |       |                                 | 2,095,576  |                            |       |                                  | 1,870,075  |   |   |   | 12.1 |   |   |
| Junior subordinated deferrable interest  debentures |       |                                 | 210,908    |                            |       |                                  | 236,391    |   |   |   | (10.8 | ) |   |
| Shareholders’  equity                          |       |                                 | 842,056    |                            |       |                                  | 792,867    |   |   |   | 6.2 |   |   |

 

**Consolidated Statements ofIncome Information**

| ** **                         | ** ** | **Year Ended  December 31,  2006** | ** ** | **Year Ended  December 31,  2005** | ** ** | **Percent  Increase  (Decrease)  2006 vs. 2005** | ** ** | **Year ended  December 31,  2004** | ** ** | **Percent  Increase  (Decrease)  2005 vs. 2004** | ** ** |
|------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|------------------------------------------------------------|------------|----------------------------------------------|------------|------------------------------------------------------------|------------|
| ** **                         | ** ** | **(Dollars in Thousands)**         | ** ** |
| Interest income                    |       |                                         | $          | 609,073                                      |       |                                                       |       | $                                            | 508,705    |                                                       |       |   | 19.7 | % |   |   | $ | 352,378 |   |   |   | 44.4 | % |   |
| Interest expense                   |       |                                         | 319,588    |                                         |       |                                                       | 206,830    |                                         |       |                                                       | 54.5       |   |   |   | 108,602 |   |   |   | 90.4 |   |   |
| Net interest income                |       |                                         | 289,485    |                                         |       |                                                       | 301,875    |                                         |       |                                                       | (4.1       | ) |   |   | 243,776 |   |   |   | 23.8 |   |   |
| Provision for possible loan losses |       |                                         | 3,849      |                                         |       |                                                       | 960        |                                         |       |                                                       | 300.9      |   |   |   | 5,196 |   |   |   | (81.5 | ) |   |
| Non-interest income                |       |                                         | 176,971    |                                         |       |                                                       | 167,222    |                                         |       |                                                       | 5.8        |   |   |   | 134,816 |   |   |   | 24.0 |   |   |
| Non-interest expense               |       |                                         | 288,677    |                                         |       |                                                       | 255,988    |                                         |       |                                                       | 12.8       |   |   |   | 196,484 |   |   |   | 30.3 |   |   |
| Net income                         |       |                                         | 117,001    |                                         |       |                                                       | 140,779    |                                         |       |                                                       | (16.9      | ) |   |   | 119,032 |   |   |   | 18.3 |   |   |
| Per  common share:                 |       |                                         |       |                                         |       |                                                       |       |                                         |       |                                                       |       |   |   |   |   |   |   |   |   |   |   |
| Basic                              |       |                                         | $          | 1.85                                         |       |                                                       |       | $                                            | 2.21       |                                                       |       |   | (16.3 | )% |   |   | $ | 1.92 |   |   |   | 15.1 | % |   |
| Diluted                            |       |                                         | 1.83       |                                         |       |                                                       | 2.18       |                                         |       |                                                       | (16.1      | ) |   |   | 1.88 |   |   |   | 16.0 |   |   |

 

 

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**Net Income**

Net income decreased forthe year ended December 31, 2006 as compared to the year ended December 31,2005 due in part, to a $8.9 million, net of tax, charge to operations as aresult of the loss of a tax lawsuit with the Internal Revenue Service that waslitigated during the third quarter of 2005 in the Federal District Court in SanAntonio, Texas and that relates to certain leasing transactions previouslydiscussed in Note 17 of the Notes to Consolidated Financial Statements.  Because of the trial court judgment issued onMarch 31, 2006, the uncertainty of the outcome at the appellate level and thesimilarity between the litigated lawsuit and the other tax case that ispending, the Company took the $8.9 million charge, net of tax.  Additionally, net income for the year endedDecember 31, 2006 was negatively impacted due to the inverted yield curve,increasing competition for deposits, and strategic decisions to reduce certainloan and deposit categories acquired from Local Financial Corporation (“LFIN”).  As a result of the inverted yield curve, theCompany’s interest revenue coming from its securities portfolio has beennegatively affected.  Because the Companyfaces the challenges of an inverted yield, the Company has placed greater emphasison growing its loan portfolio and potentially improving the volume of interestincome derived from loans.  However, thegreater emphasis on increasing loan balances comes with more risk and takestime to produce quality loans and does not guarantee the Company will achieveits goal.

Net income increased forthe year ended December 31, 2005 as compared to the year ended December 31,2004 primarily because of the full integration of the Company’s acquisition of LFIN,improved results in its Texas operations, and the efficiencies created by theoperations of the combined companies. Net income was positively impacted by $5,613,000, net of tax, ofdistributions received in the first and second quarter of 2005 from the January2005 merger of the PULSE EFT Association with Discover Financial Services, abusiness unit of Morgan Stanley.  Membersof the PULSE EFT Association received these distributions based in part upontheir volume of transactions through the PULSE network.  Net income for 2006, 2005 and 2004 has beennegatively affected by the aggressive de novo branching activity by theCompany.  The Company has added 32, 32,and 17 new branches in 2006, 2005 and 2004, respectively.  The new branches do not include the 52branches the Company acquired as a result of the LFIN acquisition.  The Company believes that the de novobranching will help in attracting new low cost deposits and loans and also helpwith the retention of current customers as more out of market banks expandtheir branching activities in Texas; however, the Company realizes that thereis a certain amount of time before each branch becomes  profitable and thus de novo branchingnegatively impacts earnings in the short term. As part of the LFIN acquisition, the Company decided to exit certainnational lending strategies that LFIN employed. As a result, the Company’s total loans have decreased from 2004 to2005.  During the fourth quarter of 2003,the Company reduced its assets by approximately $1 billion in anticipation ofthe LFIN acquisition.  The Company alsoincreased its overnight liquidity in the form of fed funds sold to prepare forthe cash payment required as part of the transaction.  On June 18, 2004, the Company completed itsacquisition of LFIN.  As a result of thestrategic management of earning assets, net interest income for the first,second and third quarters of 2004 was negatively affected.

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**Net Interest Income**

Netinterest income is the spread between income on interest-earning assets, suchas loans and securities, and the interest expense on liabilities used to fundthose assets, such as deposits, repurchase agreements and funds borrowed. Netinterest income is the Company’s largest source of revenue. Net interest incomeis affected by both changes in the level of interest rates and changes in theamount and composition of interest earning assets and interest bearingliabilities. Net interest income has decreased over the period from 2005 to2006 because of the inverted yield curve and the enormous competition fordeposits.

| ** **                                          | ** ** | **For the years ended December 31,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                          | ** ** | **2006  Average  Rate/Cost**                                  | ** ** | **2005  Average  Rate/Cost** | ** ** | **2004  Average  Rate/Cost** | ** ** |
| **Assets**                                          |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Interest earning assets:                            |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Loan, net of unearned discounts:                    |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Domestic                                            |       |                                                          | 8.42       | % |   |   | 7.12 | % |   |   | 5.99 | % |   |
| Foreign                                             |       |                                                          | 7.16       |   |   |   | 5.44 |   |   |   | 4.91 |   |   |
| Investment securities:                              |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Taxable                                             |       |                                                          | 4.58       |   |   |   | 3.98 |   |   |   | 3.64 |   |   |
| Tax-exempt                                          |       |                                                          | 4.88       |   |   |   | 4.84 |   |   |   | 4.54 |   |   |
| Federal funds sold                                  |       |                                                          | 4.79       |   |   |   | 2.77 |   |   |   | 1.22 |   |   |
| Other                                               |       |                                                          | 6.82       |   |   |   | 6.12 |   |   |   | 4.81 |   |   |
| Total interest-earning  assets                      |       |                                                          | 6.51       | % |   |   | 5.59 | % |   |   | 4.87 | % |   |
| **Liabilities**                                     |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Interest bearing liabilities:                       |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Savings and interest  bearing demand deposits       |       |                                                          | 1.91       | % |   |   | 1.23 | % |   |   | .75 | % |   |
| Time deposits:                                      |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Domestic                                            |       |                                                          | 3.81       |   |   |   | 2.29 |   |   |   | 1.44 |   |   |
| Foreign                                             |       |                                                          | 3.77       |   |   |   | 2.42 |   |   |   | 1.85 |   |   |
| Securities sold under  repurchase agreements        |       |                                                          | 4.50       |   |   |   | 3.65 |   |   |   | 3.64 |   |   |
| Other borrowings                                    |       |                                                          | 5.07       |   |   |   | 3.21 |   |   |   | 1.55 |   |   |
| Junior subordinated  deferrable interest debentures |       |                                                          | 9.72       |   |   |   | 7.88 |   |   |   | 6.38 |   |   |
| Senior notes                                        |       |                                                          | —     |   |   |   | — |   |   |   | 11.47 |   |   |
| Total interest bearing liabilities                  |       |                                                          | 3.84       | % |   |   | 2.53 | % |   |   | 1.69 | % |   |

 

Forthe three years ended December 31, 2006, as short term interest ratesincreased and stabilized, the Company accordingly increased interest rates onloans and deposits. The level of interest rates and the volume and mix ofearning assets and interest-bearing liabilities impact net income and netinterest margin. The yield on average interest-earning assets increased 16.5%from 5.59% in 2005 to 6.51% in 2006, and the rates paid on average interest-bearingliabilities increased 51.8% from 2.53% in 2005 to 3.84% in 2006. The yield onaverage interest-earning assets increased 14.8% from 4.87% in 2004 to 5.59% in2005, and the rates paid on average interest-bearing liabilities increased49.7% from 1.69% in 2004 to 2.53% in 2005. The majority of the Company’s taxableinvestment securities are invested in mortgage backed securities and duringrapid increases or reduction in interest rates, the yield on these securitiesdo not re-price as quickly as the loans.

The Company hasstrategically reduced loans acquired in the LFIN acquisition.  LFIN had a national real estate group thatloaned funds throughout the United States and after extensive review by theCompany, the Company concluded the national real estate group goals were notconsistent with the Company’s loan origination goals that emphasize risk,pricing and the desire to lend primarily in the markets that the Companyoccupies.  This strategic reductionnegatively impacted the interest recognized on loans.  The decrease in interest income arising fromthis strategic reduction was offset by continued 

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growthin the Company’s Texas branches. The Company has continued to grow depositsthrough its internal sales program. The Company strategically reduced certaindeposit categories of LFIN such as brokered deposits and certain public funddeposits. The Company decided not to continue the recruitment of brokereddeposits and certain public funds because of the high expense associated withthose types of funding sources and the lack of relationships those deposits carry.The strategic reduction in loans and deposits acquired with LFIN has negativelyimpacted net interest income.

The following table analyzes the changes in netinterest income during 2006 and 2005 and the relative effect of changes ininterest rates and volumes for each major classification of interest-earning assets and interest-bearingliabilities. Non-accrual loans have been included in assets for the purpose ofthis analysis, which reduces the resulting yields:

| ** **                                          | ** ** | **2006 compared to 2005**               | ** ** | **2005 compared to 2004**               | ** ** |
|-----------------------------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                          | ** ** | **Net increase (decrease) due to** | ** ** | **Net increase (decrease) due to** | ** ** |
| ** **                                          | ** ** | **Volume(1)**                                          | ** ** | **Rate(1)**                                            | ** ** | **Total** | ** ** | **Volume(1)** | ** ** | **Rate(1)** | ** ** | **Total** | ** ** |
| ** **                                          | ** ** | **(Dollars in Thousands)**                   | ** ** | **(Dollars in Thousands)**                   | ** ** |
| Interest earned on:                                 |       |                                                   |       |                                                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans, net of unearned discounts:                   |       |                                                   |       |                                                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Domestic                                            |       |                                                   | $          | (4,700                                                 | )          |   | $ | 58,593 |   | $ | 53,893 |   |   | $ | 48,906 |   |   | $ | 51,539 |   | $ | 100,445 |   |
| Foreign                                             |       |                                                   | 1,723      |                                                   |       | 4,954 |   | 6,677 |   |   | 1,556 |   |   | 1,370 |   | 2,926 |   |
| Investment securities:                              |       |                                                   |       |                                                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Taxable                                             |       |                                                   | 13,920     |                                                   |       | 26,379 |   | 40,299 |   |   | 37,615 |   |   | 13,468 |   | 51,083 |   |
| Tax-exempt                                          |       |                                                   | (322       | )                                                      |       | 37 |   | (285 | ) |   | (510 | ) |   | 301 |   | (209 | ) |
| Federal funds sold                                  |       |                                                   | (1,586     | )                                                      |       | 1,514 |   | (72 | ) |   | 30 |   |   | 2,061 |   | 2,091 |   |
| Other                                               |       |                                                   | (187       | )                                                      |       | 43 |   | (144 | ) |   | (151 | ) |   | 142 |   | (9 | ) |
| Total interest income                               |       |                                                   | $          | 8,848                                                  |       |   | $ | 91,520 |   | $ | 100,368 |   |   | $ | 87,446 |   |   | $ | 68,881 |   | $ | 156,327 |   |
| Interest incurred on:                               |       |                                                   |       |                                                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings and interest  bearing demand deposits       |       |                                                   | $          | (729                                                   | )          |   | $ | 14,237 |   | $ | 13,508 |   |   | $ | 2,624 |   |   | $ | 10,515 |   | $ | 13,139 |   |
| Time deposits:                                      |       |                                                   |       |                                                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Domestic                                            |       |                                                   | 261        |                                                   |       | 26,233 |   | 26,494 |   |   | 1,731 |   |   | 14,494 |   | 16,225 |   |
| Foreign                                             |       |                                                   | 2,842      |                                                   |       | 20,507 |   | 23,349 |   |   | 4,281 |   |   | 8,069 |   | 12,350 |   |
| Securities sold under  repurchase agreements        |       |                                                   | (2,958     | )                                                      |       | 5,711 |   | 2,753 |   |   | 7,489 |   |   | 30 |   | 7,519 |   |
| Other borrowings                                    |       |                                                   | 4,804      |                                                   |       | 37,869 |   | 42,673 |   |   | 12,488 |   |   | 31,455 |   | 43,943 |   |
| Junior subordinated  deferrable interest debentures |       |                                                   | (288       | )                                                      |       | 4,269 |   | 3,981 |   |   | 1,889 |   |   | 3,546 |   | 5,435 |   |
| Senior notes                                        |       |                                                   | —     |                                                   |       | — |   | — |   |   | (383 | ) |   | — |   | (383 | ) |
| Total interest expense                              |       |                                                   | $          | 3,932                                                  |       |   | $ | 108,826 |   | $ | 112,758 |   |   | $ | 30,119 |   |   | $ | 68,109 |   | $ | 98,228 |   |
| Net interest income                                 |       |                                                   | $          | 12,780                                                 |       |   | $ | (17,306 | ) | $ | (12,390 | ) |   | $ | 57,540 |   |   | $ | 559 |   | $ | 58,099 |   |

----

(Note 1)      Thechange in interest due to both rate and volume has been allocated to volume andrate changes in proportion to the relationship of the absolute dollar amountsof the change in each.

Aspart of its strategy to manage interest rate risk, the Company strives tomanage both assets and liabilities so that interest sensitivities match. Onemethod of calculating interest rate sensitivity is through gap analysis. A gapis the difference between the amount of interest rate sensitive assets andinterest rate sensitive liabilities that re-price or mature in a given timeperiod. Positive gaps occur when interest rate sensitive assets exceed interestrate sensitive liabilities, and negative gaps occur when interest rate sensitiveliabilities exceed interest rate sensitive assets. A positive gap position in aperiod of rising interest rates should have a positive effect on net interestincome as assets will re-price faster than liabilities. Conversely, netinterest income should contract somewhat in a period of falling interest rates.Management can quickly change the Company’s interest rate position at any givenpoint in time as market conditions dictate. Additionally, interest rate changesdo not affect all categories of assets and liabilities equally or at the same 

7

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time. Analytical techniques employed by the Company tosupplement gap analysis include simulation analysis to quantify interest raterisk exposure. The gap analysis prepared by management is reviewed by theInvestment Committee of the Company twice a year. The Investment Committee iscomprised of certain senior managers of the various Company bank subsidiariesalong with consultants. Management currently believes that the Company isproperly positioned for interest rate changes; however, if managementdetermines at any time that the Company is not properly positioned, it willstrive to adjust the interest rate sensitive assets and liabilities in order tomanage the effect of interest rate changes.

At December 31, 2006,based on these simulations, a rate shift of 200 basis points in interest ratesup or a rate shift of 200 basis points down will not vary net interest incomeby more than 2.7% of projected 2007 net interest income. The basis point shiftin interest rates is a hypothetical rate scenario used to calibrate risk, anddoes not necessarily represent management’s current view of future marketdevelopments. The Company believes that it is properly positioned for apotential interest rate increase or decrease.

**Allowance for Possible Loan Loss**

The following tablepresents information concerning the aggregate amount of non-accrual, past dueand restructured domestic loans; certain loans may be classified in one or morecategory:

| ** **                                                                             | ** ** | **December 31,**                | ** ** |
|----------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                             | ** ** | **2006**                             | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                             | ** ** | **(Dollars in Thousands)** | ** ** |
| Loans accounted for on a  non-accrual basis                                            |       | $                                    | 13,490     |   | $ | 17,129 |   | $ | 16,998 |   | $ | 20,874 |   | $ | 3,649 |   |
| Loans contractually past  due ninety days or more as to interest or principal payments |       | 7,476                                |       | 4,475 |   | 7,833 |   | 7,666 |   | 5,241 |   |
| Loans accounted for as “troubled debt restructuring”                         |       | —                               |       | — |   | — |   | 213 |   | 165 |   |
|                                                                                        |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The allowance for possibleloan losses decreased 17.0% to $64,537,000 at December 31, 2006 from$77,796,000 at December 31, 2005. The provision for possible loan lossescharged to expense increased $2,889,000 to $3,849,000 for the year ended December 31,2006 from $960,000 for the same period in 2005. The decrease in the allowancefor possible loan losses can be attributed to the charge off of loans acquiredas part of the LFIN acquisition. The increase in the provision for possibleloan losses charged to expense can be attributed to the growth in the loanportfolio. The allowance for possible loan losses was 1.3% of total loans, netof unearned income at December 31, 2006 and 1.7% at December 31, 2005.

Thefollowing table presents information concerning the aggregate amount ofnon-accrual and past due foreign loans extended to persons or entities inforeign countries. Certain loans may be classified in one or more category:

| ** **                                                                             | ** ** | **December 31,**                | ** ** |
|----------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                             | ** ** | **2006**                             | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                             | ** ** | **(Dollars in Thousands)** | ** ** |
| Loans accounted for on a  non-accrual basis                                            |       | $                                    | 4,298      |   | $ | 12,946 |   | $ | 13,741 |   | $ | 85 |   | $ | 254 |   |
| Loans contractually past due ninety days or more as  to interest or principal payments |       | 228                                  |       | 608 |   | 104 |   | 597 |   | 21 |   |
|                                                                                        |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in non-accrual loans from 2003 to 2004can be attributed to certain non-accrual loans acquired as a result of the LFINacquisition. The gross income that would have been recorded during 2006 and2005 on non-accrual and restructured loans in accordance with their originalcontract terms was $1,074,000 and $1,144,000 on domestic loans and $798,000 and$1,185,000 on foreign loans, respectively. The amount of interest income onsuch loans that was recognized in 2006 and 2005 was $289,000 and $252,000 ondomestic loans and $18,000 and $46,000 for foreign loans, respectively.

8

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The non-accrual loan policy of the bank subsidiariesis to discontinue the accrual of interest on loans when management determinesthat it is probable that future interest accruals will be uncollectible.Interest income on non-accrual loans is recognized only to the extent paymentsare received or when, in management’s opinion, the creditor’s financialcondition warrants reestablishment of interest accruals. Under specialcircumstances, a loan may be more than 90 days delinquent as to interest orprincipal and not be placed on non-accrual status. This situation generallyresults when a bank subsidiary has a borrower who is experiencing financialdifficulties, but not to the extent that requires a restructuring ofindebtedness. The majority of this category is composed of loans that areconsidered to be adequately secured and/or for which there has been a recenthistory of payments. When a loan is placed on non-accrual status, any interestaccrued, not paid is reversed and charged to operations against interestincome.

Loan commitments, consisting ofunused commitments to lend, letters of credit, credit card lines and otherapproved loans, that have not been funded, were $2,043,213,000 and$1,542,272,000 at December 31, 2006 and 2005, respectively. See Note 19 tothe Consolidated Financial Statements.

9

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Thefollowing table summarizes loan balances at the end of each year and averageloans outstanding during the year; changes in the allowance for possible loanlosses arising from loans charged-off and recoveries on loans previouslycharged-off by loan category; and additions to the allowance which have beencharged to expense:

| ** **                                                                                                  | ** ** | **2006**                             | ** ** | **2005** | ** ** | **2004**  | ** ** | **2003**  | ** ** | **2002** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|----------|------------|-----------|------------|-----------|------------|----------|------------|
| ** **                                                                                                  | ** ** | **(Dollars in Thousands)** | ** ** |
| Loans, net of  unearned discounts, outstanding at December 31                                          |       | $                                    | 5,034,810  |     | $          | 4,625,692 |       | $         | 4,888,974  |     | $          | 2,749,000 |   | $ | 2,769,562 |   |
| Average loans  outstanding during the year (Note 1)                                                         |       | $4,796,489                           |       | $        | 4,830,881  |      | $          | 3,982,580 |       | $        | 2,756,003  |   | $ | 2,664,856 |   |
| Balance of  allowance at January 1                                                                     |       | $                                    | 77,796     |     | $          | 81,351    |       | $         | 46,396     |     | $          | 42,210 |   | $ | 38,350 |   |
| Provision charged  to expense                                                                               |       | 3,849                                |       | 960      |       | 5,196     |       | 8,044     |       | 8,253    |       |
| Loans charged off:                                                                                          |       |                                 |       |     |       |      |       |      |       |     |       |
| Domestic:                                                                                                   |       |                                 |       |     |       |      |       |      |       |     |       |
| Commercial, financial and agricultural                                                                      |       | (7,302                               | )          | (2,703   | )          | (5,732    | )          | (2,174    | )          | (2,490   | )          |
| Real estate—mortgage                                                                                   |       | (554                                 | )          | (806     | )          | (1,179    | )          | (489      | )          | (240     | )          |
| Real estate—construction                                                                               |       | (99                                  | )          | (41      | )          | (295      | )          | —    |       | —   |       |
| Consumer                                                                                                    |       | (2,056                               | )          | (2,948   | )          | (2,034    | )          | (2,173    | )          | (2,412   | )          |
| Foreign                                                                                                     |       | (8,377                               | )          | (73      | )          | (273      | )          | (107      | )          | (115     | )          |
| Total loans  charged off:                                                                                   |       | (18,388                              | )          | (6,571   | )          | (9,513    | )          | (4,943    | )          | (5,257   | )          |
| Recoveries credited to allowance:                                                                           |       |                                 |       |     |       |      |       |      |       |     |       |
| Domestic:                                                                                                   |       |                                 |       |     |       |      |       |      |       |     |       |
| Commercial, financial and agricultural                                                                      |       | 625                                  |       | 1,436    |       | 4,841     |       | 313       |       | 495      |       |
| Real estate—mortgage                                                                                   |       | 130                                  |       | 69       |       | 93        |       | 41        |       | 247      |       |
| Real estate—construction                                                                               |       | 53                                   |       | 24       |       | 17        |       | —    |       | —   |       |
| Consumer                                                                                                    |       | 448                                  |       | 511      |       | 451       |       | 287       |       | 553      |       |
| Foreign                                                                                                     |       | 24                                   |       | 16       |       | 5         |       | 444       |       | 34       |       |
| Total recoveries                                                                                            |       | 1,280                                |       | 2,056    |       | 5,407     |       | 1,085     |       | 1,329    |       |
| Net loans charged  off                                                                                      |       | (17,108                              | )          | (4,515   | )          | (4,106    | )          | (3,858    | )          | (3,928   | )          |
| Allowance  acquired (disposed) in purchase or sale transactions                                             |       | —                               |       | —   |       | 33,865    |       | —    |       | (465     | )          |
| Balance of  allowance at December 31                                                                   |       | $                                    | 64,537     |     | $          | 77,796    |       | $         | 81,351     |     | $          | 46,396 |   | $ | 42,210 |   |
| Ratio of net  loans charged-off during the year to average loans outstanding during the  year (Note 1) |       | .36                                  | %          | .09      | %          | .10       | %          | .14       | %          | .15      | %          |
| Ratio of allowance to  loans, net of unearned discounts, outstanding at December 31                    |       | 1.28                                 | %          | 1.68     | %          | 1.66      | %          | 1.69      | %          | 1.52     | %          |

----

(Note 1)      Theaverage balances for purposes of the above table are calculated on the basis ofmonth-end balances for the years ended 2005, 2004, 2003 and 2002.

The loan balances increased despite the decline ofloans as a result of the Company’s strategy to reduce the exposure to certainloan categories that LFIN employed prior to the acquisition by the 

10

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Company. LFIN had anational real estate group that loaned funds throughout the United States andafter extensive review by the Company, the Company concluded the national realestate group goals were not consistent with the Company’s loan originationgoals that emphasize risk, pricing and the desire to lend primarily in themarkets that the Company occupies.

Theallowance for possible loan losses has been allocated based on the amountmanagement has deemed to be reasonably necessary to provide for the probablelosses incurred within the following categories of loans at the dates indicatedand the percentage of loans to total loans in each category:

| ** ** | ** ** | **At December 31,**        | ** ** |
|------------|------------|--------------------------------------|------------|
| ** ** | ** ** | **2006**                             | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** ** | ** ** | **Allowance**                        | ** ** | **Percent  of total** | ** ** | **Allowance** | ** ** | **Percent  of total** | ** ** | **Allowance** | ** ** | **Percent  of total** | ** ** | **Allowance** | ** ** | **Percent  of total** | ** ** | **Allowance** | ** ** | **Percent  of total** | ** ** |
| ** ** | ** ** | **(Dollars in Thousands)** | ** ** |
|            |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

| Commercial, Financial and Agricultural |   |   | $      | 28,158 |   |   |   | 46.5   | %      |   |   | $      | 34,283 |   |   |   | 51.4   | %      |   |   | $      | 46,061 |   |   |   | 55.5   | %     |   |   | $      | 25,112 |   |   |   | 50.9  | %      |   |   | $    | 25,767 |   |   |   | 57.5  | % |   |
|----------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|-------|--------|--------|--------|--------|--------|--------|--------|-------|--------|--------|--------|------|--------|--------|--------|--------|-------|---|--------|
| Real estate— Mortgage             |   |   | 9,461  |   |   |   | 15.6   |   |   |   | 12,228 |   |   |   | 18.3   |   |   |   | 16,325 |   |   |   | 19.6   |   |   |   | 8,887 |   |   |   | 18.0   |   |   |   | 8,203 |   |   |   | 18.3 |   |   |
| Real estate— Construction         |   |   | 16,914 |   |   |   | 27.9   |   |   |   | 13,007 |   |   |   | 19.5   |   |   |   | 12,741 |   |   |   | 15.3   |   |   |   | 8,828 |   |   |   | 17.9   |   |   |   | 4,468 |   |   |   | 10.0 |   |   |
| Consumer                               |   |   | 2,392  |   |   |   | 3.9    |   |   |   | 3,154  |   |   |   | 4.7    |   |   |   | 3,897  |   |   |   | 4.7    |   |   |   | 2,511 |   |   |   | 5.1    |   |   |   | 2,593 |   |   |   | 5.8  |   |   |
| Foreign                                |   |   | 7,612  |   |   |   | 6.1    |   |   |   | 15,124 |   |   |   | 6.1    |   |   |   | 2,327  |   |   |   | 4.9    |   |   |   | 1,058 |   |   |   | 8.1    |   |   |   | 1,179 |   |   |   | 8.4  |   |   |
|                                   |   |   | $      | 64,537 |   |   |   | 100.0  | %      |   |   | $      | 77,796 |   |   |   | 100.0  | %      |   |   | $      | 81,351 |   |   |   | 100.0  | %     |   |   | $      | 46,396 |   |   |   | 100.0 | %      |   |   | $    | 42,210 |   |   |   | 100.0 | % |   |

 

The allowance for possible loan losses consists of theaggregate loan loss allowances of the bank subsidiaries. The allowances areestablished through charges to operations in the form of provisions forpossible loan losses. Loan losses or recoveries are charged or crediteddirectly to the allowances. The decrease in the allowance for possible loanlosses can be attributed to the decrease in total loans, which is the result ofthe strategies employed after the consummation of the LFIN acquisition and thecharging off of certain loans acquired as part of the LFIN acquisition.

The bank subsidiaries charge offthat portion of any loan which management considers to represent a loss as wellas that portion of any other loan which is classified as a “loss” by bankexaminers. Commercial, financial and agricultural or real estate loans aregenerally considered by management to represent a loss, in whole or part, (i) whenan exposure beyond any collateral coverage is apparent, (ii) when nofurther collection of the portion of the loan so exposed is anticipated basedon actual results, (iii) when the credit enhancements, if any, are notadequate, and (iv) when the borrower’s financial condition would indicateso. Generally, unsecured consumer loans are charged off when 90 days past due.

Whilemanagement of the Company considers that it is generally able to identifyborrowers with financial problems reasonably early and to monitor creditextended to such borrowers carefully, there is no precise method of predictingloan losses. The determination that a loan is likely to be uncollectible andthat it should be wholly or partially charged off as a loss is an exercise ofjudgment. Similarly, the determination of the adequacy of the allowance forpossible loan losses can be made only on a subjective basis. It is the judgmentof the Company’s management that the allowance for possible loan losses at December 31,2006 was adequate to absorb probable losses from loans in the portfolio at thatdate. See Critical Accounting Policies on page 24.

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**Non-Interest Income**

| ** **                                   | ** ** | **Year Ended  December 31,  2006** | ** ** | **Year Ended  December 31,  2005** | ** ** | **Percent  Increase  (Decrease)  2006 vs. 2005** | ** ** | **Year Ended  December 31,  2004** | ** ** | **Percent  Increase  (Decrease)  2005 vs. 2004** | ** ** |
|----------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|------------------------------------------------------------|------------|----------------------------------------------|------------|------------------------------------------------------------|------------|
| ** **                                   | ** ** | **(Dollars in Thousands)**         | ** ** |
| Service charges on deposit accounts          |       |                                         | $          | 84,770                                       |       |                                                       |       | $                                            | 83,917     |                                                       |       |   | 1.0 | % |   |   | $ | 73,877 |   |   |   | 13.6 | % |   |
| Other service charges,  commissions and fees |       |                                         |       |                                         |       |                                                       |       |                                         |       |                                                       |       |   |   |   |   |   |   |   |   |   |   |
| Banking                                      |       |                                         | 29,523     |                                         |       |                                                       | 25,212     |                                         |       |                                                       | 17.1       |   |   |   | 19,320 |   |   |   | 30.5 |   |   |
| Non-banking                                  |       |                                         | 21,605     |                                         |       |                                                       | 12,248     |                                         |       |                                                       | 76.4       |   |   |   | 7,083 |   |   |   | 72.9 |   |   |
| Investment  securities transactions, net     |       |                                         | (930       | )                                            |       |                                                       | (181       | )                                            |       |                                                       | 413.8      |   |   |   | 8,884 |   |   |   | (102.0 | ) |   |
| Other  investments, net                      |       |                                         | 20,035     |                                         |       |                                                       | 20,629     |                                         |       |                                                       | (2.9       | ) |   |   | 13,012 |   |   |   | 58.5 |   |   |
| Other income                                 |       |                                         | 21,968     |                                         |       |                                                       | 25,397     |                                         |       |                                                       | (13.5      | ) |   |   | 12,640 |   |   |   | 100.9 |   |   |
| Total  non-interest income                   |       |                                         | $          | 176,971                                      |       |                                                       |       | $                                            | 167,222    |                                                       |       |   | 5.8 | % |   |   | $ | 134,816 |   |   |   | 24.0 | % |   |
|                                              |            |                                              |            |                                              |            |                                                            |            |                                              |            |                                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Non-interest incomeincreased in 2006 as compared to 2005 primarily because of income recognized bythe Company’s investment services unit. Non-interest income increased in 2005as compared to 2004 primarily because of the full integration of the Company’sacquisition of LFIN. The increase in other income from 2005 to 2004 can beattributed primarily to a gain of $8,636,000 from a distribution resulting fromthe January 2005 merger of the PULSE EFT Association with DiscoverFinancial Services, a business unit of Morgan Stanley. Members of the PULSE EFTAssociation received these distributions based in part upon their volume oftransactions through the PULSE network.

**Non-Interest Expense**

| ** **                                    | ** ** | **Year Ended  December 31,  2006** | ** ** | **Year Ended  December 31,  2005** | ** ** | **Percent  Increase  (Decrease)  2006 vs. 2005** | ** ** | **Year Ended  December 31,  2004** | ** ** | **Percent  Increase  (Decrease)  2005 vs. 2004** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|------------------------------------------------------------|------------|----------------------------------------------|------------|------------------------------------------------------------|------------|
| ** **                                    | ** ** | **(Dollars in Thousands)**         | ** ** |
| Employee compensation and benefits            |       |                                         | $          | 124,359                                      |       |                                                       |       | $                                            | 113,620    |                                                       |       |   | 9.5 | % |   |   | $ | 83,631 |   |   |   | 35.9 | % |   |
| Occupancy                                     |       |                                         | 27,886     |                                         |       |                                                       | 25,053     |                                         |       |                                                       | 11.3       |   |   |   | 18,403 |   |   |   | 36.1 |   |   |
| Depreciation of  bank premises and equipment  |       |                                         | 28,251     |                                         |       |                                                       | 25,538     |                                         |       |                                                       | 10.6       |   |   |   | 18,975 |   |   |   | 34.6 |   |   |
| Professional fees                             |       |                                         | 11,050     |                                         |       |                                                       | 12,497     |                                         |       |                                                       | (11.6      | ) |   |   | 6,513 |   |   |   | 91.9 |   |   |
| Stationery and  supplies                      |       |                                         | 6,490      |                                         |       |                                                       | 5,809      |                                         |       |                                                       | 11.7       |   |   |   | 5,075 |   |   |   | 14.5 |   |   |
| Amortization of  identified intangible assets |       |                                         | 4,866      |                                         |       |                                                       | 5,176      |                                         |       |                                                       | (6.0       | ) |   |   | 3,681 |   |   |   | 40.6 |   |   |
| Advertising                                   |       |                                         | 12,052     |                                         |       |                                                       | 10,596     |                                         |       |                                                       | 13.7       |   |   |   | 10,082 |   |   |   | 5.1 |   |   |
| Other                                         |       |                                         | 73,723     |                                         |       |                                                       | 57,699     |                                         |       |                                                       | 27.8       |   |   |   | 50,124 |   |   |   | 15.1 |   |   |
| Total  non-interest expense                   |       |                                         | $          | 288,677                                      |       |                                                       |       | $                                            | 255,988    |                                                       |       |   | 12.8 | % |   |   | $ | 196,484 |   |   |   | 30.3 | % |   |

 

Expensecontrol is an essential element in the Company’s profitability. This isachieved through maintaining optimum staffing levels, an effective budgetingprocess, and internal consolidation of bank functions. The increase in otherexpense in 2006 compared to 2005 can be attributed to the $13,640,000 inconnection with the tax lawsuits (see Note 17 to the consolidated financialstatements) expensed in the first quarter 2006. The increase in employeecompensation and benefits in 2006 compared to 2005 can be 

12

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attributed to increased fees paid by the Company’sinvestment banking unit, the GulfStar Group and the growth experienced with thede novo branch activity. The increase in non-interest expense for the threeyears ended 2006 can be attributed primarily to the expanded operations of theCompany’s bank subsidiaries, which added 81 branches in the three year periodended December 31, 2006 (excluding the acquisition of LFIN in June 2004,which added approximately 700 employees, 52 branches and $42,188,000 inidentified intangible assets), the amount expensed in connection with the taxlawsuits and increased fees paid by the Company’s investment banking unit, theGulfStar Group, in 2006.

**Effects of Inflation**

Theprincipal component of earnings is net interest income, which is affected bychanges in the level of interest rates. Changes in rates of inflation affectinterest rates. It is difficult to precisely measure the impact of inflation onnet interest income because it is not possible to accurately differentiatebetween increases in net interest income resulting from inflation and increasesresulting from increased business activity. Inflation also raises costs ofoperations, primarily those of employment and services.

**Financial Condition**

**Investment Securities**

Thefollowing table sets forth the carrying value of investment securities as of December 31,2006, 2005 and 2004:

| ** **                                        | ** ** | **December 31,**                | ** ** |
|---------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                        | ** ** | **2006**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                        | ** ** | **(Dollars in Thousands)** | ** ** |
| U.S. Treasury and  Government Securities          |       |                                 |       |   |   |   |   |
| Available for sale                                |       | $                                    | 1,268      |   | $ | 1,283 |   | $ | 9,276 |   |
| Mortgage-backed  securities                       |       |                                 |       |   |   |   |   |
| Available for sale                                |       | 4,376,284                            |       | 4,148,859 |   | 3,743,225 |   |
| Obligations of  states and political subdivisions |       |                                 |       |   |   |   |   |
| Available for sale                                |       | 95,897                               |       | 99,557 |   | 104,317 |   |
| Equity securities                                 |       |                                 |       |   |   |   |   |
| Available for sale                                |       | 14,629                               |       | 14,654 |   | 13,235 |   |
| Other securities                                  |       |                                 |       |   |   |   |   |
| Held to maturity                                  |       | 2,375                                |       | 2,375 |   | 2,385 |   |
| Available for sale                                |       | 2,079                                |       | 2,599 |   | 4,780 |   |
| Total                                             |       | $                                    | 4,492,532  |   | $ | 4,269,327 |   | $ | 3,877,218 |   |
|                                                   |            |                                      |            |  |  |  |  |  |  |  |  |  |  |

 

The following tables set forth the contractualmaturities of investment securities, based on amortized cost, at December 31,2006 and the average yields of such securities, except for the totals, whichreflect the weighted average yields. Actual maturities will differ fromcontractual maturities because borrowers may have the right to prepayobligations with or without prepayment penalties.

13

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| ** **                                                 | ** ** | **Available for Sale**     | ** ** |
|------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                 | ** ** | **Maturing**                         | ** ** |
| ** **                                                 | ** ** | **Within one year**        | ** ** | **After one but  within five years** | ** ** | **After five but  within ten years** | ** ** | **After ten years** | ** ** |
| ** **                                                 | ** ** | **Adjusted**                         | ** ** | **Adjusted** | ** ** | **Adjusted** | ** ** | **Adjusted** | ** ** |
| ** **                                                 | ** ** | **Cost**                             | ** ** | **Yield** | ** ** | **Cost** | ** ** | **Yield** | ** ** | **Cost** | ** ** | **Yield** | ** ** | **Cost** | ** ** | **Yield** | ** ** |
| ** **                                                 | ** ** | **(Dollars in Thousands)** | ** ** |
| U.S. Treasury and  obligations of U.S. Government agencies |       | $                                    | 1,268      |   |   | 5.09 | % |   | $ | — |   |   | — | % |   | $ | — |   |   |   | % |   | $ | — |   | — | % |
| Mortgage-backed  securities                                |       | 516                                  |       |   | 7.53 |   |   | 136,437 |   |   | 4.76 |   |   | 68,267 |   |   | 5.34 |   |   | 4,235,045 |   | 4.79 |   |
| Obligations of  states and political subdivisions          |       | —                               |       |   | — |   |   | 750 |   |   | 4.45 |   |   | 85,169 |   |   | 4.78 |   |   | 6,959 |   | 4.91 |   |
| Equity securities                                          |       | 325                                  |       |   | — |   |   | — |   |   | — |   |   | — |   |   | — |   |   | 13,500 |   | 4.41 |   |
| Other securities                                           |       | —                               |       |   | — |   |   | — |   |   | — |   |   | — |   |   | — |   |   | 4,630 |   | 13.00 |   |
| Total                                                      |       | $                                    | 2,109      |   |   | 4.89 | % |   | $ | 137,187 |   |   | 4.75 | % |   | $ | 153,436 |   |   | 5.03 | % |   | $ | 4,260,134 |   | 4.80 | % |

 

| ** **       | ** ** | **Held to Maturity**       | ** ** |
|------------------|------------|--------------------------------------|------------|
| ** **       | ** ** | **Maturing**                         | ** ** |
| ** **       | ** ** | **Within one year**        | ** ** | **After one but  within five years** | ** ** | **After five but  within ten years** | ** ** | **After ten years** | ** ** |
| ** **       | ** ** | **Adjusted**                         | ** ** | **Adjusted** | ** ** | **Adjusted** | ** ** | **Adjusted** | ** ** |
| ** **       | ** ** | **Cost**                             | ** ** | **Yield** | ** ** | **Cost** | ** ** | **Yield** | ** ** | **Cost** | ** ** | **Yield** | ** ** | **Cost** | ** ** | **Yield** | ** ** |
| ** **       | ** ** | **(Dollars in Thousands)** | ** ** |
| Other securities |       |                                 | $          | 75 |   |   |   | 5.72 | % |   | $ | 2,300 |   |   | 5.14 | % |   |   | $ | — |   |   |   | — |   |   |   | $ | — |   |   |   | — |   |   |
| Total            |       |                                 | $          | 75 |   |   |   | 5.72 | % |   | $ | 2,300 |   |   | 5.14 | % |   |   | $ | — |   |   |   | — |   |   |   | $ | — |   |   |   | — |   |   |

 

Mortgage-backed securitiesare securities primarily issued by the Federal Home Loan Mortgage Corporation (“FreddieMac”), Federal National Mortgage Association (“Fannie Mae”), and the GovernmentNational Mortgage Association (“Ginnie Mae”).

**Loans**

Theamounts of loans outstanding, by classification, at December 31, 2006,2005, 2004, 2003 and 2002 are shown in the following table:

| ** **                              | ** ** | **December 31,**                | ** ** |
|-----------------------------------------|------------|--------------------------------------|------------|
| ** **                              | ** ** | **2006**                             | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                              | ** ** | **(Dollars in Thousands)** | ** ** |
| Commercial,  financial and agricultural |       | $                                    | 2,337,573  |   | $ | 2,376,276 |   | $ | 2,710,270 |   | $ | 1,400,173 |   | $ | 1,595,140 |   |
| Real  estate-mortgage                   |       | 785,401                              |       | 847,512 |   | 960,599 |   | 495,481 |   | 507,837 |   |
| Real  estate—construction          |       | 1,404,186                            |       | 901,518 |   | 749,689 |   | 492,208 |   | 276,595 |   |
| Consumer                                |       | 198,580                              |       | 218,607 |   | 229,302 |   | 139,987 |   | 160,546 |   |
| Foreign                                 |       | 309,144                              |       | 281,947 |   | 239,622 |   | 222,797 |   | 233,276 |   |
| Total loans                             |       | 5,034,884                            |       | 4,625,860 |   | 4,889,482 |   | 2,750,646 |   | 2,773,394 |   |
| Unearned discount                       |       | (74                                  | )          | (168 | ) | (508 | ) | (1,646 | ) | (3,832 | ) |
| Loans, net of  unearned discount        |       | $                                    | 5,034,810  |   | $ | 4,625,692 |   | $ | 4,888,974 |   | $ | 2,749,000 |   | $ | 2,769,562 |   |

 

14

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Thefollowing table shows the amounts of loans (excluding real estate mortgages andconsumer loans) outstanding as of December 31, 2006, which based onremaining scheduled repayments of principal are due in the years indicated. Also,the amounts due after one year are classified according to the sensitivity tochanges in interest rates:

| ** **                              | ** ** | **Maturing**                         | ** ** |
|-----------------------------------------|------------|--------------------------------------|------------|
| ** **                              | ** ** | **Within  one year**            | ** ** | **After one  but within  five years** | ** ** | **After  five years** | ** ** | **Total** | ** ** |
| ** **                              | ** ** | **(Dollars in Thousands)** | ** ** |
| Commercial,  financial and agricultural |       | $                                    | 713,711    |   | $ | 1,401,687 |   | $ | 222,175 |   | $ | 2,337,573 |   |
| Real estate—construction           |       | 779,399                              |       | 583,278 |   | 41,509 |   | 1,404,186 |   |
| Foreign                                 |       | 190,915                              |       | 115,967 |   | 2,262 |   | 309,144 |   |
| Total                                   |       | $                                    | 1,684,025  |   | $ | 2,100,932 |   | $ | 265,946 |   | $ | 4,050,903 |   |

 

| ** **                           | ** ** | **Interest sensitivity**        | ** ** |
|--------------------------------------|------------|--------------------------------------|------------|
| ** **                           | ** ** | **Fixed Rate**                  | ** ** | **Variable Rate** | ** ** |
| ** **                           | ** ** | **(Dollars in Thousands)** | ** ** |
| Due after one but  within five years |       | $                                    | 298,744    |   |   | $ | 1,802,188 |   |   |
| Due after five  years                |       | 42,131                               |       |   | 223,815 |   |   |
| Total                                |       | $                                    | 340,875    |   |   | $ | 2,026,003 |   |   |

 

Total loan balances as of December 31,2006 as compared to December 31, 2005 have increased because of theCompany’s desire to grow loans organically. This increase occurred despite theCompany’s strategy to reduce the exposure to certain loan categories that LFINemployed prior to the acquisition by the Company. LFIN had a national realestate group that loaned funds throughout the United States and after extensivereview by the Company, the Company concluded the national real estate groupgoals were not consistent with the Company’s loan origination goals thatemphasize risk, pricing and the desire to lend primarily in the markets thatthe Company occupies.

**International Operations**

On December 31,2006, the Company had $309,144,000 (2.8% of total assets) in loans outstandingto borrowers domiciled in foreign countries. The loan policies of the Company’sbank subsidiaries generally require that loans to borrowers domiciled inforeign countries be primarily secured by assets located in the United Statesor have credit enhancements, in the form of guarantees, from significant UnitedStates corporations. The composition of such loans and the related amounts ofallocated allowance for possible loan losses as of December 31, 2006 ispresented below.

| ** **                                                                          | ** ** | **Amount   of Loans**      | ** ** | **Related  Allowance for  Possible Losses** | ** ** |
|-------------------------------------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                                          | ** ** | **(Dollars in Thousands)** | ** ** |
| Secured by certificates of deposits in United States banks                          |       | $                                    | 177,435    |                                                  |       | $ | 89 |   |   |
| Secured by United States real estate                                                |       | 40,518                               |       |                                                  | 421        |   |   |
| Secured by other United States collateral (securities, gold,  silver, etc.)         |       | 21,378                               |       |                                                  | 2,453      |   |   |
| Foreign real estate guaranteed under lease obligations primarily  by U.S. companies |       | 689                                  |       |                                                  | 121        |   |   |
| Direct unsecured Mexican sovereign debt (principally former  FICORCA debt)          |       | 2,249                                |       |                                                  | 22         |   |   |
| Other (principally Mexico real estate)                                              |       | 66,875                               |       |                                                  | 4,506      |   |   |
|                                                                                |       | $                                    | 309,144    |                                                  |       | $ | 7,612 |   |   |

 

15

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The transactions for the year ended December 31,2006, in that portion of the allowance for possible loan losses related toforeign debt were as follows:

| ** **                         | ** ** | **(Dollars in Thousands)** | ** ** |
|------------------------------------|------------|--------------------------------------|------------|
| Balance at December 31, 2005  |       |                                 | $          | 15,138 |   |   |
| Charge-offs                        |       |                                 | (8,537     | ) |   |
| Recoveries                         |       |                                 | 84         |   |   |
| Net charge-offs                    |       |                                 | (8,453     | ) |   |
| Provision charged to expense       |       |                                 | 927        |   |   |
| Balance  at December 31, 2006 |       |                                 | $          | 7,612 |   |   |

 

**Deposits**

| ** **                                | ** ** | **2006**                             | ** ** | **2005**                 | ** ** |
|-------------------------------------------|------------|--------------------------------------|------------|--------------------------|------------|
| ** **                                | ** ** | **Average Balance**             | ** ** | **Average Balance** | ** ** |
| ** **                                | ** ** | **(Dollars in Thousands)** | ** ** |
| Deposits:                                 |       |                                 |       |                     |       |   |   |   |   |
| Demand—non-interest bearing          |       |                                 |       |                     |       |   |   |   |   |
| Domestic                                  |       |                                 | $          | 1,240,419                |       |   |   | $ | 1,139,614 |   |   |
| Foreign                                   |       |                                 | 124,192    |                     |       |   | 114,080 |   |   |
| Total demand non-interest bearing         |       |                                 | 1,364,611  |                     |       |   | 1,253,694 |   |   |
| Savings and interest bearing demand       |       |                                 |       |                     |       |   |   |   |   |
| Domestic                                  |       |                                 | 1,810,759  |                     |       |   | 1,848,257 |   |   |
| Foreign                                   |       |                                 | 311,543    |                     |       |   | 333,046 |   |   |
| Total savings and interest bearing demand |       |                                 | 2,122,302  |                     |       |   | 2,181,303 |   |   |
| Time certificates of deposit              |       |                                 |       |                     |       |   |   |   |   |
| $100,000 or more:                         |       |                                 |       |                     |       |   |   |   |   |
| Domestic                                  |       |                                 | 823,145    |                     |       |   | 810,358 |   |   |
| Foreign                                   |       |                                 | 1,147,864  |                     |       |   | 1,050,166 |   |   |
| Less than $100,000:                       |       |                                 |       |                     |       |   |   |   |   |
| Domestic                                  |       |                                 | 897,597    |                     |       |   | 898,917 |   |   |
| Foreign                                   |       |                                 | 380,094    |                     |       |   | 360,299 |   |   |
| Total time, certificates of deposit       |       |                                 | 3,248,700  |                     |       |   | 3,119,740 |   |   |
| Total deposits                            |       |                                 | $          | 6,735,613                |       |   |   | $ | 6,554,737 |   |   |

 

16

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| ** **                                 | ** ** | **2006**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------|------------|--------------------------------------|------------|----------|------------|----------|------------|
| ** **                                 | ** ** | **(Dollars in Thousands)** | ** ** |
| Interest  expense:                         |       |                                 |       |     |       |     |       |
| Savings  and interest bearing demand       |       |                                 |       |     |       |     |       |
| Domestic                                   |       | $                                    | 36,606     |     | $          | 24,583   |       | $ | 11,991 |   |
| Foreign                                    |       | 3,838                                |       | 2,353    |       | 1,806    |       |
| Total  savings and interest bearing demand |       | 40,444                               |       | 26,936   |       | 13,797   |       |
| Time,  certificates of deposit             |       |                                 |       |     |       |     |       |
| $100,000  or more                          |       |                                 |       |     |       |     |       |
| Domestic                                   |       | 32,851                               |       | 18,705   |       | 10,483   |       |
| Foreign                                    |       | 44,143                               |       | 26,710   |       | 17,327   |       |
| Less  than $100,000                        |       |                                 |       |     |       |     |       |
| Domestic                                   |       | 33,225                               |       | 20,399   |       | 12,396   |       |
| Foreign                                    |       | 12,858                               |       | 7,420    |       | 4,453    |       |
| Total  time, certificates of deposit       |       | 123,077                              |       | 73,234   |       | 44,659   |       |
| Total  interest expense on deposits        |       | $                                    | 163,521    |     | $          | 100,170  |       | $ | 58,456 |   |

 

TheCompany offers a variety of deposit accounts having a wide range of interestrates and terms. The Company relies primarily on its high quality customerservice, sales programs, customer referrals and advertising to attract andretain these deposits. Deposits provide the primary source of funding for theCompany’s lending and investment activities, and the interest paid for depositsmust be managed carefully to control the level of interest expense. Deposits atDecember 31, 2006 were $6,989,918,000, an increase of 5.0% from$6,656,426,000 at December 31, 2005. The increase in deposits from 2005 to2006 is primarily the result of the Company’s internal sales programs toorganically grow deposits, despite the Company strategically reducing certaindeposit categories of LFIN such as brokered deposits and certain public funds. TheCompany decided not to continue the recruitment of brokered deposits andcertain public funds because of the high expense associated with those types offunding sources and the lack of relationships those deposits carry.

**Return on Equityand Assets**

Certainkey ratios for the Company for the years ended December 31, 2006, 2005 and2004 follows (Note 1):

| ** **                                                               | ** ** | **Years ended December 31,** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                               | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Percentage of net  income to:                                            |       |                                        |       |   |   |   |   |
| Average shareholders’ equity                                        |       | 14.02                                       | %          | 17.97 | % | 18.17 | % |
| Average total assets                                                     |       | 1.10                                        |       | 1.37 |   | 1.46 |   |
| Percentage of  average shareholders’ equity to average total assets |       | 7.82                                        |       | 7.62 |   | 8.04 |   |
| Percentage of cash  dividends per share to net income per share          |       | 37.64                                       |       | 32.58 |   | 38.42 |   |

 

----

(Note 1) The average balances for purposes of theabove table are calculated on the basis of month-end balances for 2005 and2004.

17

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**Liquidity andCapital Resources**

**Liquidity**

Themaintenance of adequate liquidity provides the Company’s bank subsidiaries withthe ability to meet potential depositor withdrawals, provide for customercredit needs, maintain adequate statutory reserve levels and take fulladvantage of high-yield investment opportunities as they arise. Liquidity isafforded by access to financial markets and by holding appropriate amounts ofliquid assets. The Company’s bank subsidiaries derive their liquidity largelyfrom deposits of individuals and business entities. Deposits from persons andentities domiciled in Mexico comprise a stable portion of the deposit base ofthe Company’s bank subsidiaries. Historically, the Mexico based deposits of theCompany’s bank subsidiaries have been a stable source of funding. Such depositscomprised approximately 30%, 28% and 28% of the Company’s bank subsidiaries’total deposits as of December 31, 2006, 2005 and 2004, respectively. Otherimportant funding sources for the Company’s bank subsidiaries have beenborrowings from the Federal Home Loan Bank (“FHLB”), securities sold underrepurchase agreements and large certificates of deposit, requiring managementto closely monitor its asset/liability mix in terms of both rate sensitivityand maturity distribution. Primary liquidity of the Company and itssubsidiaries has been maintained by means of increased investment inshorter-term securities, certificates of deposit and repurchase agreements. Asin the past, the Company will continue to monitor the volatility and cost offunds in an attempt to match maturities of rate-sensitive assets andliabilities, and respond accordingly to anticipated fluctuations in interestrates over reasonable periods of time.

**Asset/Liability Management**

The Company’s fund managementpolicy has as its primary focus the measurement and management of the banks’earnings at risk in the face of rising or falling interest rate forecasts. Theearliest and most simplistic concept of earnings at risk measurement is the gapreport, which is used to generate a rough estimate of the vulnerability of netinterest income to changes in market rates as implied by the relativere-pricings of assets and liabilities. The gap report calculates the differencebetween the amounts of assets and liabilities re-pricing across a series ofintervals in time, with emphasis typically placed on the one-year period. Thisdifference, or gap, is usually expressed as a percentage of total assets.

If an excess of liabilities overassets matures or re-prices within the one-year period, the statement ofcondition is said to be negatively gapped. This condition is sometimesinterpreted to suggest that an institution is liability-sensitive, indicatingthat earnings would suffer from rising rates and benefit from falling rates. Ifa surplus of assets over liabilities occurs in the one-year time frame, thestatement of condition is said to be positively gapped, suggesting a conditionof asset sensitivity in which earnings would benefit from rising rates andsuffer from falling rates.

The gap report thus consists of an inventory of dollaramounts of assets and liabilities that have the potential to mature or re-pricewithin a particular period. The flaw in drawing conclusions about interest raterisk from the gap report is that it takes no account of the probability thatpotential maturities or re-pricings of interest-rate-sensitive accounts willoccur, or at what relative magnitudes. Because simplicity, rather than utility,is the only virtue of gap analysis, financial institutions increasingly haveeither abandoned gap analysis or accorded it a distinctly secondary role inmanaging their interest-rate risk exposure.

The net interest ratesensitivity at December 31, 2006, is illustrated in the following table. Thisinformation reflects the balances of assets and liabilities whose rates aresubject to change. As indicated in the table on the following page, the Companyis liability-sensitive during the early time periods and is asset-sensitive inthe longer periods. The table shows the sensitivity of the statement ofcondition at one point in time and is not necessarily indicative of theposition at future dates.

18

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**INTERESTRATE SENSITIVITY(Dollars in Thousands)**

| ** **                                                      | ** ** | **Rate/Maturity**                    | ** ** |
|-----------------------------------------------------------------|------------|--------------------------------------|------------|
| **December 31, 2006**                                 | ** ** | ** **                           | ** ** | **3 Months or  Less** | ** ** | **Over 3  Months  to 1 Year** | ** ** | **Over 1  Year to 5  Years** | ** ** | **Over 5  Years** | ** ** | **Total** | ** ** |
| ** **                                                      | ** ** | **(Dollars in Thousands)** | ** ** |
| Rate sensitive assets                                           |       |                                 |       |   |   |   |   |   |   |   |   |
| Federal funds sold                                              |       | $                                    | 29,000     |   | $ | — |   | $ | — |   | $ | — |   | $ | 29,000 |   |
| Time deposits  with banks                                       |       | 396                                  |       | — |   | — |   | — |   | 396 |   |
| Investment  securities                                          |       | 27,155                               |       | 216,524 |   | 4,027,992 |   | 220,861 |   | 4,492,532 |   |
| Loans, net of non-accruals                                      |       | 3,664,838                            |       | 319,527 |   | 460,461 |   | 572,270 |   | 5,017,095 |   |
| Total earning assets                                            |       | $                                    | 3,721,389  |   | $ | 536,051 |   | $ | 4,488,453 |   | $ | 793,131 |   | $ | 9,539,024 |   |
| Cumulative earning assets                                       |       | $                                    | 3,721,389  |   | $ | 4,257,440 |   | $ | 8,745,893 |   | $ | 9,539,024 |   |   |   |
| Rate sensitive  liabilities                                     |       |                                 |       |   |   |   |   |   |   |   |   |
| Time deposits                                                   |       | $                                    | 1,441,173  |   | $ | 1,517,241 |   | $ | 372,482 |   | $ | 1,095 |   | $ | 3,331,991 |   |
| Other interest  bearing deposits                                |       | 2,204,451                            |       | — |   | — |   | — |   | 2,204,451 |   |
| Securities sold  under repurchase agreements                    |       | 268,183                              |       | 135,974 |   | 202,178 |   | 100,000 |   | 706,335 |   |
| Other borrowed  funds                                           |       | 2,095,505                            |       | — |   | — |   | 71 |   | 2,095,576 |   |
| Junior  subordinated deferrable interest debentures             |       | 177,975                              |       | 22,681 |   | — |   | 10,252 |   | 210,908 |   |
| Total interest bearing liabilities                              |       | $                                    | 6,187,287  |   | $ | 1,675,896 |   | $ | 574,660 |   | $ | 111,418 |   | $ | 8,549,261 |   |
| Cumulative sensitive liabilities                                |       | $                                    | 6,187,287  |   | $ | 7,863,183 |   | $ | 8,437,843 |   | $ | 8,549,261 |   |   |   |
| Repricing gap                                                   |       | $                                    | (2,465,898 | ) | $ | (1,139,845 | ) | $ | 3,913,793 |   | $ | 681,713 |   | $ | 989,763 |   |
| Cumulative repricing  gap                                       |       | (2,465,898                           | )          | (3,605,743 | ) | 308,050 |   | 989,763 |   |   |   |
| Ratio of  interest-sensitive assets to liabilities              |       | .601                                 |       | .320 |   | 7.811 |   | 7.119 |   | 1.116 |   |
| Ratio of cumulative,  interest- sensitive assets to liabilities |       | .601                                 |       | .541 |   | 1.037 |   | 1.116 |   |   |   |
|                                                                 |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The detailed inventory ofstatement of condition items contained in gap reports is the starting point ofincome simulation analysis. Income simulation analysis also focuses on thevariability of net interest income and net income, but without the limitationsof gap analysis. In particular, the fundamental, but often unstated, assumptionof the gap approach that every statement of condition item that can re-pricewill do so to the full extent of any movement in market interest rates is takeninto consideration in income simulation analysis.

Accordingly, income simulation analysis captures notonly the potential of assets and liabilities to mature or re-price, but alsothe probability that they will do so. Moreover, income simulation analysisfocuses on the relative sensitivities of these balance sheet items and projectstheir behavior over an extended period of time in a motion picture rather thansnapshot fashion. Finally, income simulation analysis permits management toassess the probable effects on balance sheet items not only of changes inmarket interest rates, but also of proposed strategies for responding to suchchanges. The Company and many other institutions rely primarily upon incomesimulation analysis in measuring and managing exposure to interest rate risk.

19

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At December 31, 2006, based on these simulations,a rate shift of 200 basis points in interest rates up or a rate shift of 200basis points down will not vary net interest income by more than 2.7% ofprojected 2007 net interest income.  Thebasis point shift in interest rates is a hypothetical rate scenario used tocalibrate risk, and does not necessarily represent management’s current view offuture market developments. The Company believes that it is properly positionedfor a potential interest rate increase or decrease.

All the measurements of risk described above are madebased upon the Company’s business mix and interest rate exposures at theparticular point in time. The exposure changes continuously as a result of theCompany’s ongoing business and its risk management initiatives. Whilemanagement believes these measures provide a meaningful representation of theCompany’s interest rate sensitivity, they do not necessarily take into accountall business developments that have an effect on net income, such as changes incredit quality or the size and composition of the statement of condition.

Principal sources of liquidity and funding for theCompany are dividends from subsidiaries and borrowed funds, with such fundsbeing used to finance the Company’s cash flow requirements. The Company closelymonitors the dividend restrictions and availability from the bank subsidiariesas disclosed in Note 20 to the Consolidated Financial Statements. At December 31,2006, the aggregate amount legally available to be distributed to the Companyfrom bank subsidiaries as dividends was approximately $140,250,000, assumingthat each bank subsidiary continues to be classified as “well capitalized”under the applicable regulations and excluding certified surplus. Pursuant toTexas law, a Texas state bank’s lending limit is twenty-five percent of thebank’s capital and certified surplus. The board of directors of the bankdetermines how much surplus will be certified. Except to absorb losses inexcess of undivided profits and uncertified surplus, certified surplus may notbe reduced without the prior written approval of the Texas banking commissioner.The restricted capital (capital, surplus and certified surplus) of the banksubsidiaries was approximately $908,783,000 as of December 31, 2006. Theundivided profits of the bank subsidiaries were approximately $536,740,000 asof December 31, 2006.

At December 31,2006, the Company has outstanding $2,095,576,000 in other borrowed funds and $210,908,000in junior subordinated deferrable interest debentures. In addition to borrowedfunds and dividends, the Company has a number of other available alternativesto finance the growth of its existing banks as well as future growth andexpansion.

**Capital**

The Company maintains anadequate level of capital as a margin of safety for its depositors andshareholders. At December 31, 2006, shareholders’ equity was $842,056,000compared to $792,867,000 at December 31, 2005, an increase of $49,189,000,or 6.2%. Shareholders’ equity increased due to the retention of earnings offsetby the payment of cash dividends to shareholders. The accumulated othercomprehensive loss is not included in the calculation of regulatory capitalratios.

During 1990, the Federal ReserveBoard (“FRB”) adopted a minimum leverage ratio of 3% for the most highly ratedbank holding companies and at least 4% to 5% for all other bank holdingcompanies. The Company’s leverage ratio (defined as shareholders’ equity pluseligible trust preferred securities issued and outstanding less goodwill andcertain other intangibles divided by average quarterly assets) was 7.36% at December 31,2006 and 7.26% at December 31, 2005. The core deposit intangibles andgoodwill of $316,604,000 as of December 31, 2006, recorded in connectionwith financial institution acquisitions of the Company after February 1992,are deducted from the sum of core capital elements when determining the capitalratios of the Company. The substantial increase in core deposit intangibles andgoodwill and the resulting decrease in the Company’s leverage ratio can beattributed to the LFIN acquisition.

The FRB has adopted risk-based capital guidelineswhich assign risk weightings to assets and off-balance sheet items. Theguidelines also define and set minimum capital requirements (risk-based capital

20

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ratios). Under the final1992 rules, all banks are required to have Tier 1 capital of at least 4.0% ofrisk-weighted assets and total capital of 8.0% of risk-weighted assets. Tier 1capital consists principally of shareholders’ equity plus trust preferredsecurities issued and outstanding less goodwill and certain other intangibles,while total capital consists of Tier 1 capital, certain debt instruments and aportion of the reserve for loan losses. In order to be deemed well capitalizedpursuant to the regulations, an institution must have a total risk-weightedcapital ratio of 10%, a Tier 1 risk-weighted ratio of 6% and a Tier 1 leverageratio of 5%. The Company had risk-weighted Tier 1 capital ratios of 12.49% and12.97% and risk weighted total capital ratios of 13.61% and 14.22% as of December 31,2006 and 2005, respectively, which are well above the minimum regulatoryrequirements and exceed the well capitalized ratios (see Note 20 to Notes toConsolidated Financial Statements).

During the past few yearsthe Company has expanded its banking facilities. Among the activities andcommitments the Company funded during 2006 and 2005 were certain capitalexpenditures relating to the modernization and improvement of several existingbank facilities and the expansion of the bank branch network.

**Junior SubordinatedDeferrable Interest Debentures**

The Company has formed ten statutory business trustsunder the laws of the State of Delaware, for the purpose of issuing trustpreferred securities. As part of the LFIN acquisition, the Company acquiredthree additional statutory business trusts previously formed by LFIN for thepurpose of issuing trust preferred securities. The ten statutory businesstrusts formed by the Company and the three business trusts acquired in the LFINtransaction (the “Trusts”) have each issued Capital and Common Securities andinvested the proceeds thereof in an equivalent amount of junior subordinateddebentures (the “Debentures”) issued by the Company or LFIN, as appropriate. TheCompany has succeeded to the obligations of LFIN under the LFIN Debentures,which have an outstanding principal balance of $20,620,000. The Debentures willmature on various dates; however the Debentures may be redeemed at specifiedprepayment prices, in whole or in part after the optional redemption datesspecified in the respective indentures or in whole upon the occurrence of anyone of certain legal, regulatory or tax events specified in respectiveindentures. As of December 31, 2006, the principal amount of debenturesoutstanding totaled $210,908,000.

On July 25, 2006, pursuant to the Indenture datedas of July 16, 2001, between the Company and The Bank of New York, asTrustee, the Company redeemed all of its Floating Rate Junior Subordinated DebtSecurities (the “Debt Securities”), issued to International Bancshares CapitalTrust II (“Trust II”) at a redemption price equal to approximately $27,998,000,which includes accrued interest to, but not including, the redemption date.

In accordance with the Amended and RestatedDeclaration of Trust dated as of July 16, 2001 between the Company and TheBank of New York as Institutional Trustee, the proceeds from the redemption ofthe Debt Securities were used to simultaneously redeem an equal amount of TrustII Floating Capital Securities and the Trust II Floating Rate Common Securitiesissued by Trust II.

On September 30, 2006, pursuant to the Indenturedated as of September 20, 2001, between Local Financial Corporation andThe Bank of New York, as Trustee, the Company redeemed all of its Fixed RateJunior Subordinated Debt Securities (the “Debt Securities”), issued to LocalFinancial Capital Trust I (“LFIN Trust I”) at a redemption price equal toapproximately $41,155,625, which includes accrued interest to, but notincluding, the redemption date.

In accordance with the Amended and RestatedDeclaration of Trust dated as of September 20, 2001 between LocalFinancial Capital Corporation and The Bank of New York as InstitutionalTrustee, the proceeds from the redemption of the Debt Securities were used tosimultaneously redeem an equal 

21

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amount of LFIN Trust IFixed Rate Capital Securities and the LFIN Trust I Fixed Rate Common Securitiesissued by LFIN Trust I.

On December 8, 2006, pursuant to the Indenturedated as of November 28, 2001, between the Company and Wilmington Trustcompany, as Trustee, the Company redeemed all of its Floating Rate JuniorSubordinated Debt Securities (the “Debt Securities”) issued to InternationalBancshares Capital Trust III (“Trust III”) at a redemption price equal toapproximately $34,538,000, which includes accrued interest to, but notincluding, the redemption date.

In accordance with the Amended and Restated Declarationof Trust dated as of November 28, 2001, between the Company and WilmingtonTrust Company, as the Institutional Trustee and Delaware Trustee and theAdministrators named therein, the proceeds from the redemption of the DebtSecurities were used to simultaneously redeem an equal amount of Trust IIIfloating rate Capital Securities and the Trust III floating rate CommonSecurities issued by Trust III.

On June 9, 2006, the Company formed InternationalBancshares Corporation Capital Trust IX (“Trust IX”), its ninth statutorybusiness trust formed under the laws of the State of Delaware, for the purposeof issuing trust preferred securities. On July 27, 2006, Trust IX issued$40,000,000 of Capital Securities. The Capital Securities accrue interest forthe first five years at a fixed rate of 7.10%, and subsequently at a floatingrate of 1.62% over the London Interbank Offered Rate (“LIBOR”), and interest ispayable quarterly beginning October 1, 2006. The Trust IX CapitalSecurities will mature on October 1, 2036; however, the Capital Securitiesmay be redeemed at specified prepayment prices (a) in whole or in part onany interest payment date on or after October 1, 2011, or (b) inwhole or in part within 90 days upon the occurrence of certain legal,regulatory, or tax events. The Capital Securities are subordinated and juniorin right of payment to all present and future senior indebtedness of theCompany. The Company has fully and unconditionally guaranteed the obligation ofTrust IX with respect to the Capital Securities. The Company has the right,unless an Event of Default has occurred and is continuing, to defer payment ofinterest on the Capital Securities for up to twenty consecutive quarterlyperiods. The redemption prior to maturity of any of the Capital Securities mayrequire the prior approval of the Federal Reserve and/or other regulatoryagencies.

On November 8, 2006, the Company formedInternational Bancshares Corporation Capital Trust X (“Trust X”), its tenthstatutory business trust formed under the laws of the State of Delaware, forthe purpose of issuing trust preferred securities. On November 15, 2006,Trust X issued $33,000,000 of Capital Securities. The Capital Securities accrueinterest for the first five years at a fixed rate of 6.66% and subsequently ata floating rate of 1.65% over the three month LIBOR, and interest is payablequarterly beginning February 1, 2007. The Trust X Capital Securities willmature on February 1, 2037; however, the Capital Securities may beredeemed at specified prepayment prices (a) in whole or in part on anyinterest payment date on or after February 1, 2012, or (b) in wholeor in part within 90 days upon the occurrence of certain legal, regulatory, ortax events. The Capital Securities are subordinated and junior in right ofpayment to all present and future senior indebtedness of the Company. TheCompany has fully and unconditionally guaranteed the obligation of Trust X withrespect to the Capital Securities. The Company has the right, unless an Eventof Default has occurred and is continuing, to defer payment of interest on theCapital Securities for up to twenty consecutive quarterly periods. Theredemption prior to maturity of any of the Capital Securities may require theprior approval of the Federal Reserve and/or other regulatory agencies.

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The Debentures aresubordinated and junior in right of payment to all present and future seniorindebtedness (as defined in the respective indentures) of the Company, and are *pari passu* with one another. The interest rate payable on,and the payment terms of the Debentures are the same as the distribution rateand payment terms of the respective issues of Capital and Common Securitiesissued by the Trusts. The Company has fully and unconditionally guaranteed theobligations of each of the Trusts with respect to the Capital and CommonSecurities. The Company has the right, unless an Event of Default (as definedin the Indentures) has occurred and is continuing, to defer payment of intereston the Debentures for up to ten consecutive semi-annual periods on Trusts I andIV and LFIN Trust II and for up to twenty consecutive quarterly periods onTrusts V, VI, VII, VIII, IX and X and LFIN Trust III. If interest payments onany of the Debentures are deferred, distributions on both the Capital andCommon Securities related to that Debenture would also be deferred. Theredemption prior to maturity of any of the Debentures may require the priorapproval of the Federal Reserve and/or other regulatory bodies.

For financial reportingpurposes, the Trusts are treated as investments of the Company and notconsolidated in the consolidated financial statements. Although the CapitalSecurities issued by each of the Trusts are not included as a component ofshareholders’ equity on the consolidated statement of condition, the CapitalSecurities are treated as capital for regulatory purposes. Specifically, underapplicable regulatory guidelines, the Capital Securities issued by the Trustsqualify as Tier 1 capital up to a maximum of 25% of Tier 1 capital on anaggregate basis. Any amount that exceeds the 25% threshold would qualify asTier 2 capital. For December 31, 2006, the total $210,908,000 of theCapital Securities outstanding qualified as Tier 1 capital.

In March 2005, theFederal Reserve Board issued a final rule that would continue to allow theinclusion of trust preferred securities in Tier 1 capital, but with stricterquantitative limits. Under the final rule, after a transition period ending March 31,2009, the aggregate amount of trust preferred securities and certain othercapital elements would be limited to 25% of Tier 1 capital elements, net ofgoodwill, less any associated deferred tax liability. The amount of trustpreferred securities and certain other elements in excess of the limit could beincluded in Tier 2 capital, subject to restrictions. Bank holding companieswith significant international operations will be expected to limit trustpreferred securities to 15% of Tier 1 capital elements, net of goodwill;however, they may include qualifying mandatory convertible preferred securitiesup to the 25% limit. The Company believes that substantially all of the currenttrust preferred securities will be included in Tier 1 capital after thefive-year transition period ending March 31, 2009.

Thefollowing table illustrates key information about each of the Debentures andtheir interest rates at December 31, 2006:

| ** **     | ** ** | **Junior  Subordinated  Deferrable  Interest  Debentures** | ** ** | **Repricing  Frequency** | ** ** | **Interest  Rate** | ** **    | **Interest  Rate Index(1)** | ** ** | **Maturity Date** | ** ** | **Optional  Redemption Date** | ** **     |
|----------------|------------|------------------------------------------------------------|------------|--------------------------|------------|--------------------|---------------|----------------------------------|------------|------------------------|------------|------------------------------------|----------------|
| ** **     | ** ** | **(in thousands)**                                    | ** ** | ** **               | ** ** | ** **         | ** **    | ** **                       | ** ** | ** **             | ** ** | ** **                         | ** **     |
| Trust I        |       |                                                       | $          | 10,252                   |       |               | Fixed         |                             |       | 10.18                  | %          |                               | Fixed          |   | June 2031 |   |   | June 2011 |   |   |
| Trust IV       |       |                                                       | $          | 22,681                   |       |               | Semi-Annually |                             |       | 9.09                   | %          |                               | LIBOR  + 3.70  |   | April 2032 |   |   | April 2007 |   |   |
| Trust V        |       |                                                       | $          | 20,558                   |       |               | Quarterly     |                             |       | 9.02                   | %          |                               | LIBOR  + 3.65  |   | July 2032 |   |   | July 2007 |   |   |
| Trust VI       |       |                                                       | $          | 25,662                   |       |               | Quarterly     |                             |       | 8.82                   | %          |                               | LIBOR  + 3.45  |   | November 2032 |   |   | November 2007 |   |   |
| Trust VII      |       |                                                       | $          | 10,310                   |       |               | Quarterly     |                             |       | 8.62                   | %          |                               | LIBOR  + 3.25  |   | April 2033 |   |   | April 2008 |   |   |
| Trust VIII     |       |                                                       | $          | 25,566                   |       |               | Quarterly     |                             |       | 8.42                   | %          |                               | LIBOR  + 3.05  |   | October 2033 |   |   | October 2008 |   |   |
| Trust IX       |       |                                                       | $          | 41,238                   |       |               | Quarterly     |                             |       | 7.10                   | %          |                               | Fixed          |   | October 2036 |   |   | October 2011 |   |   |
| Trust X        |       |                                                       | $          | 34,021                   |       |               | Quarterly     |                             |       | 6.66                   | %          |                               | Fixed          |   | February 2037 |   |   | February 2012 |   |   |
| LFIN Trust II  |       |                                                       | $          | 10,310                   |       |               | Semi-Annually |                             |       | 9.17                   | %          |                               | LIBOR  + 3.625 |   | July 2032 |   |   | July 2007 |   |   |
| LFIN Trust III |       |                                                       | $          | 10,310                   |       |               | Quarterly     |                             |       | 8.82                   | %          |                               | LIBOR  + 3.45  |   | November 2032 |   |   | November 2007 |   |   |
|           |       |                                                       | $          | 210,908                  |       |               |          |                             |       |                   |       |                               |           |   |   |   |   |   |   |   |

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(1)          TrustIX and Trust X accrue interest at a fixed rate for the first five years,then floating at LIBOR+1.62 and LIBOR+1.65 thereafter, respectively.

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**Contractual Obligations and Commercial Commitments**

The following table presents contractual cashobligations of the Company (other than deposit liabilities) as of December 31,2006:

| ** **                                          | ** ** | **Payments due by Period** | ** ** |
|-----------------------------------------------------|------------|-------------------------------------------|------------|
| **Contractual Cash Obligations**          | ** ** | ** **                                | ** ** | **Total** | ** ** | **Less than  One Year** | ** ** | **One to  Three Years** | ** ** | **Three to  Five Years** | ** ** | **After  Five Years** | ** ** |
| ** **                                          | ** ** | **(Dollars in Thousands)**      | ** ** |
| Securities sold under repurchase  agreements        |       | $                                         | 706,335    |   | $ | 419,157 |   |   | $ | 2,178 |   |   |   | $ | — |   |   | $ | 285,000 |   |
| Federal Home Loan Bank  borrowings                  |       | $                                         | 2,095,576  |   | 2,095,505 |   |   | — |   |   |   | — |   |   | 71 |   |
| Junior subordinated deferrable interest  debentures |       | $                                         | 210,908    |   | — |   |   | — |   |   |   | — |   |   | 210,908 |   |
| Total  Contractual Cash Obligations                 |       | $                                         | 3,012,819  |   | $ | 2,514,662 |   |   | $ | 2,178 |   |   |   | $ | — |   |   | $ | 495,979 |   |
|                                                     |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Thefollowing table presents contractual commercial commitments of the Company(other than deposit liabilities) as of December 31, 2006:

| ** **                                           | ** ** | **Amount of Commitment Expiration Per Period** | ** ** |
|------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| **Commercial Commitments**                      | ** ** | ** **                                                              | ** ** | **Total** | ** ** | **Less than  One Year** | ** ** | **One to  Three Years** | ** ** | **Three to  Five Years** | ** ** | **After  Five Years** | ** ** |
| ** **                                           | ** ** | **(Dollars in Thousands)**                                    | ** ** |
| Financial and  Performance Standby Letters of Credit |       | $                                                                       | 124,113    |   | $ | 117,199 |   |   | $ | 6,814 |   |   | $ | 100 |   |   | $ | — |   |   |
| Commercial  Letters of Credit                        |       | $                                                                       | 22,314     |   | 22,314 |   |   | — |   |   | — |   |   | — |   |   |
| Credit Card Lines                                    |       | $                                                                       | 36,404     |   | 36,404 |   |   | — |   |   | — |   |   | — |   |   |
| Other Commercial  Commitments                        |       | $                                                                       | 1,860,382  |   | 1,159,433 |   |   | 555,884 |   |   | 101,325 |   |   | 43,740 |   |   |
| Total Commercial  Commitments                        |       | $                                                                       | 2,043,213  |   | $ | 1,335,350 |   |   | $ | 562,698 |   |   | $ | 101,425 |   |   | $ | 43,740 |   |   |
|                                                      |            |                                                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Due to the nature of theCompany’s commercial commitments, including unfunded loan commitments and linesof credit, the amounts presented above do not necessarily reflect the amountsthe Company anticipates funding in the periods presented above.

**Critical AccountingPolicies**

The Company has establishedvarious accounting policies which govern the application of accountingprinciples in the preparation of the Company’s consolidated financialstatements. The significant accounting policies are described in the Notes tothe Consolidated Financial Statements. Certain accounting policies involvesignificant subjective judgments and assumptions by management which have amaterial impact on the carrying value of certain assets and liabilities;management considers such accounting policies to be critical accounting policies.

The Company considers itsAllowance for Possible Loan Losses as a policy critical to the sound operationsof the bank subsidiaries. The allowance for possible loan losses consists ofthe aggregate loan loss allowances of the bank subsidiaries. The allowances areestablished through charges to operations in the form of provisions forpossible loan losses. Loan losses or recoveries are charged or crediteddirectly to the allowances. The allowance for possible loan losses of each banksubsidiary is maintained at a level considered appropriate by management, basedon estimated probable losses in the loan portfolio. The allowance is derivedfrom the following elements: (i) allowances established on specific loansand (ii) allowances based on historical loss experience on the Company’sremaining loan portfolio, which includes general economic conditions and otherqualitative risk factors both internal and external to the Company. See alsodiscussion regarding the allowance for possible loan losses and provision forpossible 

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loanlosses included in the results of operations and “Provision and Allowance forPossible Loan Losses” included in Notes 1 and 5 of the Notes to ConsolidatedFinancial Statements.

The specific loan loss provisionis determined using the following methods. On a weekly basis, loan past duereports are reviewed by the servicing loan officer to determine if a loan hasany potential problem and if a loan should be placed on the Company’s internalclassified report. Additionally, the Company’s credit department reviews themajority of the loans regardless of whether they are past due and segregatesany loans with potential problems for further review. The credit departmentwill discuss the potential problem loans with the servicing loan officers todetermine any relevant issues that were not discovered in the evaluation. Also,any analysis on loans that is provided through examinations by regulatoryauthorities is considered in the review process. After the above analysis iscompleted, the Company will determine if a loan should be placed on an internalclassified report because of issues related to the analysis of the credit,credit documents, collateral and/or payment history.

The Company’s internalclassified report is segregated into the following categories: (i) “PassCredits,” (ii) “Special Review Credits,” (iii) “Watch ListCredits-Pass Credits,” or (iv) “Watch List Credits-Substandard andDoubtful Credits.” The loans placed in the “Pass Credits” category reflect theCompany’s opinion that the loan conforms to the bank’s lending policies, whichincludes the borrower’s ability to repay, the value of the underlyingcollateral, if any, as it relates to the outstanding indebtedness of the loan,and the economic environment and industry in which the borrower operates. Theloans placed in the “Special Review Credits” or the “Watch List Credits-PassCredits” category reflect the Company’s opinion that the loans reflectpotential weakness which require monitoring on a more frequent basis; however,the “Special Review Credits” or the “Watch List Credits-Pass Credits” are notconsidered to need a specific reserve at the time, but are reviewed anddiscussed on a regular basis with the credit department and the lending staffto determine if a change in category is warranted. The loans placed in the “WatchList Credits-Substandard and Doubtful Credits” category reflect the Company’sopinion that the loans contain clearly pronounced credit weaknesses and/orinherent financial weaknesses of the borrower. Credits classified as “WatchList Credits-Substandard and Doubtful Credits” are potentially evaluated underStatement of Financial Accounting Standards No. 114, “Accounting byCreditors for Impairment of a Loan,” criteria and, if deemed necessary aspecific reserve is allocated to the credit. The specific reserve allocatedunder SFAS No. 114, is based on (1) the present value of expectedfuture cash flows discounted at the loan’s effective interest rate; (2) theloan’s observable market price; or (3) the fair value of the collateral ifthe loan is collateral dependent. Substantially all of the Company’s loansevaluated under SFAS No. 114 are measured using the fair value ofcollateral method. In limited cases, the Company may use other methods todetermine the specific reserve of a loan under SFAS No. 114 if such loanis not collateral dependent.

The allowance, based onhistorical loss experience on the Company’s remaining loan portfolio, whichincludes the “Pass Credits,” “Special Review Credits,” “Watch List Credits-PassCredits,” and “Watch List Credits-Substandard and Doubtful Credits” isdetermined by segregating the remaining loan portfolio into certain categoriessuch as commercial loans, installment loans, international loans, loanconcentrations and overdrafts. Installment loans are then further segregated bynumber of days past due. A historical loss percentage, adjusted for (i) management’sevaluation of changes in lending policies and procedures, (ii) currenteconomic conditions in the market area served by the Company, (iii) otherrisk factors, (iv) the effectiveness of the internal loan review function,(v) changes in loan portfolios, and (vi) the composition andconcentration of credit volume is applied to each category. Each category isthen added together to determine the allowance allocated under Statement ofFinancial Accounting Standards No. 5.

The Company’s management continually reviews theallowance for loan loss of the bank subsidiaries using the amounts determinedfrom the allowances established on specific loans, the allowance establishedbased on historical percentages and the loans charged off and recoveries toestablish an appropriate amount to maintain in the Company’s allowance for loanloss. If the bases of the Company’s assumptions 

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change, the allowance forloan loss would either decrease or increase and the Company would increase ordecrease the provision for loan loss charged to operations accordingly.

Through December 31, 2005, the Company accountedfor stock-based employee compensation plans based on the intrinsic value methodprovided in Accounting Principles Board Opinion No. 25 “Accounting forStock Issued to Employees,” (“APB No. 25”), and related interpretations. Becausethe exercise price of the Company’s employee stock options equals the marketprice of the underlying stock on the measurement date, which is generally thedate of grant, no compensation expense was recognized on options granted. Compensationexpense for stock awards is based on the market price of the stock on themeasurement date, which is generally the date of grant, and is recognizedratably over the service period of the award.

Statement of Financial Accounting Standards No. 123(“SFAS No. 123”), “Accounting for Stock-Based Compensation,” as amended byStatement of Financial Accounting Standards No. 148 (“SFAS No. 148”),“Accounting for Stock-Based Compensation—Transition and Disclosure, anamendment of FASB Statement No. 123,” requires pro forma disclosures ofnet income and earnings per share for companies not adopting its fair valueaccounting method for stock-based employee compensation. The pro forma disclosurespresented in Note 3 in the accompanying Notes to Consolidated FinancialStatements included elsewhere in this report use the fair value method of SFAS No. 123to measure compensation expense for stock-based employee compensation plans. Thefair value of stock options granted was estimated as the measurement date,which is generally the date of grant, using the Black-Sholes-Mertonoption-pricing model. This model was developed for use in estimating the fairvalue of publicly traded options that have no vesting restrictions and arefully transferable. Additionally, the model requires the input of highlysubjective assumptions. Because the Company’s employee stock options havecharacteristics significantly different from those of publicly traded options,and because changes in the subjective input assumptions can materially affectthe fair value estimate, in management’s opinion, the Black-Sholes-Mertonoption-pricing model does not necessarily provide a reliable single measure ofthe fair value of the Company’s stock options.

In December 2004, theFinancial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards No. 123R (“SFAS No. 123R”), “Share-Based Payment(Revised 2004).”  Among other things,SFAS No. 123R eliminates the ability to account for stock-basedcompensation using APB No. 25 and requires that such transactions berecognized as compensation cost in the income statement based on their fairvalues on the date of the grant. SFAS No. 123R was adopted by the Companyon January 1, 2006.

**Recent AccountingStandards Issued**

SeeNote 1—Summary of Significant Accounting Policies in the accompanying Notes tothe Consolidated Financial Statements for details of recently issued andrecently adopted accounting standards and their impact on the Company’sconsolidated financial statements.

**Common Stock andDividends**

The Company had issued andoutstanding 63,015,435 shares of $1.00 par value Common Stock held byapproximately 2,563 holders of record at February 22, 2007. The book valueof the stock at December 31, 2006 was $14.41 per share compared with$13.66 per share at December 31, 2005.

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The Common Stock is traded on the NASDAQ NationalMarket under the symbol “IBOC.”  The following table sets forth the approximatehigh and low bid prices in the Company’s Common Stock during 2005 and 2006, asquoted on the NASDAQ National Market for each of the quarters in the two yearperiod ended December 31, 2006. Some of the quotations reflectinter-dealer prices, without retail mark-up, mark-down or commission and maynot necessarily represent actual transactions. The closing sales price of the Company’sCommon Stock was $31.37 per share at February 22, 2007.

|  

** ** | ** ** | ** **      | ** ** | **High** | ** ** | **Low** | ** ** |
|--------------------|------------|-----------------|------------|----------|------------|---------|------------|
| 2006:              |       | First quarter   |       | $        | 29.69      |    | $          | 28.49 |   |
|               |       | Second quarter  |       | 30.12    |       | 27.48   |       |
|               |       | Third quarter   |       | 30.23    |       | 27.52   |       |
|               |       | Fourth  quarter |       | 31.87    |       | 29.20   |       |
|                    |            |                 |            |          |            |         |            |  |  |

 

| ** ** | ** ** | ** **      | ** ** | **High** | ** ** | **Low** | ** ** |
|------------|------------|-----------------|------------|----------|------------|---------|------------|
| 2005:      |       | First quarter   |       | $        | 31.89      |    | $          | 27.52 |   |
|       |       | Second quarter  |       | 30.06    |       | 26.80   |       |
|       |       | Third quarter   |       | 30.49    |       | 28.01   |       |
|       |       | Fourth  quarter |       | 30.49    |       | 29.15   |       |
|            |            |                 |            |          |            |         |            |  |  |

 

TheCompany paid cash dividends to the shareholders in 2006 of $.35 and $.35 pershare on May 1, 2006 and November 1, 2006, respectively to allholders of record on April 17, 2006 and October 16, 2006,respectively, or $44,166,000 in the aggregate during 2006. In 2005, the Companypaid cash dividends of $.40 ($.32 adjusted for the effect of the May 2,2005 stock dividend) and $.32 per share on April 30, and November 1,2005, respectively, or $40,833,000 in the aggregate during 2005. The Companyhas no set schedule for paying cash or stock dividends and the amount paid inprevious periods is not necessarily indicative of amounts that may be paid oravailable to be paid in future periods. In addition, the Company has issuedstock dividends during the last five-year period as follows:

| **Date**           | ** ** | ** ** | ** ** | **Stock Dividend** | ** ** |
|--------------------|------------|------------|------------|-------------------------|------------|
| May 20, 2002  |       |       | 25         | %                       |       |
| May 19, 2003  |       |       | 25         | %                       |       |
| May  3, 2004  |       |       | 25         | %                       |       |
| May   2, 2005 |       |       | 25         | %                       |       |
| May 2006      |       |       | 0          | %                       |       |

 

TheCompany’s principal source of funds to pay cash dividends on its Common Stockis cash dividends from its bank subsidiaries. There are certain statutorylimitations on the payment of dividends from the subsidiary banks. For adiscussion of the limitations, please see Note 20 of Notes to ConsolidatedFinancial Statements.

**Stock RepurchaseProgram**

The Company expanded its formal stock repurchaseprogram on November 2, 2006. Under the expanded stock repurchase program,the Company is authorized to repurchase up to $200,000,000 of its common stockthrough December 2007. Stock repurchases may be made from time to time, onthe open market or through private transactions. Shares repurchased in thisprogram will be held in treasury for reissue for various corporate purposes,including employee stock option plans. As of February 22, 2007, a total of5,012,258 shares had been repurchased under this program at a cost of $183,971,000.Stock repurchases are reviewed quarterly at the Company’s Board of Directorsmeetings and the Board of Directors has stated that the aggregate investment intreasury stock should not exceed $220,973,000. In the 

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past, the Board ofDirectors has increased previous caps on treasury stock once they were met, butthere are no assurances that an increase of the $220,973,000 cap will occur inthe future. As of February 22, 2007, the Company has approximately $204,944,000invested in treasury shares, which amount has been accumulated since theinception of the Company.

Sharerepurchases are only conducted under publicly announced repurchase programsapproved by the Board of Directors. The following table includes informationabout share repurchases for the quarter ended December 31, 2006.

| ** **                                     | ** ** | **Total Number  of Shares  Purchased** | ** ** | **Average  Price Paid  Per Share** | ** ** | **Shares Purchased as  Part of a Publicly  Announced Program** | ** ** | **Approximate Dollar  Value of Shares  Available for  Repurchase(1)** | ** ** |
|------------------------------------------------|------------|--------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|
| October 1 – October 31,  2006        |       |                                             | —     |                                         |       |                                                                                         | —     |                                                                                      |       |   | — |   |   |   | $ | 21,379,000 |   |   |
| November 1 –  November 30, 2006 |       |                                             | 110,067    |                                         |       |                                                                                         | 31.00      |                                                                                      |       |   | 110,067 |   |   |   | 17,967,000 |   |   |
| December 1 –  December 31, 2006 |       |                                             | 8,898      |                                         |       |                                                                                         | 30.34      |                                                                                      |       |   | 8,168 |   |   |   | 17,697,000 |   |   |
|                                           |       |                                             | 118,965    |                                         |       |                                                                                         | $          | 30.95                                                                                     |       |   |   | 118,235 |   |   |   |   |   |   |
|                                                |            |                                                  |            |                                              |            |                                                                                              |            |                                                                                           |            |  |  |  |  |  |  |  |  |  |  |

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(1)          Theformal stock repurchase program was initiated in 1999 and has been expandedperiodically with the most recent expansion occurring in November 2006. Thecurrent program allows for the repurchase of up to $200,000,000 of treasurystock through December 2007 of which $17,697,000 remains.

**Equity Compensation Plan Information**

Thefollowing table sets forth information as of December 31, 2006, withrespect to the Company’s equity compensation plans:

| **Plan Category**                                        | ** ** | ** ** | ** ** | **(A)  Number of securities to  be issued upon exercise  of outstanding options,  warrants and rights** | ** ** | **(B)  Weighted average  exercise price of  outstanding options,  warrants and rights** | ** ** | **(C)  Number of securities  remaining available for  future issuance under  equity compensation plans  (excluding securities  reflected in column A)** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity Compensation plans approved by security holders        |       |       | 1,237,768  |                                                                                                                                                      |       |                                                                                                                  | $          | 17.96                                                                                                                                                                                                               |       |   |   | 130,200 |   |   |
| Equity Compensation plans not approved by security holders(1) |       |       | 140,382    |                                                                                                                                                      |       |                                                                                                                  | $          | 10.66                                                                                                                                                                                                               |       |   |   | — |   |   |
| Total                                                         |       |       | 1,378,150  |                                                                                                                                                      |       |                                                                                                                  | $          | 17.22                                                                                                                                                                                                               |       |   |   | 130,200 |   |   |

----

(1)          TheCompany granted non-qualified stock options exercisable for a total of 140,382shares, adjusted for stock dividends, of Common Stock to certain employees ofthe GulfStar Group. The grants were not made under any of the shareholderapproved Stock Option Plans. The options are exercisable for a period of sevenyears and vest in equal increments over a period of five years. All optionsgranted to the GulfStar Group employees had an option price of not less thanthe fair market value of the Common Stock on the date of grant.

28

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**Stock Performance**

****

**TotalReturn To Shareholders(Includes reinvestment of dividends)**

| ** **                         | ** ** | **INDEXED RETURNS** | ** ** |
|------------------------------------|------------|--------------------------|------------|
| ** **                         | ** ** | **Base Period**     | ** ** | **December 31,** | ** ** |
| **Company / Index**      | ** ** | ** **               | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** |
| **INTERNATIONAL  BANCSHARES CORP** | ** ** |                     | **100**    |   |   | 119.18 |   | 182.18 |   | 194.06 |   | 184.82 |   | 199.21 |   |
| **S&P  500 INDEX**             | ** ** |                     | **100**    |   |   | 77.90 |   | 100.25 |   | 111.15 |   | 116.61 |   | 135.03 |   |
| **S&P 500 BANKS**              | ** ** |                     | **100**    |   |   | 98.98 |   | 125.37 |   | 143.44 |   | 141.35 |   | 164.11 |   |
|                                    |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

29

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**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

The Board of Directors andShareholdersInternational Bancshares Corporation:

We have audited the accompanyingconsolidated statements of condition of International Bancshares Corporationand subsidiaries (the “Company”) as of December 31, 2006 and 2005, and therelated consolidated statements of income, comprehensive income, shareholders’equity, and cash flows for each of the years in the three-year period ended December 31,2006. These consolidated financial statements are the responsibility of theCompany’s management. Our responsibility is to express an opinion on theseconsolidated financial statements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of International Bancshares Corporation 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.

As discussed in Note 1 to theConsolidated Financial Statements, effective January 1, 2006, the Companyadopted Statement of Financial Accounting Standards No. 123R,*Share-based Payment*, to account for stock-basedcompensation.

We also have audited inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the effectiveness of International Bancshares Corporation’sinternal control over financial reporting as of December 31, 2006, basedon criteria established in *Internal Control—IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission (COSO)*, and our report dated February 28, 2007expressed an unqualified opinion on management’s assessment of, and theeffective operation of, internal control over financial reporting.

/s/KPMG LLP

San Antonio, TexasFebruary 28, 2007

30

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**INTERNATIONAL BANCSHARESCORPORATION AND SUBSIDIARIESConsolidated Statements of ConditionDecember 31, 2006 and 2005(Dollars in Thousands, Except Per ShareAmounts)**

| ** **                                                                                                            | ** ** | **2006**  | ** ** | **2005**  | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|-----------|------------|-----------|------------|
| **Assets**                                                                                                            |       |      |       |      |       |
| Cash and due from  banks                                                                                              |       | $         | 268,207    |      | $          | 216,118 |   |
| Federal funds  sold                                                                                                   |       | 29,000    |       | 242,000   |       |
| Total cash and cash equivalents                                                                                       |       | 297,207   |       | 458,118   |       |
| Time deposits with banks                                                                                              |       | 396       |       | 396       |       |
| Investment  securities:                                                                                               |       |      |       |      |       |
| Held to maturity (Market value of $2,375 on  December 31, 2006 and $2,375 on December 31, 2005)             |       | 2,375     |       | 2,375     |       |
| Available for sale (Amortized cost of $4,552,866 on  December 31, 2006 and $4,331,517 on December 31, 2005) |       | 4,490,157 |       | 4,266,952 |       |
| Total investment securities                                                                                           |       | 4,492,532 |       | 4,269,327 |       |
| Loans, net of unearned discounts                                                                                      |       | 5,034,810 |       | 4,625,692 |       |
| Less allowance for possible loan losses                                                                               |       | (64,537   | )          | (77,796   | )          |
| Net loans                                                                                                             |       | 4,970,273 |       | 4,547,896 |       |
| Bank premises and equipment, net                                                                                      |       | 390,323   |       | 351,986   |       |
| Accrued interest  receivable                                                                                          |       | 57,288    |       | 48,647    |       |
| Other investments                                                                                                     |       | 343,909   |       | 332,675   |       |
| Identified  intangible assets, net                                                                                    |       | 34,358    |       | 39,224    |       |
| Goodwill, net                                                                                                         |       | 282,246   |       | 289,262   |       |
| Other assets                                                                                                          |       | 42,922    |       | 54,322    |       |
| Total assets                                                                                                          |       | $         | 10,911,454 |      | $          | 10,391,853 |   |

** **

See accompanying notes to consolidated financial statements.

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**INTERNATIONAL BANCSHARESCORPORATION AND SUBSIDIARIESConsolidated Statements of Condition (Continued)December 31, 2006 and 2005(Dollars in Thousands, Except Per ShareAmounts)**

| ** **                                                                                                                                                            | ** ** | **2006**   | ** ** | **2005**  | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|-----------|------------|
| **Liabilities  and Shareholders’ Equity:**                                                                                                                       |       |       |       |      |       |
| Liabilities:                                                                                                                                                          |       |       |       |      |       |
| Deposits:                                                                                                                                                             |       |       |       |      |       |
| Demand—non-interest bearing                                                                                                                                      |       | $          | 1,453,476  |      | $          | 1,339,380 |   |
| Savings and interest bearing demand                                                                                                                                   |       | 2,204,451  |       | 2,156,234 |       |
| Time                                                                                                                                                                  |       | 3,331,991  |       | 3,160,812 |       |
| Total deposits                                                                                                                                                        |       | 6,989,918  |       | 6,656,426 |       |
| Securities sold under repurchase agreements                                                                                                                           |       | 706,335    |       | 760,762   |       |
| Other borrowed  funds                                                                                                                                                 |       | 2,095,576  |       | 1,870,075 |       |
| Junior  subordinated deferrable interest debentures                                                                                                                   |       | 210,908    |       | 236,391   |       |
| Other liabilities                                                                                                                                                     |       | 66,661     |       | 75,332    |       |
| Total liabilities                                                                                                                                                     |       | 10,069,398 |       | 9,598,986 |       |
| Commitments, Contingent Liabilities and Other Tax  Matters (Note 17)                                                                                                  |       |       |       |      |       |
| Shareholders’  equity:                                                                                                                                           |       |       |       |      |       |
| Common shares of $1.00 par value. Authorized  275,000,000 shares; issued 86,224,046 shares on December 31, 2006 and  86,059,121 shares on December 31, 2005 |       | 86,224     |       | 86,059    |       |
| Surplus                                                                                                                                                               |       | 138,247    |       | 135,619   |       |
| Retained earnings                                                                                                                                                     |       | 861,251    |       | 788,416   |       |
| Accumulated other comprehensive loss                                                                                                                                  |       | (40,390    | )          | (41,968   | )          |
|                                                                                                                                                                  |       | 1,045,332  |       | 968,126   |       |
| Less cost of shares in treasury, 23,312,331 shares  on December 31, 2006 and 22,330,354 shares on December 31, 2005                                         |       | (203,276   | )          | (175,259  | )          |
| Total shareholders’ equity                                                                                                                                       |       | 842,056    |       | 792,867   |       |
| Total liabilities  and shareholders’ equity                                                                                                                      |       | $          | 10,911,454 |      | $          | 10,391,853 |   |

 

See accompanying notes to consolidated financial statements.

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**INTERNATIONAL BANCSHARESCORPORATION AND SUBSIDIARIESConsolidated Statements of IncomeYears ended December 31, 2006, 2005and 2004(Dollars in Thousands, Except Per ShareAmounts)**

| ** **                                                    | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Interest income:                                              |       |     |       |     |       |     |       |
| Loans, including fees                                         |       | $        | 400,020    |     | $          | 339,450  |       | $ | 236,079 |   |
| Federal funds sold                                            |       | 3,596    |       | 3,668    |       | 1,577    |       |
| Investment  securities:                                       |       |     |       |     |       |     |       |
| Taxable                                                       |       | 200,474  |       | 160,175  |       | 109,092  |       |
| Tax-exempt                                                    |       | 4,577    |       | 4,862    |       | 5,071    |       |
| Other interest income                                         |       | 406      |       | 550      |       | 559      |       |
| Total interest income                                         |       | 609,073  |       | 508,705  |       | 352,378  |       |
| Interest expense:                                             |       |     |       |     |       |     |       |
| Savings and interest bearing demand deposits                  |       | 40,444   |       | 26,936   |       | 13,797   |       |
| Time deposits                                                 |       | 123,077  |       | 73,234   |       | 44,659   |       |
| Securities sold under repurchase agreements                   |       | 30,137   |       | 27,384   |       | 19,865   |       |
| Other borrowings                                              |       | 103,362  |       | 60,689   |       | 16,746   |       |
| Junior subordinated deferrable interest debentures            |       | 22,568   |       | 18,587   |       | 13,152   |       |
| Senior notes                                                  |       | —   |       | —   |       | 383      |       |
| Total interest expense                                        |       | 319,588  |       | 206,830  |       | 108,602  |       |
| Net interest income                                           |       | 289,485  |       | 301,875  |       | 243,776  |       |
| Provision for possible loan losses                            |       | 3,849    |       | 960      |       | 5,196    |       |
| Net interest income after provision for possible  loan losses |       | 285,636  |       | 300,915  |       | 238,580  |       |
| Non-interest  income:                                         |       |     |       |     |       |     |       |
| Service charges on deposit accounts                           |       | 84,770   |       | 83,917   |       | 73,877   |       |
| Other service  charges, commissions and fees                  |       |     |       |     |       |     |       |
| Banking                                                       |       | 29,523   |       | 25,212   |       | 19,320   |       |
| Non-banking                                                   |       | 21,605   |       | 12,248   |       | 7,083    |       |
| Investment securities transactions, net                       |       | (930     | )          | (181     | )          | 8,884    |       |
| Other investments, net                                        |       | 20,035   |       | 20,629   |       | 13,012   |       |
| Other income                                                  |       | 21,968   |       | 25,397   |       | 12,640   |       |
| Total  non-interest income                                    |       | 176,971  |       | 167,222  |       | 134,816  |       |
|                                                               |            |          |            |          |            |          |            |  |  |  |

** **

See accompanying notes to consolidated financial statements.

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**INTERNATIONAL BANCSHARESCORPORATION AND SUBSIDIARIESConsolidated Statements of Income (Continued)Years ended December 31, 2006, 2005and 2004(Dollars in Thousands, Except Per ShareAmounts)**

| ** **                                     | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Non-interest expense:                          |       |       |       |       |       |       |       |
| Employee compensation and benefits             |       | $          | 124,359    |       | $          | 113,620    |       | $ | 83,631 |   |
| Occupancy                                      |       | 27,886     |       | 25,053     |       | 18,403     |       |
| Depreciation of bank premises and equipment    |       | 28,251     |       | 25,538     |       | 18,975     |       |
| Professional fees                              |       | 11,050     |       | 12,497     |       | 6,513      |       |
| Stationery and supplies                        |       | 6,490      |       | 5,809      |       | 5,075      |       |
| Amortization of identified intangible assets   |       | 4,866      |       | 5,176      |       | 3,681      |       |
| Advertising                                    |       | 12,052     |       | 10,596     |       | 10,082     |       |
| Other                                          |       | 73,723     |       | 57,699     |       | 50,124     |       |
| Total non-interest expense                     |       | 288,677    |       | 255,988    |       | 196,484    |       |
| Income before income taxes                     |       | 173,930    |       | 212,149    |       | 176,912    |       |
| Minority interest in consolidated subsidiaries |       | 40         |       | —     |       | —     |       |
| Provision for  income taxes                    |       | 56,889     |       | 71,370     |       | 57,880     |       |
| Net income                                     |       | $          | 117,001    |       | $          | 140,779    |       | $ | 119,032 |   |
| Basic earnings  per common share:              |       |       |       |       |       |       |       |
| Weighted average number of shares outstanding  |       | 63,133,522 |       | 63,695,017 |       | 62,134,149 |       |
| Net income                                     |       | $          | 1.85       |       | $          | 2.21       |       | $ | 1.92 |   |
| Fully diluted earnings  per common share:      |       |       |       |       |       |       |       |
| Weighted average number of shares outstanding  |       | 63,776,888 |       | 64,485,167 |       | 63,380,556 |       |
| Net income                                     |       | $          | 1.83       |       | $          | 2.18       |       | $ | 1.88 |   |

 

See accompanying notes to consolidated financial statements.

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIESConsolidated Statements of ComprehensiveIncomeYears ended December 31, 2006, 2005,and 2004(Dollars in Thousands)**

| ** **                                                                                                | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net income                                                                                                |       | $        | 117,001    |     | $          | 140,779  |       | $ | 119,032 |   |
| Other comprehensive income, net of tax:                                                                   |       |     |       |     |       |     |       |
| Net unrealized gains (losses)  on securities available for sale  arising  during the year                 |       | 2,798    |       | (58,397  | )          | (6,361   | )          |
| Reclassification adjustment  for (losses) gains on securities  available  for sale included in net income |       | (1,220   | )          | 1,419    |       | 8,529    |       |
| Comprehensive income                                                                                      |       | $        | 118,579    |     | $          | 83,801   |       | $ | 121,200 |   |

 

See accompanying notes to consolidated financial statements.

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**INTERNATIONAL BANCSHARESCORPORATION AND SUBSIDIARIESConsolidated Statements of Shareholders’ EquityYears ended December 31, 2006, 2005and 2004(in Thousands)**

| ** **                                                                                                          | ** ** | **Number  of** Shares | ** ** | **Common  Stock** | ** ** | **Surplus** | ** ** | **Retained**  Earnings | ** ** | **Accumulated  Other  Comprehensive  Income (Loss)** | ** ** | **Treasury  Stock** | ** ** | **Total** | ** ** |   |
|---------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|-------------------|------------|-------------|------------|------------------------|------------|-----------------------------------------------------------|------------|---------------------|------------|-----------|------------|--------|
| Balance at December 31, 2003                                                                                   |       |                       | 52,774     |              |       |        | 52,774     |                   |       | 37,777                                                    |       | 639,606             |       |      | 12,842     |   |   | (165,616 | ) | 577,383 |   |
| Net income                                                                                                          |       |                       | —     |              |       |        | —     |                   |       | —                                                    |       | 119,032             |       |      | —     |   |   | — |   | 119,032 |   |
| Dividends:                                                                                                          |       |                       |       |              |       |        |       |                   |       |                                                      |       |                |       |      |       |   |   |   |   |   |   |
| Shares issued                                                                                                       |       |                       | 13,229     |              |       |        | 13,229     |                   |       | —                                                    |       | (13,229             | )          |      | —     |   |   | — |   | — |   |
| Cash                                                                                                                |       |                       | —     |              |       |        | —     |                   |       | —                                                    |       | (39,767             | )          |      | —     |   |   | — |   | (39,767 | ) |
| Purchase of treasury stock                                                                                          |       |                       | —     |              |       |        | —     |                   |       | —                                                    |       | —              |       |      | —     |   |   | (974 | ) | (974 | ) |
| Exercise of stock options                                                                                           |       |                       | 313        |              |       |        | 313        |                   |       | 3,761                                                     |       | —              |       |      | —     |   |   | — |   | 4,074 |   |
| Tax benefit for exercise of stock options                                                                           |       |                       | —     |              |       |        | —     |                   |       | 1,192                                                     |       | —              |       |      | —     |   |   | — |   | 1,192 |   |
| Stock issued in acquisition                                                                                         |       |                       | 2,115      |              |       |        | 2,115      |                   |       | 87,867                                                    |       | —              |       |      | —     |   |   | — |   | 89,982 |   |
| Other  comprehensive income, net of  tax:                                                                           |       |                       |       |              |       |        |       |                   |       |                                                      |       |                |       |      |       |   |   |   |   |   |   |
| Net change in unrealized gains and  losses on  available for sale  securities, net  of reclassification  adjustment |       |                       |       |              |       |        |       |                   |       |                                                      |       |                |       |      | 2,168      |   |   |   |   | 2,168 |   |
| Balance at December 31, 2004                                                                                   |       |                       | 68,431     |              |       |        | 68,431     |                   |       | 130,597                                                   |       | 705,642             |       |      | 15,010     |   |   | (166,590 | ) | 753,090 |   |
| Net income                                                                                                          |       |                       | —     |              |       |        | —     |                   |       | —                                                    |       | 140,779             |       |      | —     |   |   | — |   | 140,779 |   |
| Dividends:                                                                                                          |       |                       |       |              |       |        |       |                   |       |                                                      |       |                |       |      |       |   |   |   |   |   |   |
| Shares issued                                                                                                       |       |                       | 17,172     |              |       |        | 17,172     |                   |       | —                                                    |       | (17,172             | )          |      | —     |   |   | — |   | — |   |
| Cash                                                                                                                |       |                       | —     |              |       |        | —     |                   |       | —                                                    |       | (40,833             | )          |      | —     |   |   | — |   | (40,833 | ) |
| Purchase of treasury stock                                                                                          |       |                       | —     |              |       |        | —     |                   |       | —                                                    |       | —              |       |      | —     |   |   | (8,669 | ) | (8,669 | ) |
| Exercise of stock options                                                                                           |       |                       | 456        |              |       |        | 456        |                   |       | 4,785                                                     |       | —              |       |      | —     |   |   | — |   | 5,241 |   |
| Tax benefit for exercise of stock options                                                                           |       |                       | —     |              |       |        | —     |                   |       | 237                                                       |       | —              |       |      | —     |   |   | — |   | 237 |   |
| Other  comprehensive income, net of  tax:                                                                           |       |                       |       |              |       |        |       |                   |       |                                                      |       |                |       |      |       |   |   |   |   |   |   |
| Net change in unrealized gains and  losses on  available for sale  securities, net  of reclassification  adjustment |       |                       | —     |              |       |        | —     |                   |       | —                                                    |       | —              |       |      | (56,978    | )      |   | — |   | (56,978 | ) |
| Balance at December 31, 2005                                                                                   |       |                       | 86,059     |              |       |        | 86,059     |                   |       | 135,619                                                   |       | 788,416             |       |      | (41,968    | )      |   | (175,259 | ) | 792,867 |   |
| Net income                                                                                                          |       |                       | —     |              |       |        | —     |                   |       | —                                                    |       | 117,001             |       |      | —     |   |   | — |   | 117,001 |   |
| Dividends:                                                                                                          |       |                       |       |              |       |        |       |                   |       |                                                      |       |                |       |      |       |   |   |   |   |   |   |
| Shares issued                                                                                                       |       |                       | —     |              |       |        | —     |                   |       | —                                                    |       | —              |       |      | —     |   |   | — |   | — |   |
| Cash                                                                                                                |       |                       | —     |              |       |        | —     |                   |       | —                                                    |       | (44,166             | )          |      | —     |   |   | — |   | (44,166 | ) |
| Purchase of treasury stock                                                                                          |       |                       | —     |              |       |        | —     |                   |       | —                                                    |       | —              |       |      | —     |   |   | (28,017 | ) | (28,017 | ) |
| Exercise of stock options                                                                                           |       |                       | 165        |              |       |        | 165        |                   |       | 1,754                                                     |       | —              |       |      | —     |   |   | — |   | 1,919 |   |
| Stock based compensation expense recognized in earnings                                                             |       |                       | —     |              |       |        | —     |                   |       | 874                                                       |       | —              |       |      | —     |   |   | — |   | 874 |   |
| Other  comprehensive income, net of  tax:                                                                           |       |                       |       |              |       |        |       |                   |       |                                                      |       |                |       |      |       |   |   |   |   |   |   |
| Net change in unrealized gains and  losses on  available for sale  securities, net  of reclassification  adjustment |       |                       | —     |              |       |        | —     |                   |       | —                                                    |       | —              |       |      | 1,578      |   |   | — |   | 1,578 |   |
| Balance at December 31, 2006                                                                                   |       |                       | 86,224     |              |       |        | $          | 86,224                 |       |                                                      | $          | 138,247             |       | $         | 861,251    |   |   | $ | (40,390 | ) |   | $ | (203,276 | ) | $ | 842,056 |   |
|                                                                                                                     |            |                            |            |                   |            |             |            |                        |            |                                                           |            |                     |            |           |            |        |  |  |  |  |  |  |  |  |  |  |  |  |

 

See accompanying notes to consolidated financial statements.

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Consolidated Statements of Cash Flows**Years ended December 31, 2006, 2005 and 2004 (Dollars in Thousands)

| ** **                                                                         | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Operating  activities:                                                             |       |       |       |       |       |       |       |
| Net income:                                                                        |       | $          | 117,001    |       | $          | 140,779    |       | $ | 119,032 |   |
| Adjustments to reconcile net income to net cash provided  by operating activities: |       |       |       |       |       |       |       |
| Provision for possible loan  losses                                                |       | 3,849      |       | 960        |       | 5,196      |       |
| Amortization of loan premiums                                                      |       | 1,190      |       | 2,813      |       | 451        |       |
| Accretion of time deposit  discounts                                               |       | —     |       | (5,391     | )          | (3,600     | )          |
| Depreciation of bank premises  and equipment                                       |       | 28,251     |       | 25,538     |       | 18,975     |       |
| Loss (gain) on sale of bank  premises and equipment                                |       | 2,096      |       | (2,244     | )          | (3,230     | )          |
| Depreciation and amortization  of leased assets                                    |       | 2,169      |       | 1,967      |       | 1,687      |       |
| Accretion of investment  securities discounts                                      |       | (416       | )          | (572       | )          | (611       | )          |
| Amortization of investment  securities premiums                                    |       | 4,097      |       | 24,042     |       | 29,215     |       |
| Investment securities  transactions, net                                           |       | 930        |       | 181        |       | (8,884     | )          |
| Accretion of junior subordinated debenture discounts                               |       | 548        |       | 996        |       | 1,026      |       |
| Amortization of identified  intangible assets                                      |       | 4,866      |       | 5,176      |       | 3,681      |       |
| Stock based compensation  expense                                                  |       | 874        |       | —     |       | —     |       |
| Earnings from affiliates and  other investments                                    |       | (12,204    | )          | (15,495    | )          | (11,993    | )          |
| Deferred tax (benefit) expense                                                     |       | (15,686    | )          | 22,752     |       | 11,353     |       |
| (Increase) decrease in accrued  interest receivable                                |       | (8,641     | )          | (7,507     | )          | (3,983     | )          |
| Decrease in other assets                                                           |       | 9,423      |       | 5,598      |       | 20,341     |       |
| Net increase (decrease) in  other liabilities                                      |       | 13,561     |       | 11,349     |       | (20,558    | )          |
| Net cash provided by operating  activities                                         |       | 151,908    |       | 210,942    |       | 158,098    |       |
| Investing activities:                                                              |       |       |       |       |       |       |       |
| Proceeds from maturities of  securities                                            |       | 7,720      |       | 4,366      |       | 29,558     |       |
| Proceeds from sales of available  for sale securities                              |       | 60,447     |       | 189,902    |       | 875,816    |       |
| Purchases of available for  sale securities                                        |       | (1,159,306 | )          | (1,616,504 | )          | (2,223,915 | )          |
| Principal collected on  mortgage backed securities                                 |       | 864,611    |       | 918,819    |       | 791,425    |       |
| Principal collected on other  securities                                           |       | 568        |       | —     |       | —     |       |
| Proceeds from matured time  deposits with banks                                    |       | —     |       | —     |       | 87,400     |       |
| Purchases of time deposits  with banks                                             |       | —     |       | —     |       | (296       | )          |
| Net (increase) decrease in  loans                                                  |       | (427,416   | )          | 255,954    |       | 51,692     |       |
| Purchases of other investments                                                     |       | (15,294    | )          | (25,053    | )          | (5,161     | )          |
| Distributions from other  investments                                              |       | 16,264     |       | 9,451      |       | 53,227     |       |
| Purchases of bank premises and  equipment                                          |       | (85,363    | )          | (76,162    | )          | (51,866    | )          |
| Proceeds from sales of bank  premises and equipment                                |       | 16,679     |       | 3,112      |       | 4,648      |       |
| Cash paid in purchase  transaction                                                 |       | —     |       | —     |       | (276,555   | )          |
| Cash acquired in purchase  transaction                                             |       | —     |       | —     |       | 66,009     |       |
| Net cash used in investing activities                                              |       | (721,090   | )          | (336,115   | )          | (598,018   | )          |
|                                                                                    |            |            |            |            |            |            |            |  |  |  |

 

See accompanying notes to consolidated financial statements.

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Consolidated Statements of Cash Flows (Continued)**Years ended December 31, 2006, 2005 and 2004 (Dollars in Thousands)

 

| ** **                                                                 | ** ** | **2006**    | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------------------------------|------------|-------------|------------|----------|------------|----------|------------|
| Financing  activities:                                                     |       |        |       |     |       |     |       |
| Net increase in non-interest  bearing demand deposits                      |       | 114,096     |       | 188,381  |       | 103,547  |       |
| Net increase (decrease) in  savings and interest bearing  demand  deposits |       | 48,217      |       | (75,868  | )          | 70,306   |       |
| Net increase (decrease) in  time deposits                                  |       | 171,179     |       | (21,800  | )          | 27,961   |       |
| Net (decrease) increase in  securities sold under repurchase  agreements   |       | (54,427     | )          | 140,956  |       | 74,372   |       |
| Other borrowed funds, net                                                  |       | 225,501     |       | 199,876  |       | 200,545  |       |
| Principal payments on senior  notes                                        |       | —      |       | —   |       | (21,295  | )          |
| Principal payments of  long-term debt                                      |       | (101,290    | )          | —   |       | —   |       |
| Proceeds from issuance of  long-term debt                                  |       | 75,259      |       | —   |       | —   |       |
| Purchase of treasury stock                                                 |       | (28,017     | )          | (8,669   | )          | (974     | )          |
| Proceeds from stock  transactions                                          |       | 1,919       |       | 5,478    |       | 5,266    |       |
| Payments of cash dividends                                                 |       | (44,166     | )          | (40,808  | )          | (39,729  | )          |
| Payments of cash dividends in  lieu of fractional shares                   |       | —      |       | (25      | )          | (38      | )          |
| Net cash provided by financing  activities                                 |       | 408,271     |       | 387,521  |       | 419,961  |       |
| Increase (decrease) in cash and cash equivalents                           |       | (160,  911) |       | 262,348  |       | (19,959  | )          |
| Cash and cash equivalents at beginning of year                             |       | 458,118     |       | 195,770  |       | 215,729  |       |
| Cash and cash equivalents at end of year                                   |       | $           | 297,207    |     | $          | 458,118  |       | $ | 195,770 |   |
| Supplemental cash flow information:                                        |       |        |       |     |       |     |       |
| Interest paid                                                              |       | $           | 312,018    |     | $          | 197,023  |       | $ | 93,337 |   |
| Income taxes paid                                                          |       | 67,421      |       | 39,040   |       | 36,277   |       |
| Adjustment to goodwill arising from acquisition                            |       | 7,016       |       | —   |       | —   |       |

 

See accompanying notes to consolidated financial statements.

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES**Notes to Consolidated Financial Statements

**(1) Summary of Significant Accounting Policies**

The accounting andreporting policies of International Bancshares Corporation (“Corporation”) andSubsidiaries (the Corporation and Subsidiaries collectively referred to hereinas the “Company”) conform to  accountingprinciples generally accepted in the United States of America and to generalpractices within the banking industry. The following is a description of themore significant of those policies.

*Consolidation andBasis of Presentation*

The consolidated financialstatements include the accounts of the Corporation and its wholly-owned banksubsidiaries, International Bank of Commerce, Laredo (“IBC”), Commerce Bank,International Bank of Commerce, Zapata, International Bank of Commerce,Brownsville, and the Corporation’s wholly-owned non-bank subsidiaries, IBCSubsidiary Corporation, IBC Life Insurance Company, IBC Trading Company and IBCCapital Corporation. All significant inter-company balances and transactionshave been eliminated in consolidation.

The Company, through itssubsidiaries, is primarily engaged in the business of banking, including theacceptance of checking and savings deposits and the making of commercial, realestate, personal, home improvement, automobile and other installment and term loans.The primary markets of the Company are South, Central, and Southeast Texas andthe state of Oklahoma. Each bank subsidiary is very active in facilitatinginternational trade along the United States border with Mexico and elsewhere. Althoughthe Company’s loan portfolio is diversified, the ability of the Company’sdebtors to honor their contracts is primarily dependent upon the economicconditions in the Company’s trade area. In addition, the investment portfoliois directly impacted by fluctuations in market interest rates. The Company andits bank subsidiaries are subject to the regulations of certain Federalagencies as well as the Texas Department of Banking and undergo periodicexaminations by those regulatory authorities. Such agencies may require certainstandards or impose certain limitations based on their judgments or changes inlaw and regulations.

Thepreparation of the consolidated financial statements in conformity withaccounting policies generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities as of the dates of the statement of condition andincome and expenses for the periods. Actual results could differ significantlyfrom those estimates. Material estimates that are particularly susceptible tosignificant changes in the near-term relate to the determination of theallowance for possible loan losses.

*Per Share Data*

Allshare and per share information has been restated giving retroactive effect tostock dividends distributed.

*InvestmentSecurities*

The Company classifies debt and equity securities intoone of these categories: held-to-maturity, available-for-sale, or trading.  Such classifications are reassessed forappropriate classification at each reporting date.  Securities that are intended and expected tobe held until maturity are classified as “held-to-maturity” and are carried atamortized cost for financial statement reporting.  Securities that are not positively expectedto be held until maturity, but are intended to be held for an indefinite periodof time

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES**Notes to Consolidated Financial Statements (Continued)

**(1)  Summary of Significant Accounting Policies(Continued)**

are classified as“available-for-sale” or “trading” and are carried at their fair value.  Unrealized holding gains and losses areincluded in net income for those securities classified as “trading”, whileunrealized holding gains and losses related to those securities classified as“available-for-sale” are excluded from net income and reported net of tax asother comprehensive income and in shareholders’ equity as accumulated othercomprehensive income until realized.  TheCompany did not maintain any trading securities during the three year periodended December 31, 2006.

Mortgage-backed securitiesheld at December 31, 2006 and 2005 represent participating interests inpools of long-term first mortgage loans originated and serviced by the issuersof the securities. Premiums and discounts are amortized using the level yieldor “interest method.”  Mortgage-backedsecurities are either issued or guaranteed by the U.S. Government or itsagencies. Market interest rate fluctuations can affect the prepayment speed ofprincipal and the yield on the security.

*Unearned Discounts*

Consumerloans are frequently made on a discount basis. The amount of the discount issubsequently included in interest income ratably over the term of the relatedloans to approximate the effective interest method.

*Provision and Allowance for Possible Loan Losses*

The allowance for possible loan losses is maintainedat a level considered adequate by management to provide for probable loanlosses. The allowance is increased by provisions charged to operating expenseand reduced by net charge-offs. The provision for possible loan losses is theamount, which, in the judgment of management, is necessary to establish theallowance for probable loan losses at a level that is adequate to absorb knownand inherent risks in the loan portfolio.

Managementbelieves that the allowance for possible loan losses is adequate. Whilemanagement uses available information to recognize losses on loans, futureadditions to the allowance may be necessary based on changes in economicconditions. In addition, various regulatory agencies, as an integral part oftheir examination process, periodically review the Company’s bank subsidiaries’allowances for possible loan losses. Such agencies may require the Company’sbank subsidiaries to make additions or reductions to their GAAP allowancesbased on their judgments of information available to them at the time of theirexamination.

*Loans*

Loansare reported at the principal balance outstanding, net of unearned discounts. Interestincome on loans is reported on an accrual basis. Loan fees and costs associatedwith originating the loans are amortized over the life of the loan using theinterest method.

*Non-Accrual Loans*

Thenon-accrual loan policy of the Company’s bank subsidiaries is to discontinuethe accrual of interest on loans when management determines that it is probablethat future interest accruals will be un-collectible. Interest income onnon-accrual loans is recognized only to the extent payments are received orwhen, in management’s opinion, the debtor’s financial condition warrantsreestablishment of interest accruals.

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES**Notes to Consolidated Financial Statements (Continued)

**(1)  Summary of Significant Accounting Policies(Continued)**

*Other Real EstateOwned*

Other real estate owned iscomprised of real estate acquired by foreclosure and deeds in lieu offoreclosure. Other real estate is carried at the lower of the recordedinvestment in the property or its fair value less estimated costs to sell suchproperty (as determined by independent appraisal). Prior to foreclosure, thevalue of the underlying loan is written down to the fair value of the realestate to be acquired by a charge to the allowance for loan possible losses, ifnecessary. Any subsequent write-downs are charged against other non-interestexpense. Operating expenses of such properties and gains and losses on theirdisposition are included in other non-interest expense.

*Bank Premises andEquipment*

Bankpremises and equipment are stated at cost less accumulated depreciation. Depreciationis computed on straight-line and accelerated methods over the estimated usefullives of the assets. Repairs and maintenance are charged to operations asincurred and expenditures for renewals and betterments are capitalized.

*Income Taxes*

Deferred income tax assets andliabilities are determined using the asset and liability method. Under thismethod, the net deferred tax asset or liability is determined based on the taxeffects of the differences between the book and tax basis of the variousbalance sheet assets and liabilities and gives current recognition to changesin tax rates and laws. The Company files a consolidated federal income taxreturn with its subsidiaries.

Recognitionof deferred tax assets is based on management’s belief that the benefit relatedto certain temporary differences, tax operating loss carryforwards, and taxcredits are more likely than not to be realized. A valuation allowance isrecorded for the amount of the deferred tax items for which it is more likelythan not that the tax benefits will not be realized.

*Stock Options*

Through December 31, 2005, the Company accountedfor stock-based employee compensation plans based on the intrinsic value methodprovided in Accounting Principles Board Opinion No. 25 “Accounting forStock Issued to Employees,” (“APB No. 25”), and related interpretations. Becausethe exercise price of the Company’s employee stock options equals the marketprice of the underlying stock on the measurement date, which is generally thedate of grant, no compensation expense was recognized on options granted. Compensationexpense for stock awards is based on the market price of the stock on themeasurement date, which is generally the date of grant, and is recognizedratably over the service period of the award.

Statement of Financial Accounting Standards No. 123(“SFAS No. 123”), “Accounting for Stock-Based Compensation,” as amended byStatement of Financial Accounting Standards No. 148 (“SFAS No. 148”),“Accounting for Stock-Based Compensation—Transition and Disclosure, anamendment of FASB Statement No. 123,” requires pro forma disclosures ofnet income and earnings per share for companies not adopting its fair valueaccounting method for stock-based employee compensation. The pro formadisclosures presented in Note 16 in the accompanying Notes to ConsolidatedFinancial Statements 

41

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES**Notes to Consolidated Financial Statements (Continued)

**(1)  Summary ofSignificant Accounting Policies (Continued)**

includedelsewhere in this report use the fair value method of SFAS No. 123 tomeasure compensation expense for stock-based employee compensation plans. Thefair value of stock options granted was estimated as the measurement date,which is generally the date of grant, using the Black-Sholes-Mertonoption-pricing model. This model was developed for use in estimating the fairvalue of publicly traded options that have no vesting restrictions and arefully transferable. Additionally, the model requires the input of highlysubjective assumptions. Because the Company’s employee stock options havecharacteristics significantly different from those of publicly traded options,and because changes in the subjective input assumptions can materially affect thefair value estimate, in management’s opinion, the Black-Sholes-Mertonoption-pricing model does not necessarily provide a reliable single measure ofthe fair value of the Company’s stock options.

In December 2004, theFinancial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards No. 123R (“SFAS No. 123R”), “Share-Based Payment(Revised 2004).”  Among other things,SFAS No. 123R eliminates the ability to account for stock-basedcompensation using APB No. 25 and requires that such transactions berecognized as compensation cost in the income statement based on their fairvalues on the date of the grant. SFAS No. 123R was adopted by the Companyon January 1, 2006.

*Net Income Per Share*

BasicEarnings Per Share (“EPS”) is calculated by dividing net income by the weightedaverage number of common shares outstanding. The computation of diluted EPSassumes the issuance of common shares for all dilutive potential common sharesoutstanding during the reporting period. The dilutive effect of stock optionsis considered in earnings per share calculations, if dilutive, using thetreasury stock method.

*Goodwill and Identified Intangible Assets*

Goodwill represents theexcess of costs over fair value of assets of businesses acquired. Prior to2002, goodwill was amortized over its estimated useful life using thestraight-line method or an accelerated basis (as appropriate) over periodsgenerally not exceeding 25 years. On January 1, 2002, in accordance with anew accounting standard, the Company stopped amortizing goodwill and adopted anew policy for measuring goodwill for impairment. Under the new policy,goodwill is assigned to reporting units. Goodwill is then tested for impairmentat least annually or on an interim basis if an event occurs or circumstanceschange that would more likely than not reduce the fair value of the reportingunit below its carrying value.

Identified intangibleassets are acquired assets that lack physical substance but can bedistinguished from goodwill because of contractual or other legal rights orbecause the asset is capable of being sold or exchanged either on its own or incombination with a related contract, asset, or liability. The Company’sidentified intangible assets relate to core deposits. Identified intangibleassets with definite useful lives are amortized on an accelerated basis overtheir estimated life. Identified intangible assets, premises and equipment andother long lived assets are tested for impairment whenever events or changes incircumstances indicate the carrying amount of the assets may not be recoverablefrom future undiscounted cash flow. If impaired, the assets are recorded atfair value. See Note 7—Goodwill and Other Intangible Assets.

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIESNotes to Consolidated Financial Statements (Continued)**

**(1)  Summary of Significant Accounting Policies(Continued)**

*Impairment ofLong-Lived Assets*

Long-livedassets, such as property, plant and equipment, and purchased intangiblessubject to amortization, are reviewed for impairment whenever events or changesin circumstances indicate that the carrying value of an asset may not berecoverable. Recoverability of assets to be held and used is measured by acomparison of the carrying value of the asset to the estimated undiscountedfuture cash flows expected to be generated by the asset. If the carrying valueof an asset exceeds its estimated future cash flows, an impairment charge isrecognized by the amount by which the carrying value of the asset exceeds thefair value of the asset. Assets to be disposed of would be separately presentedin the statement of condition and reported at the lower of the carrying valueor fair value less costs to sell, and are no longer depreciated. The assets andliabilities of a disposed group classified as held for sale would be presentedseparately in the appropriate asset and liability sections of the statement ofcondition.

*ConsolidatedStatements of Cash Flows*

Forpurposes of the consolidated statements of cash flows, the Company considersall short-term investments with a maturity at date of purchase of three monthsor less to be cash equivalents. Also, the Company reports transactions relatedto deposits loans to customers on a net basis.

*Accounting forTransfers and Servicing of Financial Assets*

TheCompany accounts for transfers and servicing of financial assets andextinguishments of liabilities based on the application of afinancial-components approach that focuses on control. After a transfer offinancial assets, the Company recognizes the financial and servicing assets itcontrols and liabilities it has incurred, derecognizes financial assets whencontrol has been surrendered and derecognizes liabilities when extinguished.The Company has retained mortgage servicing rights in connection with the saleof mortgage loans. The value of the mortgage servicing rights are reviewedperiodically for impairment and are amortized in proportion to and over theperiod of estimated net servicing income or net servicing losses.

*Segments of anEnterprise and Related Information*

TheCompany operates as one segment. The operating information used by theCompany’s chief executive officer for purposes of assessing performance andmaking operating decisions about the Company is the consolidated financialstatements presented in this report. The Company has four active operatingsubsidiaries, namely, the bank subsidiaries, otherwise known as InternationalBank of Commerce, Laredo, Commerce Bank, International Bank of Commerce, Zapataand International Bank of Commerce, Brownsville. The Company applies theprovisions of SFAS No. 131, “Disclosures about Segments of an Enterpriseand Related Information,” in determining its reportable segments and relateddisclosures. None of the Company’s other subsidiaries meets the 10% thresholdfor disclosure under SFAS No. 131.

*DerivativeInstruments*

TheCompany currently does not directly engage in hedging activities and does notdirectly hold any derivative instruments or embedded derivatives.

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIESNotes to Consolidated Financial Statements (Continued)**

**(1)  Summary of Significant Accounting Policies(Continued)**

*Guarantor’s Accounting and Disclosure Requirements forGuarantees*

InNovember 2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”),“Guarantor’s Accounting and Disclosure Requirements for Guarantees, IncludingIndirect Guarantees of Indebtedness of Others, an interpretation of FASBStatements No. 5, 57 and 107 and rescission of FASB InterpretationNo. 34.”  FIN 45 elaborates on thedisclosures to be made by a guarantor in its interim and annual financialstatements about its obligations under certain guarantees that it has issued.This Interpretation also incorporates, without change, the guidance inFinancial Accounting Standards Board Interpretation No. 34 (“FIN 34”),“Disclosure of Indirect Guarantees of Indebtedness of Others,” which has beensuperceded. FIN 45 also clarifies that a guarantor is required to recognize, atthe inception of a guarantee, a liability for the obligations it has undertakenin issuing the guarantee, including its ongoing obligations to stand ready toperform over the term of the guarantee in the event that the specifiedtriggering events or conditions occur. The initial recognition and initialmeasurement provisions of FIN 45 were applicable on a prospective basis to guaranteesissued or modified after December 31, 2002, irrespective of theguarantor’s fiscal year-end. The disclosure requirements were effective forfinancial statements of interim or annual periods ending afterDecember 15, 2002, and are included in the notes to the Company’sconsolidated financial statements. The adoption of FIN 45 did not have asignificant impact on the Company’s consolidated financial statements.

*Reclassifications*

**Certainamounts in the prior year’s presentations have been reclassified to conform tothe current presentation. These reclassifications had no effect on previouslyreported net income.**

*New Accounting Standards*

In May 2005, The FinancialAccounting Standards Board issued Statement of Financial Accounting StandardsNo. 154, (“SFAS No. 154”), “Accounting Changes and Error Corrections,a Replacement of APB Opinion No. 20 and FASB Statement No. 3.”  SFAS No. 154 establishes, unlessimpracticable, retrospective application as the required method for reporting achange in accounting principle in the absence of explicit transitionalrequirements specific to a newly adopted accounting principle. Previously, mostchanges in accounting principle were recognized by reporting a cumulativechange in accounting principle to the net income of the period of the change.Under SFAS No. 154, retrospective application requires that (i) thecumulative effect of the change to the new accounting principle on periodsprior to those presented be reflected in the carrying amounts of asset and liabilitiesas of the beginning of the first period presented, (ii) an offsettingadjustment, if any, be made to the opening balance of retained earnings orother appropriate components of equity for that period, and(iii) financial statements for each prior period presented be adjusted toreflect the direct period specific effects of applying the new accountingprinciple. Special retroactive application rules apply in certainsituations where it is impracticable to determine either the period specificeffects or the cumulative effect of the change. Indirect effects of a change inaccounting principle are required to be reported in the period in which theaccounting change is made. SFAS No. 154 carries forward the guidance inAPB Opinion No. 20 “Accounting Changes,” requiring justification of achange in accounting principle on the basis of preferability. SFAS No. 154also carries forward, without change, the guidance in APB Opinion 20, forreporting the correction of an error in previously issued financial statementsand for a change in accounting estimate. SFAS No. 154 is effective foraccounting changes and corrections of errors made in fiscal years beginningafter December 15, 2005. 

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIESNotes to Consolidated Financial Statements (Continued)**

**(1)  Summary of Significant Accounting Policies(Continued)**

Theadoption of this new accounting standard did not have an impact on theCompany’s consolidated financial statements.

In November 2005, theFinancial Accounting Standards Board issued FASB Staff Position No 115-1(“FSP 115-1”), “The Meaning of Other-Than-Temporary Impairment and ItsApplication to Certain Investments.”  FSP115-1 provides guidance for determining when an investment is consideredimpaired, whether impairment is other-than-temporary, and measurement of animpairment loss. An investment is considered impaired if the fair value of theinvestment is less than its cost. If, after consideration of all availableevidence to evaluate the realizable value of its investment, impairment isdetermined to be other-thank-temporary, then an impairment loss should berecognized equal to the difference between the investments’ cost and its fairvalue. FSB 115-1 nullifies certain provision of Emerging Issues TaskForce (“EITF”) Issue No 01-1, “The Meaning of Other-Than-TemporaryImpairment and Its Application to Certain Investments,” while retaining thedisclosure requirements of EITF 01-1 which were adopted in 2003. FSP 115-1is effective for reporting periods beginning after December 15, 2005. Thecompany adopted FSP 115-1 on January 1, 2006. The adoption did nothave a significant impact on the consolidated financial statements.

In December 2004, theFinancial Accounting Standards Board issued Statement of Financial AccountingStandards No. 123R, (“SFAS No. 123R”), “Share-Based Payment, anAmendment of Statements No. 123 and 95.” The revision to the existing SFAS No. 123 eliminates the ability ofpublic companies to account for stock-based compensation using AccountingPrinciples Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issuesto Employees” and requires such transactions be recognized as compensationexpense in the Company’s consolidated financial statements based on the fairvalue of the options issued as of their grant date. SFAS No. 123R was tobe effective for the Company for interim and reporting periods after December 31,2005. The Company adopted the provisions of SFAS No. 123R onJanuary 1, 2006. “Details related to the adoption of SFAS No. 123Rand the impact to the Consolidated Financial Statements are discussed inNote 1b—Stock Options.”

In February 2006, theFinancial Accounting Standards Board issued Statement of Financial AccountingStandards No. 155, (“SFAS No. 155”), “Accounting for Certain HybridFinancial Instruments—an amendment of FASB Statements No. 133 and 140.”SFAS No. 155 amends SFAS No. 133, “Accounting for DerivativeInstruments and Hedging Activities,” and SFAS No. 140, “Accounting forTransfers and Servicing of Financial Assets and Extinguishments of Liabilities.”  SFAS No. 155 permits fair valuemeasurements for any hybrid financial instrument that contains an embeddedderivative and that otherwise would require bifurcation, clarifies which interest-onlystrips and principal-only strips are not subject to the requirements of SFAS No. 133,  establishes a requirement to evaluateinterests in securitized financial assets to identify interests that arefreestanding derivatives or that are hybrid financial instruments that containan embedded derivative requiring bifurcation, clarifies that concentrations ofcredit risk in the form of subordination are not embedded derivatives, andamends SFAS No. 140 to eliminate the prohibition on a qualifying specialpurpose entity from holding a derivative financial nstrument that pertains to abeneficial interest other than another derivative financial interest. SFAS No. 155is effective for all financial instruments acquired, issued, or subject to are-measurement event occurring after the beginning of an entity’s first fiscalyear that begins after September 15, 2006. The adoption of this newstandard at January 1, 2007 did not have an impact on the Company’sfinancial statements.

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIESNotes to Consolidated Financial Statements (Continued)**

**(1)  Summary of Significant Accounting Policies(Continued)**

In March 2006, the Financial Accounting StandardsBoard issued Statement of Financial Accounting Standards No. 156, (“SFAS No. 156”),“Accounting for Servicing of Financial Assets—an amendment of FASB Statement No. 140.”  SFAS No. 156 amends SFAS No. 140, “Accountingfor Transfers and Servicing of Financial Assets and Extinguishments ofLiabilities—a replacement of FASB Statement No. 125,” by requiring, incertain situations, an entity to recognize a servicing asset or servicing liabilityeach time it undertakes an obligation to service a financial asset by enteringinto a servicing contract. All separately recognized servicing assets andservicing liabilities are required to be initially measured at fair value. Subsequentmeasurement methods include the amortization method, whereby servicing assetsor servicing liabilities are amortized in proportion to an over the period ofestimated net servicing income or net servicing loss or the fair value method,whereby servicing assets or servicing liabilities are measured at fair value ateach reporting date and changes in fair value are reported in earnings in theperiod in which they occur. If the amortization method is used, an entity mustassess servicing assets or servicing liabilities for impairment or increasedobligation based on the fair value at each reporting date. SFAS No. 156 iseffective as of the beginning of an entity’s first fiscal year that beginsafter September 15, 2006. The adoption of this new standard at January 1,2007 did not have a significant impact on the Company’s consolidated financialstatements.

In September 2006, the Financial AccountingStandards Board issued Statement of Financial Accounting Standards No. 157(“SFAS No. 157”), “Fair Value Measurements.”  SFAS No. 157 defines fair value,establishes a framework for measuring fair value in generally acceptedaccounting principles, and expands disclosures about fair value measurements. SFASNo. 157 is effective for fiscal years beginning after November 15,2007. The Company does not anticipate a significant impact to the financialstatements upon the adoption of this new standard.

In December 2006, the Financial AccountingStandards Board issued Statement of Financial Accounting Standards No. 158(“SFAS No. 158”), “Employers’ Accounting for Defined Benefit Pension andOther Postretirement Plans, an amendment of FASB Statements No. 87, 88,106 and 132(R).”  SFAS No 158 requires anemployer to recognize the over-funded or under-funded status of defined benefitpost-retirement benefit plans as an asset or liability in its financialstatements. The funded status is measured as the difference between plan assetsat fair value and the benefit obligation (the projected benefit obligation forpension plans or the accumulated benefit obligation for other post-retirementbenefit plans). An employer is also required to measure the funded status of aplan as of the date of its year-end financial statements with changes in thefunded status recognized through comprehensive income. SFAS No. 158 alsorequires certain disclosures regarding the effects on net periodic benefit costfor the next fiscal year that arise from delayed recognition of gains orlosses, prior service costs or credits, and the transition asset or obligation.Publicly traded companies are to apply the disclosure requirements of SFAS No. 158for fiscal years ending after December 15, 2006, with full adoption forfiscal years ending after December 15, 2008. The adoption of this newstandard is not expected to have an impact on the Company’s financialstatements.

46

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**(1)  Summary of Significant Accounting Policies(Continued)**

In June 2006, the Financial Accounting StandardsBoard issued FASB Interpretation No. 48 (“FIN 48”), “ Accounting forUncertainty in Income Taxes, an interpretation of FASB Statement 109.”  FIN 48 prescribes a recognition threshold anda measurement attribute for the financial statement recognition and measurementof a tax position taken or expected to be taken in a tax return. Benefits fromtax positions should be recognized in the financial statements only when it ismore likely than not that the tax position will be sustained upon examinationby the appropriate taxing authority that would have full knowledge of allrelevant information. A tax position that meets the more likely than notrecognition threshold is measured at the largest amount of benefit that isgreater than fifty percent likely of being realized upon ultimate settlement.Tax positions that previously failed to meet the more likely than notrecognition threshold should be recognized in the first subsequent financialreporting period in which that threshold is met. Previously recognized taxpositions that no longer meet the more likely than not recognition thresholdshould be derecognized in the first subsequent financial reporting period inwhich that threshold is no longer met. FIN 48 also provides guidance on theaccounting for and disclosure of unrecognized tax benefits, interest andpenalties. FIN 48 is effective for fiscal years beginning afterDecember 15, 2006. The adoption of this new standard is not expected tohave an impact on the Company’s financial statements.

In September 2006,the Securities and Exchange Commission issued Staff Accounting BulletinNo. 108 (“SAB No. 108”), “Considering the Effects of a Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements.”  SAB No.108 addresses howthe effects of prior year uncorrected errors must be considered in quantifyingmisstatements in the current year financial statements. The effects of prioryear uncorrected errors include the potential accumulation of improper amountsthat may result in a material misstatement on the balance sheet or the reversalof prior period errors in the current period that result in a materialmisstatement of the current period income statement amounts. Adjustments tocurrent or prior period financial statements would be required in the eventthat after application of various approaches for assessing materiality ofmisstatement in current period financial statements and consideration of allrelevant quantitative and qualitative factors, a misstatement is determined tobe material. SAB No. 108 is effective for fiscal years ending afterNovember 15, 2006.

**(2) Potentialand Completed Acquisitions**

On December 1, 2006, the Companysigned a definitive agreement pursuant to which the Company will acquireSouthwest First Community, Inc. (“Southwest Community”), a bank holdingcompany with approximately $129 million in assets that owns StateBank & Trust in Beeville, Texas and Commercial State Bank in Sinton,Texas. The transaction is expected to close in the spring of 2007 and issubject to various closing conditions, including receipt of all requisiteregulatory approvals. The Board of Directors of both the Company and SouthwestCommunity and the shareholders of Southwest Community have approved thetransaction.

On June 18, 2004, theCompany acquired Local Financial Corporation (“LFIN”), an Oklahoma based bankholding company with approximately $3.0 billion in assets. The acquisition waseffected pursuant to the Agreement and Plan of Merger dated as of January 22,2004 (the “Merger Agreement”). The Company paid consideration totalingapproximately $276.6 million in cash and 2.11 million shares of Company commonstock. The aggregate purchase price was $367.4 million. Under the termsof the Merger Agreement, LFIN shareholders were entitled to elect to receiveeither cash or Company common stock in 

47

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**(2)Potential and Completed Acquisitions (Continued)**

the merger, subject to therequirement that 75% of LFIN’s shares be exchanged for cash and 25% beexchanged for Company common stock. Based on the elections of LFIN shareholdersand the terms of the Merger Agreement, LFIN shares held by LFIN shareholderswho elected to receive shares of Company common stock in the Merger and LFINshareholders who did not timely make a cash/stock election were exchangedentirely for shares of Company common stock. As to those LFIN shares for whichan election to receive cash was timely made, each such share was exchanged forapproximately $20.59 in cash and 0.033 shares of Company common stock. Theexchange rate for those LFIN shareholders receiving Company common stock in theMerger was 0.5170 shares of Company common stock for each share of LFIN.

The following tablesummarizes the estimated fair value of the assets acquired and liabilitiesassumed at the date of the acquisition, in thousands.

| ** **                                  | ** ** | **As of  June 18, 2004** | ** ** |
|---------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                  | ** ** | **(Dollars in  thousands)**        | ** ** |
| Assets                                      |       |                                    |       |   |   |
| Cash and cash equivalents                   |       |                                    | $          | 66,009 |   |   |
| Time deposits with banks                    |       |                                    | 87,400     |   |   |
| Investment securities                       |       |                                    | 331,656    |   |   |
| Net loans                                   |       |                                    | 2,152,912  |   |   |
| Bank premises and equipment                 |       |                                    | 50,155     |   |   |
| Accrued interest receivable                 |       |                                    | 8,266      |   |   |
| Other investments                           |       |                                    | 93,538     |   |   |
| Identified intangible asset                 |       |                                    | 42,188     |   |   |
| Goodwill                                    |       |                                    | 221,814    |   |   |
| Other assets                                |       |                                    | 30,230     |   |   |
| Total assets acquired                       |       |                                    | 3,084,168  |   |   |
| Liabilities                                 |       |                                    |       |   |   |
| Demand deposits                             |       |                                    | 232,982    |   |   |
| Savings deposits                            |       |                                    | 766,178    |   |   |
| Time deposits                               |       |                                    | 938,031    |   |   |
| Securities sold under repurchase agreements |       |                                    | 44,138     |   |   |
| Other borrowed funds                        |       |                                    | 624,382    |   |   |
| Senior notes                                |       |                                    | 21,295     |   |   |
| Other liabilities                           |       |                                    | 89,764     |   |   |
| Total liabilities assumed                   |       |                                    | 2,716,770  |   |   |
| Net assets  acquired                        |       |                                    | $          | 367,398 |   |   |

 

48

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**(2)Potential and Completed Acquisitions (Continued)**

Thefollowing table reflects the pro forma results of operations for the year endedDecember 31, 2004 as though the acquisition had been completed as of January 1,2004 (dollars in thousands, except per share data):

| ** **                         | ** ** | **Year Ended  December 31, 2004** | ** ** |
|------------------------------------|------------|--------------------------------------------------|------------|
| Interest income                    |       |                                             | $          | 417,945 |   |   |
| Interest expense                   |       |                                             | 136,886    |   |   |
| Net interest income                |       |                                             | 281,059    |   |   |
| Provision for possible loan losses |       |                                             | 18,000     |   |   |
| Non-interest income                |       |                                             | 150,917    |   |   |
| Non-interest expense               |       |                                             | 267,923    |   |   |
| Income before income taxes         |       |                                             | 146,053    |   |   |
| Income taxes                       |       |                                             | 47,962     |   |   |
| Net income                         |       |                                             | $          | 98,091 |   |   |
| Per common share:                  |       |                                             |       |   |   |
| Basic                              |       |                                             | $          | 1.58 |   |   |
| Diluted                            |       |                                             | $          | 1.55 |   |   |

 

Included in the non-interest expense of the combinedoperations for the year ended December 31, 2004 are certain costsassociated with contractual obligations related to the closing of thetransaction.

**(3) InvestmentSecurities**

Theamortized cost and estimated fair value by type of investment security at December 31,2006 are as follows:

| ** **                   | ** ** | **Held to Maturity**       | ** ** |
|------------------------------|------------|--------------------------------------|------------|
| ** **                   | ** ** | **Amortized  cost**                  | ** ** | **Gross  unrealized  gains** | ** ** | **Gross  unrealized  losses** | ** ** | **Estimated  fair value** | ** ** | **Carrying  value** | ** ** |
| ** **                   | ** ** | **(Dollars in Thousands)** | ** ** |
| Other securities             |       |                                 | $          | 2,375 |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | 2,375 |   |   |   | $ | 2,375 |   |   |
| Total investment  securities |       |                                 | $          | 2,375 |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | 2,375 |   |   |   | $ | 2,375 |   |   |

 

| ** **                                        | ** ** | **Available for Sale**     | ** ** |
|---------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                        | ** ** | **Amortized  cost**                  | ** ** | **Gross  unrealized  gains** | ** ** | **Gross  unrealized  losses** | ** ** | **Estimated  fair value** | ** ** | **Carrying  value** | ** ** |
| ** **                                        | ** ** | **(Dollars in Thousands)** | ** ** |
| U.S. Treasury  securities                         |       | $                                    | 1,268      |   |   | $ | — |   |   | $ | — |   | $ | 1,268 |   | $ | 1,268 |   |
| Mortgage-backed  securities                       |       | 4,440,265                            |       |   | 1,025 |   |   | (65,006 | ) | 4,376,284 |   | 4,376,284 |   |
| Obligations of  states and political subdivisions |       | 92,878                               |       |   | 3,019 |   |   | — |   | 95,897 |   | 95,897 |   |
| Other securities                                  |       | 4,630                                |       |   | — |   |   | (2,551 | ) | 2,079 |   | 2,079 |   |
| Equity securities                                 |       | 13,825                               |       |   | 804 |   |   | — |   | 14,629 |   | 14,629 |   |
| Total investment  securities                      |       | $                                    | 4,552,866  |   |   | $ | 4,848 |   |   | $ | (67,557 | ) | $ | 4,490,157 |   | $ | 4,490,157 |   |

 

49

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**(3)Investment Securities (Continued)**

The amortized cost andestimated fair value of investment securities at December 31, 2006, bycontractual maturity, are shown below. Expected maturities will differ fromcontractual maturities because borrowers may have the right to prepayobligations with or without prepayment penalties.

| ** **                              | ** ** | **Held to Maturity**       | ** ** | **Available for Sale** | ** ** |
|-----------------------------------------|------------|--------------------------------------|------------|----------------------------------|------------|
| ** **                              | ** ** | **Amortized  Cost**                  | ** ** | **Estimated  fair value**   | ** ** | **Amortized  Cost** | ** ** | **Estimated  fair value** | ** ** |
| ** **                              | ** ** | **(Dollars in Thousands)** | ** ** |
| Due in one year  or less                |       |                                 | $          | 75                               |       |   |   | $ | 75 |   |   | $ | 1,268 |   | $ | 1,268 |   |
| Due after one  year through five years  |       |                                 | 2,300      |                             |       |   | 2,300 |   |   | — |   | — |   |
| Due after five  years through ten years |       |                                 | —     |                             |       |   | — |   |   | 8,199 |   | 8,304 |   |
| Due after ten  years                    |       |                                 | —     |                             |       |   | — |   |   | 89,309 |   | 89,672 |   |
| Mortgage-backed  securities             |       |                                 | —     |                             |       |   | — |   |   | 4,440,265 |   | 4,376,284 |   |
| Equity securities                       |       |                                 | —     |                             |       |   | — |   |   | 13,825 |   | 14,629 |   |
| Total investment  securities            |       |                                 | $          | 2,375                            |       |   |   | $ | 2,375 |   |   | $ | 4,552,866 |   | $ | 4,490,157 |   |

 

Theamortized cost and estimated fair value by type of investment security at December 31,2005 are as follows:

| ** **                   | ** ** | **Held to Maturity**       | ** ** |
|------------------------------|------------|--------------------------------------|------------|
| ** **                   | ** ** | **Amortized  cost**                  | ** ** | **Gross  unrealized  gains** | ** ** | **Gross  unrealized  losses** | ** ** | **Estimated  fair value** | ** ** | **Carrying  value** | ** ** |
| ** **                   | ** ** | **(Dollars in Thousands)** | ** ** |
| Other securities             |       |                                 | $          | 2,375 |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | 2,375 |   |   |   | $ | 2,375 |   |   |
| Total investment  securities |       |                                 | $          | 2,375 |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | 2,375 |   |   |   | $ | 2,375 |   |   |

 

| ** **                                        | ** ** | **Available for Sale**     | ** ** |
|---------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                        | ** ** | **Amortized  cost**                  | ** ** | **Gross  unrealized  gains** | ** ** | **Gross  unrealized  losses** | ** ** | **Estimated  fair value** | ** ** | **Carrying  value** | ** ** |
| ** **                                        | ** ** | **(Dollars in Thousands)** | ** ** |
| U.S. Treasury  securities                         |       | $                                    | 1,283      |   |   | $ | — |   |   | $ | — |   | $ | 1,283 |   | $ | 1,283 |   |
| Mortgage-backed  securities                       |       | 4,214,461                            |       |   | 913 |   |   | (66,515 | ) | 4,148,859 |   | 4,148,859 |   |
| Obligations of  states and political subdivisions |       | 96,750                               |       |   | 2,833 |   |   | (26 | ) | 99,557 |   | 99,557 |   |
| Other securities                                  |       | 5,198                                |       |   | — |   |   | (2,599 | ) | 2,599 |   | 2,599 |   |
| Equity securities                                 |       | 13,825                               |       |   | 978 |   |   | (149 | ) | 14,654 |   | 14,654 |   |
| Total investment  securities                      |       | $                                    | 4,331,517  |   |   | $ | 4,724 |   |   | $ | (69,289 | ) | $ | 4,266,952 |   | $ | 4,266,952 |   |

 

Mortgage-backed securities areprimarily securities issued by the Federal Home Loan Mortgage Corporation (“FreddieMac”), the Federal National Mortgage Association (“Fannie Mae”) and theGovernment National Mortgage Association (“Ginnie Mae”).

The amortized cost and fairvalue of available for sale investment securities pledged to qualify forfiduciary powers, to secure public monies as required by law, repurchaseagreements and short-term fixed borrowings was $3,088,095,000 and$3,043,558,000, respectively, at December 31, 2006.

50

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**(3) InvestmentSecurities (Continued)**

Proceeds from the sale ofsecurities available-for-sale were $60,447,000, $189,902,000 and $875,816,000during 2006, 2005 and 2004, respectively. Gross gains of $412,000, $1,402,000and $12,818,000 and gross losses of $1,342,000, $1,583,000 and $3,934,000 wererealized on the sales in 2006, 2005 and 2004, respectively.

Gross unrealized losses on investment securities and thefair value of the related securities, aggregated by investment category andlength of time that individual securities have been in a continuous unrealizedloss position, at December 31, 2006 were as follows:

| ** **                                        | ** ** | **Less than 12 months** | ** ** | **12 months or more** | ** ** | **Total**           | ** ** |
|---------------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|---------------------|------------|
| ** **                                        | ** ** | **Fair Value**                    | ** ** | **Unrealized  Losses**               | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
| ** **                                        | ** ** | **(Dollars in Thousands)**   | ** ** |
| Available for sale:                               |       |                                   |       |                                 |       |                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury securities                          |       | $                                      | —     |                                 |       | $                   | —     |   |   | $ | — |   |   | $ | — |   |   | $ | — |   |   | $ | — |   |   |
| Mortgage-backed securities                        |       | 812,870                                |       |                                 | (4,511     | )                   |       | 3,137,292 |   |   | (60,495 | ) |   | 3,950,162 |   |   | (65,006 | ) |   |
| Obligations of states and  political subdivisions |       | —                                 |       |                                 | —     |                |       | — |   |   | — |   |   | — |   |   | — |   |   |
| Other securities                                  |       | —                                 |       |                                 | —     |                |       | 2,079 |   |   | (2,551 | ) |   | 2,079 |   |   | (2,551 | ) |   |
|                                              |       | $                                      | 812,870    |                                 |       | $                   | (4,511     | ) |   | $ | 3,139,371 |   |   | $ | (63,046 | ) |   | $ | 3,952,241 |   |   | $ | (67,557 | ) |   |

 

The unrealized losses oninvestments in mortgage-backed securities are caused by changes in marketinterest rates. The contractual cash obligations of the securities areguaranteed by Freddie Mac, Fannie Mae, and Ginnie Mae. The decrease in fairvalue is due to market interest rates and not other factors, and because theCompany has the ability and intent to hold these investments until a marketprice recovery or maturity of the securities, it is the conclusion of theCompany that the investments are not considered other-than-temporarilyimpaired.

Theunrealized losses on investments in other securities are caused by fluctuationsin market interest rates. The underlying cash obligations of the securities areguaranteed by the entity underwriting the debt instrument. It is the belief ofthe Company that the entity issuing the debt will honor its interest paymentschedule, as well as the full debt at maturity. The securities are purchased bythe Company for their economic value. The decrease in fair value is primarilydue to market interest rates and not other factors, and because the Company hasthe ability and intent to hold these investments until a market price recoveryor maturity of the securities, it is the conclusion of the Company that theinvestments are not considered other-than-temporarily impaired.

51

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**(4) Loans**

A summary of net loans, by loan type at December 31,2006 and 2005 is as follows:

| ** **                              | ** ** | **December 31,**                | ** ** |
|-----------------------------------------|------------|--------------------------------------|------------|
| ** **                              | ** ** | **2006**                             | ** ** | **2005** | ** ** |
| ** **                              | ** ** | **(Dollars in thousands)** | ** ** |
| Commercial,  financial and agricultural |       | $                                    | 2,337,573  |   | $ | 2,376,276 |   |
| Real  estate-mortgage                   |       | 785,401                              |       | 847,512 |   |
| Real estate—construction           |       | 1,404,186                            |       | 901,518 |   |
| Consumer                                |       | 198,580                              |       | 218,607 |   |
| Foreign                                 |       | 309,144                              |       | 281,947 |   |
| Total loans                             |       | 5,034,884                            |       | 4,625,860 |   |
| Unearned discount                       |       | (74                                  | )          | (168 | ) |
| Loans, net of  unearned discount        |       | $                                    | 5,034,810  |   | $ | 4,625,692 |   |

 

**(5) Allowance for Possible Loan Losses**

A summary of the transactions in the allowance forpossible loan losses for the years ended December 31, 2006, 2005 and 2004is as follows:

| ** **                        | ** ** | **2006**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------|------------|--------------------------------------|------------|----------|------------|----------|------------|
| ** **                        | ** ** | **(Dollars in Thousands)** | ** ** |
| Balance at January 1,        |       | $                                    | 77,796     |     | $          | 81,351   |       | $ | 46,396 |   |
| Losses charged to allowance       |       | (18,388                              | )          | (6,571   | )          | (9,513   | )          |
| Recoveries credited to  allowance |       | 1,280                                |       | 2,056    |       | 5,407    |       |
| Net losses charged to  allowance  |       | (17,108                              | )          | (4,515   | )          | (4,106   | )          |
| Provision charged to  operations  |       | 3,849                                |       | 960      |       | 5,196    |       |
| Acquired in purchase transactions |       | —                               |       | —   |       | 33,865   |       |
| Balance  at December 31,     |       | $                                    | 64,537     |     | $          | 77,796   |       | $ | 81,351 |   |

 

Loans accounted for on a non-accrual basis at December 31,2006, 2005 and 2004 amounted to $17,788,000, $30,075,000 and $30,773,000,respectively. The effect of such non-accrual loans reduced interest income by$1,868,000, $2,329,000 and $1,203,000 for the years ended December 31,2006, 2005 and 2004, respectively. Amounts received on non-accruals areapplied, for financial accounting purposes, first to principal and then tointerest after all principal has been collected.

The decrease in non-accrual loans from 2005 to 2006can be attributed to the charge-off of loans acquired as part of the LFINacquisition.

Impaired loans are those loans where it is probable thatall amounts due according to contractual terms of the loan agreement will notbe collected. The Company has identified these loans through its normal loanreview procedures.   Impaired loans aremeasured based on (1) the present value of expected future cash flowsdiscounted at the loan’s effective interest rate; (2) the loan’sobservable market price; or (3) the fair value of the collateral if theloan is collateral dependent. Substantially all of the Company’s impaired loansare measured at the fair value of the collateral. In limited cases the Companymay use other methods to determine the level of impairment of a loan if suchloan is not collateral dependent.

52

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**(5)  Allowance for Possible Loan Losses(Continued)**

Thefollowing table details key information regarding the Company’s impaired loans:

| ** **                                                                   | ** ** | **2006**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------|------------|----------|------------|----------|------------|
| ** **                                                                   | ** ** | **(Dollars in Thousands)** | ** ** |
| Balance of impaired loans where there is a related allowance for loan  loss  |       | $                                    | 22,909     |     | $          | 34,796   |       | $ | 37,037 |   |
| Balance of impaired loans where there is no related allowance for loan  loss |       | —                               |       | —   |       | —   |       |
| Total impaired loans                                                         |       | $                                    | 22,909     |     | $          | 34,796   |       | $ | 37,037 |   |
| Allowance allocated to impaired loans                                        |       | $                                    | 7,171      |     | $          | 20,014   |       | $ | 15,666 |   |

 

The impaired loans included inthe table above were primarily comprised of collateral dependent commercialloans, which have not been fully charged off. The average recorded investmentin impaired loans was $25,684,000, $29,909,000, and $34,226,000 for the yearsended December 31, 2006, 2005 and 2004, respectively.

Management of the Companyrecognizes the risks associated with these impaired loans. However, management’sdecision to place loans in this category does not necessarily mean that losseswill occur.

The bank subsidiaries charge off that portion of anyloan which management considers to represent a loss as well as that portion ofany other loan which is classified as a “loss” by bank examiners. Commercialand industrial or real estate loans are generally considered by management torepresent a loss, in whole or part, when an exposure beyond any collateralcoverage is apparent and when no further collection of the loss portion isanticipated based on the borrower’s financial condition and general economicconditions in the borrower’s industry. Generally, unsecured consumer loans arecharged-off when 90 days past due.

While management of theCompany considers that it is generally able to identify borrowers withfinancial problems reasonably early and to monitor credit extended to suchborrowers carefully, there is no precise method of predicting loan losses. Thedetermination that a loan is likely to be un-collectible and that it should bewholly or partially charged-off as a loss is an exercise of judgment. Similarly,the determination of the adequacy of the allowance for possible loan losses canbe made only on a subjective basis. It is the judgment of the Company’smanagement that the allowance for possible loan losses at December 31,2006 was adequate to absorb probable losses from loans in the portfolio at thatdate.

**(6) Bank Premises and Equipment**

Asummary of bank premises and equipment, by asset classification, at December 31,2006 and 2005 were as follows:

| ** **                                        | ** ** | **Estimated  useful lives** | ** ** | **2006**                             | ** ** | **2005** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|--------------------------------------|------------|----------|------------|
| ** **                                        | ** ** | ** **                       | ** ** | **(Dollars in Thousands)** | ** ** |
| Bank buildings and improvements                   |       | 5  - 40 years                    |       | $                                    | 288,664    |     | $          | 261,787 |   |
| Furniture, equipment and vehicles                 |       | 1  - 20 years                    |       | 204,163                              |       | 185,465  |       |
| Land                                              |       |                             |       | 82,191                               |       | 65,632   |       |
| Real  estate held for future expansion:           |       |                             |       |                                 |       |     |       |
| Land, building, furniture,  fixture and equipment |       | 7  - 27 years                    |       | 868                                  |       | 919      |       |
| Less: accumulated depreciation                    |       |                             |       | (185,563                             | )          | (161,817 | )          |
| Bank premises and equipment, net                  |       |                             |       | $                                    | 390,323    |     | $          | 351,986 |   |

 

53

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**(7) Goodwill and Other Intangible Assets**

TheCompany’s identified intangibles are all in the form of amortizable coredeposit premium. In 2004, the Company acquired $42,188,000 in identifiedintangibles in the form of core deposit premium in the LFIN acquisition, whichwill be amortized over a ten year period. Information on the Company’sidentified intangible assets follows:

| ** **                  | ** ** | **Carrying  Amount**                 | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
|-----------------------------|------------|--------------------------------------|------------|-------------------------------|------------|---------|------------|
| ** **                  | ** ** | **(Dollars in Thousands)** | ** ** |
| **December 31, 2006:** |       |                                 |       |                          |       |    |       |   |   |
| Core deposit premium        |       | $                                    | 56,338     |                          |       | $       | 21,980     |   |   | $ | 34,358 |   |
| **December 31, 2005:** |       |                                 |       |                          |       |    |       |   |   |
| Core deposit  premium       |       | $                                    | 56,338     |                          |       | $       | 17,114     |   |   | $ | 39,224 |   |

 

Amortization expense of intangible assets for the yearsended December 31, 2006, 2005 and 2004, was $4,866,000, $5,176,000 and$3,681,000, respectively. Estimated amortization expense for each of the fivesucceeding fiscal years, and thereafter, is as follows:

Fiscal year ending:

| ** ** | ** ** | **Total**               | ** ** |
|------------|------------|-------------------------|------------|
| ** ** | ** ** | **(in thousands)** | ** ** |
| 2007       |       |                    | $          | 4,837 |   |   |
| 2008       |       |                    | 4,837      |   |   |
| 2009       |       |                    | 4,837      |   |   |
| 2010       |       |                    | 4,837      |   |   |
| 2011       |       |                    | 4,794      |   |   |
| Thereafter |       |                    | 10,216     |   |   |
| Total      |       |                    | $          | 34,358 |   |   |

Changes in the carrying amountof goodwill for the year ended December 31, 2006 were as illustrated inthe table below. There were no changes in the carrying amount of goodwill forthe year ended December 31, 2005.

| Balance at December 31, 2005                        |   | $      | 289,262 |   |
|----------------------------------------------------------|--------|--------|---------|--------|
| Adjustment to goodwill related  to acquisition (Note 17) |   | (7,016 | )       |
| Balance  as of December 31, 2006                    |   | $      | 282,246 |   |

 

54

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**(8) ** Deposits

Depositsas of December 31, 2006 and 2005 and related interest expense for theyears ended December 31, 2006, 2005 and 2004 were as follows:

| ** **                                 | ** ** | **2006**                             | ** ** | **2005**  | ** ** |
|--------------------------------------------|------------|--------------------------------------|------------|-----------|------------|
| ** **                                 | ** ** | **(Dollars in Thousands)** | ** ** |
| Deposits:                                  |       |                                 |       |      |       |
| Demand—non-interest  bearing          |       |                                 |       |      |       |
| Domestic                                   |       | $                                    | 1,332,525  |      | $          | 1,222,888 |   |
| Foreign                                    |       | 120,951                              |       | 116,492   |       |
| Total demand non-interest bearing          |       | 1,453,476                            |       | 1,339,380 |       |
| Savings and interest  bearing demand       |       |                                 |       |      |       |
| Domestic                                   |       | 1,838,229                            |       | 1,839,829 |       |
| Foreign                                    |       | 366,222                              |       | 316,405   |       |
| Total savings and  interest bearing demand |       | 2,204,451                            |       | 2,156,234 |       |
| Time, certificates of  deposit             |       |                                 |       |      |       |
| $100,000 or more                           |       |                                 |       |      |       |
| Domestic                                   |       | 846,185                              |       | 814,267   |       |
| Foreign                                    |       | 1,200,412                            |       | 1,091,284 |       |
| Less than  $100,000                        |       |                                 |       |      |       |
| Domestic                                   |       | 892,656                              |       | 889,016   |       |
| Foreign                                    |       | 392,738                              |       | 366,245   |       |
| Total time, certificates  of deposit       |       | 3,331,991                            |       | 3,160,812 |       |
| Total deposits                             |       | $                                    | 6,989,918  |      | $          | 6,656,426 |   |

 

| ** **                                 | ** ** | **2006**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------|------------|--------------------------------------|------------|----------|------------|----------|------------|
| ** **                                 | ** ** | **(Dollars in Thousands)** | ** ** |
| Interest  expense:                         |       |                                 |       |     |       |     |       |
| Savings and interest bearing demand        |       |                                 |       |     |       |     |       |
| Domestic                                   |       | $                                    | 36,606     |     | $          | 24,583   |       | $ | 11,991 |   |
| Foreign                                    |       | 3,838                                |       | 2,353    |       | 1,806    |       |
| Total savings and interest  bearing demand |       | 40,444                               |       | 26,936   |       | 13,797   |       |
| Time, certificates of deposit              |       |                                 |       |     |       |     |       |
| $100,000 or more                           |       |                                 |       |     |       |     |       |
| Domestic                                   |       | 32,851                               |       | 18,705   |       | 10,483   |       |
| Foreign                                    |       | 44,143                               |       | 26,710   |       | 17,327   |       |
| Less than $100,000                         |       |                                 |       |     |       |     |       |
| Domestic                                   |       | 33,225                               |       | 20,399   |       | 12,396   |       |
| Foreign                                    |       | 12,858                               |       | 7,420    |       | 4,453    |       |
| Total time, certificates of  deposit       |       | 123,077                              |       | 73,234   |       | 44,659   |       |
| Total  interest expense on deposits        |       | $                                    | 163,521    |     | $          | 100,170  |       | $ | 58,456 |   |

 

55

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**(8)  Deposits (Continued)**

Scheduled maturities of timedeposits in amounts of $100,000 or more at December 31, 2006, were asfollows:

| Due within 3 months or less             |   | $       | 876,841   |   |
|-----------------------------------------|--------|---------|-----------|--------|
| Due after 3 months and within 6 months  |   | 506,135 |      |
| Due after 6 months and within 12 months |   | 477,336 |      |
| Due after 12 months                     |   | 186,285 |      |
|                                    |   | $       | 2,046,597 |   |

 

**(9) Securities Sold Under Repurchase Agreements**

The Company’s bank subsidiaries have entered intorepurchase agreements with an investment banking firm and individual customersof the bank subsidiaries. The purchasers have agreed to resell to the banksubsidiaries identical securities upon the maturities of the agreements. Securitiessold under repurchase agreements were mortgage-backed book entry securities andaveraged $670,063,000 and $746,389,000 during 2006 and 2005, respectively, andthe maximum amount outstanding at any month end during 2006 and 2005 was$794,617,000 and $856,681,000, respectively.

Further information related to repurchase agreements at December 31,2006 and 2005 is set forth in the following table:

| ** **                    | ** ** | **Collateral Securities**                    | ** ** | **Repurchase Borrowing**                     | ** ** |
|-------------------------------|------------|---------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                    | ** ** | **Book Value of  Securities Sold** | ** ** | **Fair Value of  Securities Sold** | ** ** | **Balance of   Liability** | ** ** | **Weighted  Average Interest  Rate** | ** ** |
| ** **                    | ** ** | **(Dollars in Thousands)**              | ** ** |
| December 31,  2006 term: |       |                                              |       |                                              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Overnight agreements          |       |                                              | $          | 318,681                                           |       |   |   | $ | 314,225 |   |   |   | $ | 180,139 |   |   |   | 4.00 | % |   |
| 1 to 29 days                  |       |                                              | 39,274     |                                              |       |   | 39,048 |   |   |   | 27,181 |   |   |   | 4.53 |   |   |
| 30 to 90 days                 |       |                                              | 119,200    |                                              |       |   | 118,346 |   |   |   | 60,863 |   |   |   | 4.69 |   |   |
| Over 90 days                  |       |                                              | 558,993    |                                              |       |   | 553,223 |   |   |   | 438,152 |   |   |   | 4.92 |   |   |
| Total                         |       |                                              | $          | 1,036,148                                         |       |   |   | $ | 1,024,842 |   |   |   | $ | 706,335 |   |   |   | 4.65 | % |   |
| December 31,  2005 term: |       |                                              |       |                                              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Overnight agreements          |       |                                              | $          | 150,055                                           |       |   |   | $ | 147,175 |   |   |   | $ | 128,886 |   |   |   | 2.79 | % |   |
| 1 to 29 days                  |       |                                              | 12,461     |                                              |       |   | 12,296 |   |   |   | 3,931 |   |   |   | 3.85 |   |   |
| 30 to 90 days                 |       |                                              | 45,516     |                                              |       |   | 44,884 |   |   |   | 33,851 |   |   |   | 3.20 |   |   |
| Over 90 days                  |       |                                              | 765,644    |                                              |       |   | 756,145 |   |   |   | 594,094 |   |   |   | 4.24 |   |   |
| Total                         |       |                                              | $          | 973,676                                           |       |   |   | $ | 960,500 |   |   |   | $ | 760,762 |   |   |   | 3.95 | % |   |

 

The book value and fairvalue of securities sold includes the entire book value and fair value ofsecurities partially or fully pledged under repurchase agreements.

**(10) Other Borrowed Funds**

Other borrowed funds include Federal Home Loan Bankborrowings, which are short and long-term fixed borrowings issued by theFederal Home Loan Bank of Dallas at the market price offered at the time 

56

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**(10)Other Borrowed Funds (Continued)**

of funding. Theseborrowings are secured by mortgage-backed investment securities and a portionof the Company’s loan portfolio.

Furtherinformation regarding the Company’s other borrowed funds at December 31,2006 and 2005 is set forth in the following table:

| ** **                                       | ** ** | **December 31**                 | ** ** |
|--------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                       | ** ** | **2006**                             | ** ** | **2005** | ** ** |
| ** **                                       | ** ** | **(Dollars in Thousands)** | ** ** |
| Federal Home Loan Bank  advances—short-term |       |                                 |       |   |   |
| Balance at year end                              |       | $                                    | 2,095,505  |   | $ | 1,870,000 |   |
| Rate on balance outstanding at year end          |       | 5.29                                 | %          | 4.25 | % |
| Average daily balance                            |       | $                                    | 2,040,618  |   | $ | 1,863,096 |   |
| Average rate                                     |       | 5.07                                 | %          | 3.21 | % |
| Maximum amount outstanding at any month end      |       | $                                    | 2,247,025  |   | $ | 2,035,119 |   |
| Federal Home Loan Bank  advances—long-term  |       |                                 |       |   |   |
| Balance at year end                              |       | $                                    | 71         |   | $ | 75 |   |
| Rate on balance outstanding at year end          |       | 5.15                                 | %          | 5.15 | % |
| Average daily balance                            |       | $                                    | 73         |   | $ | 77 |   |
| Average rate                                     |       | 5.15                                 | %          | 5.15 | % |
| Maximum amount  outstanding at any month end     |       | $                                    | 75         |   | $ | 79 |   |

 

**(11)Junior Subordinated Deferrable Interest Debentures**

The Company has formed ten statutory business trustsunder the laws of the State of Delaware, for the purpose of issuing trustpreferred securities. As part of the LFIN acquisition, the Company acquiredthree additional statutory business trusts previously formed by LFIN for thepurpose of issuing trust preferred securities. The ten statutory businesstrusts formed by the Company and the three business trusts acquired in the LFINtransaction (the “Trusts”) have each issued Capital and Common Securities andinvested the proceeds thereof in an equivalent amount of junior subordinateddebentures (the “Debentures”) issued by the Company or LFIN, as appropriate. TheCompany has succeeded to the obligations of LFIN under the LFIN Debentures,which have an outstanding principal balance of $20,620,000. The Debentures willmature on various dates; however the Debentures may be redeemed at specifiedprepayment prices, in whole or in part after the optional redemption datesspecified in the respective indentures or in whole upon the occurrence of anyone of certain legal, regulatory or tax events specified in respectiveindentures. As of December 31, 2006, the principal amount of debenturesoutstanding totaled $210,908,000.

On July 25, 2006, pursuant to the Indenture datedas of July 16, 2001, between the Company and The Bank of New York, asTrustee, the Company redeemed all of its Floating Rate Junior Subordinated DebtSecurities (the “Debt Securities”), issued to International Bancshares CapitalTrust II (“Trust II”) at a redemption price equal to approximately $27,998,000,which includes accrued interest to, but not including, the redemption date.

In accordance with the Amended and RestatedDeclaration of Trust dated as of July 16, 2001 between the Company and TheBank of New York as Institutional Trustee, the proceeds from the redemption of 

57

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**(11)Junior Subordinated Deferrable Interest Debentures (Continued)**

the Debt Securities wereused to simultaneously redeem an equal amount of Trust II Floating CapitalSecurities and the Trust II Floating Rate Common Securities issued by Trust II.

On September 30, 2006, pursuant to the Indenturedated as of September 20, 2001, between Local Financial Corporation andThe Bank of New York, as Trustee, the Company redeemed all of its Fixed RateJunior Subordinated Debt Securities (the “Debt Securities”), issued to LocalFinancial Capital Trust I (“LFIN Trust I”) at a redemption price equal toapproximately $41,155,625, which includes accrued interest to, but notincluding, the redemption date.

In accordance with the Amended and RestatedDeclaration of Trust dated as of September 20, 2001 between LocalFinancial Capital Corporation and The Bank of New York as InstitutionalTrustee, the proceeds from the redemption of the Debt Securities were used tosimultaneously redeem an equal amount of LFIN Trust I Fixed Rate CapitalSecurities and the LFIN Trust I Fixed Rate Common Securities issued by LFINTrust I.

On December 8, 2006, pursuant to the Indenturedated as of November 28, 2001, between the Company and Wilmington Trustcompany, as Trustee, the Company redeemed all of its Floating Rate JuniorSubordinated Debt Securities (the “Debt Securities”) issued to InternationalBancshares Capital Trust III (“Trust III”) at a redemption price equal toapproximately $34,538,000, which includes accrued interest to, but notincluding, the redemption date.

In accordance with the Amended and RestatedDeclaration of Trust dated as of November 28, 2001, between the Companyand Wilmington Trust Company, as the Institutional Trustee and Delaware Trusteeand the Administrators named therein, the proceeds from the redemption of theDebt Securities were used to simultaneously redeem an equal amount of Trust IIIfloating rate Capital Securities and the Trust III floating rate CommonSecurities issued by Trust III.

On June 9, 2006, the Company formed InternationalBancshares Corporation Capital Trust IX (“Trust IX”), its ninth statutorybusiness trust formed under the laws of the State of Delaware, for the purposeof issuing trust preferred securities. On July 27, 2006, Trust IX issued$40,000,000 of Capital Securities. The Capital Securities accrue interest forthe first five years at a fixed rate of 7.10%, and subsequently at a floatingrate of 1.62% over the London Interbank Offered Rate (“LIBOR”), and interest ispayable quarterly beginning October 1, 2006. The Trust IX CapitalSecurities will mature on October 1, 2036; however, the Capital Securitiesmay be redeemed at specified prepayment prices (a) in whole or in part onany interest payment date on or after October 1, 2011, or (b) inwhole or in part within 90 days upon the occurrence of certain legal,regulatory, or tax events. The Capital Securities are subordinated and juniorin right of payment to all present and future senior indebtedness of theCompany. The Company has fully and unconditionally guaranteed the obligation ofTrust IX with respect to the Capital Securities. The Company has the right,unless an Event of Default has occurred and is continuing, to defer payment ofinterest on the Capital Securities for up to twenty consecutive quarterlyperiods. The redemption prior to maturity of any of the Capital Securities mayrequire the prior approval of the Federal Reserve and/or other regulatoryagencies.

On November 8, 2006, the Company formed InternationalBancshares Corporation Capital Trust X (“Trust X”), its tenth statutorybusiness trust formed under the laws of the State of Delaware, for the purposeof issuing trust preferred securities. On November 15, 2006, Trust Xissued $33,000,000 of Capital Securities. The Capital Securities accrueinterest for the first five years at a fixed rate of 6.66% and 

58

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**(11)Junior Subordinated Deferrable Interest Debentures (Continued)**

subsequently at a floatingrate of 1.65% over the three month LIBOR, and interest is payable quarterlybeginning February 1, 2007. The Trust X Capital Securities will mature on February 1,2037; however, the Capital Securities may be redeemed at specified prepaymentprices (a) in whole or in part on any interest payment date on or after February 1,2012, or (b) in whole or in part within 90 days upon the occurrence ofcertain legal, regulatory, or tax events. The Capital Securities aresubordinated and junior in right of payment to all present and future seniorindebtedness of the Company. The Company has fully and unconditionallyguaranteed the obligation of Trust X with respect to the Capital Securities. TheCompany has the right, unless an Event of Default has occurred and iscontinuing, to defer payment of interest on the Capital Securities for up totwenty consecutive quarterly periods. The redemption prior to maturity of anyof the Capital Securities may require the prior approval of the Federal Reserveand/or other regulatory agencies.

The Debentures are subordinated and junior in right ofpayment to all present and future senior indebtedness (as defined in therespective indentures) of the Company, and are *pari passu*with one another. The interest rate payable on, and the payment terms of theDebentures are the same as the distribution rate and payment terms of therespective issues of Capital and Common Securities issued by the Trusts. TheCompany has fully and unconditionally guaranteed the obligations of each of theTrusts with respect to the Capital and Common Securities. The Company has theright, unless an Event of Default (as defined in the Indentures) has occurredand is continuing, to defer payment of interest on the Debentures for up to tenconsecutive semi-annual periods on Trusts I, IV and LFIN Trust II and for up totwenty consecutive quarterly periods on Trusts V, VI, VII, VIII, IX and X andLFIN Trust III. If interest payments on any of the Debentures are deferred,distributions on both the Capital and Common Securities related to thatDebenture would also be deferred. The redemption prior to maturity of any ofthe Debentures may require the prior approval of the Federal Reserve and/orother regulatory bodies.

For financial reporting purposes, the Trusts aretreated as investments of the Company and not consolidated in the consolidatedfinancial statements. Although the Capital Securities issued by each of theTrusts are not included as a component of shareholders’ equity on theconsolidated statement of condition, the Capital Securities are treated ascapital for regulatory purposes. Specifically, under applicable regulatoryguidelines, the Capital Securities issued by the Trusts qualify as Tier 1capital up to a maximum of 25% of Tier 1 capital on an aggregate basis. Anyamount that exceeds the 25% threshold would qualify as Tier 2 capital. ForDecember 31, 2006, the total $210,908,000 of the Capital Securitiesoutstanding qualified as Tier 1 capital.

In March 2005, the Federal Reserve Board issued afinal rule that would continue to allow the inclusion of trust preferredsecurities in Tier 1 capital, but with stricter quantitative limits. Under thefinal rule, after a transition period ending March 31, 2009, the aggregateamount of trust preferred securities and certain other capital elements wouldbe limited to 25% of Tier 1 capital elements, net of goodwill, less anyassociated deferred tax liability. The amount of trust preferred securities andcertain other elements in excess of the limit could be included in Tier 2capital, subject to restrictions. Bank holding companies with significantinternational operations will be expected to limit trust preferred securitiesto 15% of Tier 1 capital elements, net of goodwill; however, they may includequalifying mandatory convertible preferred securities up to the 25% limit. TheCompany believes that substantially all of the current trust preferredsecurities will be included in Tier 1 capital after the five-year transitionperiod ending March 31, 2009.

59

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**(11) Junior SubordinatedDeferrable Interest Debentures (Continued)**

Thefollowing table illustrates key information about each of the Debentures andtheir interest rates at December 31, 2006:

| ** **          | ** ** | **Junior  Subordinated  Deferrable  Interest  Debentures** | ** ** | **Repricing  Frequency** | ** ** | **Interest  Rate** | ** **    | **Interest Rate  Index(1)** | ** ** | **Maturity  Date** | ** ** | **Optional  Redemption  Date** | ** **     |
|---------------------|------------|------------------------------------------------------------|------------|--------------------------|------------|--------------------|---------------|----------------------------------|------------|--------------------|------------|--------------------------------|----------------|
| ** **          | ** ** | **(in thousands)**                                    | ** ** | ** **               | ** ** | ** **         | ** **    | ** **                       | ** ** | ** **         | ** ** | ** **                     | ** **     |
| Trust I             |       |                                                       | $          | 10,252                   |       |               | Fixed         |                             |       | 10.18              | %          |                           | Fixed          |   | June 2031 |   | June 2011 |   |
| Trust IV            |       |                                                       | $          | 22,681                   |       |               | Semi-Annually |                             |       | 9.09               | %          |                           | LIBOR  + 3.70  |   | April 2032 |   | April 2007 |   |
| Trust V             |       |                                                       | $          | 20,558                   |       |               | Quarterly     |                             |       | 9.02               | %          |                           | LIBOR  + 3.65  |   | July 2032 |   | July 2007 |   |
| Trust VI            |       |                                                       | $          | 25,662                   |       |               | Quarterly     |                             |       | 8.82               | %          |                           | LIBOR  + 3.45  |   | November 2032 |   | November 2007 |   |
| Trust VII           |       |                                                       | $          | 10,310                   |       |               | Quarterly     |                             |       | 8.62               | %          |                           | LIBOR  + 3.25  |   | April 2033 |   | April 2008 |   |
| Trust VIII          |       |                                                       | $          | 25,566                   |       |               | Quarterly     |                             |       | 8.42               | %          |                           | LIBOR  + 3.05  |   | October 2033 |   | October 2008 |   |
| Trust IX            |       |                                                       | $          | 41,238                   |       |               | Quarterly     |                             |       | 7.10               | %          |                           | Fixed          |   | October 2036 |   | October 2011 |   |
| Trust X             |       |                                                       | $          | 34,021                   |       |               | Quarterly     |                             |       | 6.66               | %          |                           | Fixed          |   | February 2037 |   | February 2012 |   |
| LFIN Trust II  |       |                                                       | $          | 10,310                   |       |               | Semi-Annually |                             |       | 9.17               | %          |                           | LIBOR  + 3.625 |   | July 2032 |   | July 2007 |   |
| LFIN Trust III |       |                                                       | $          | 10,310                   |       |               | Quarterly     |                             |       | 8.82               | %          |                           | LIBOR  + 3.45  |   | November 2032 |   | November 2007 |   |
|                |       |                                                       | $          | 210,908                  |       |               |          |                             |       |               |       |                           |           |   |   |   |   |   |

----

(1)           Trust IX and Trust X accrue interestat a fixed rate for the first five years, then floating at LIBOR+1.62 andLIBOR+1.65 thereafter, respectively.

**(12) Earnings per Share(“EPS”)**

Basic EPS is calculated by dividing net income by theweighted average number of common shares outstanding. The computation ofdiluted EPS assumes the issuance of common shares for all dilutive potentialcommon shares outstanding during the reporting period. The calculation of thebasic EPS and the diluted EPS for the years ended December 31, 2006, 2005,and 2004 is set forth in the following table:

| ** **                        | ** ** | **Net**                                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
|-----------------------------------|------------|------------------------------------------------------------------------------------|------------|-------------------|------------|--------------------|------------|
| ** **                        | ** ** | **Income**                                                                         | ** ** | **Shares**        | ** ** | **Per Share** | ** ** |
| ** **                        | ** ** | **(Numerator)**                                                                    | ** ** | **(Denominator)** | ** ** | **Amount**         | ** ** |
| ** **                        | ** ** | **(Dollars in Thousands, Except Per Share Amounts)** | ** ** |
| December 31, 2006:           |       |                                                                               |       |              |       |               |       |   |   |   |   |   |   |
| Basic EPS                         |       |                                                                               |       |              |       |               |       |   |   |   |   |   |   |
| Net  income                       |       |                                                                               | $          | 117,001           |       |               |       | 63,133,522 |   |   |   | $ | 1.85 |   |   |
| Potential dilutive common  shares |       |                                                                               | —     |              |       |               | 643,366    |   |   |   |   |   |   |
| Diluted EPS                       |       |                                                                               | $          | 117,001           |       |               |       | 63,776,888 |   |   |   | $ | 1.83 |   |   |
| December 31, 2005:           |       |                                                                               |       |              |       |               |       |   |   |   |   |   |   |
| Basic EPS                         |       |                                                                               |       |              |       |               |       |   |   |   |   |   |   |
| Net income                        |       |                                                                               | $          | 140,779           |       |               |       | 63,695,017 |   |   |   | $ | 2.21 |   |   |
| Potential dilutive common  shares |       |                                                                               | —     |              |       |               | 790,150    |   |   |   |   |   |   |
| Diluted EPS                       |       |                                                                               | $          | 140,779           |       |               |       | 64,485,167 |   |   |   | $ | 2.18 |   |   |
| December 31, 2004:           |       |                                                                               |       |              |       |               |       |   |   |   |   |   |   |
| Basic EPS                         |       |                                                                               |       |              |       |               |       |   |   |   |   |   |   |
| Net income                        |       |                                                                               | $          | 119,032           |       |               |       | 62,134,149 |   |   |   | $ | 1.92 |   |   |
| Potential dilutive common  shares |       |                                                                               | —     |              |       |               | 1,246,407  |   |   |   |   |   |   |
| Diluted EPS                       |       |                                                                               | $          | 119,032           |       |               |       | 63,380,556 |   |   |   | $ | 1.88 |   |   |

 

60

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**(13) Employees’ Profit Sharing Plan**

The Company has a deferredprofit sharing plan for full-time employees with a minimum of one year ofcontinuous employment. The Company’s annual contribution to the plan is basedon a percentage, as determined by the Board of Directors, of income beforeincome taxes, as defined, for the year. Allocation of the contribution amongofficers and employees’ accounts is based on length of service and amount ofsalary earned. Profit sharing costs of $4,685,000, $4,950,000 and $3,823,000were charged to income for the years ended December 31, 2006, 2005, and2004, respectively.

**(14) International Operations**

The Company providesinternational banking services for its customers through its bank subsidiaries.Neither the Company nor its bank subsidiaries have facilities located outsidethe United States. International operations are distinguished from domesticoperations based upon the domicile of the customer.

Because the resources employedby the Company are common to both international and domestic operations, it isnot practical to determine net income generated exclusively from internationalactivities.

Asummary of assets attributable to international operations at December 31,2006 and 2005 are as follows:

| ** **                               | ** ** | **2006**                             | ** ** | **2005** | ** ** |
|------------------------------------------|------------|--------------------------------------|------------|----------|------------|
| ** **                               | ** ** | **(Dollars in Thousands)** | ** ** |
| Loans:                                   |       |                                 |       |     |       |
| Commercial                               |       | $                                    | 246,352    |     | $          | 219,877 |   |
| Others                                   |       | 62,792                               |       | 62,070   |       |
|                                     |       | 309,144                              |       | 281,947  |       |
| Less  allowance for possible loan losses |       | (7,612                               | )          | (15,138  | )          |
| Net loans                                |       | $                                    | 301,532    |     | $          | 266,809 |   |
| Accrued interest receivable              |       | $                                    | 2,655      |     | $          | 1,672 |   |

 

At December 31, 2006, the Company had$146,427,000 in outstanding standby and commercial letters of credit tofacilitate trade activities. The letters of credit are issued primarily in conjunctionwith credit facilities, which are available to various Mexican banks doingbusiness with the Company.

Revenuesdirectly attributable to international operations were $20,344,000, $14,003,000and $11,077,000 for the years ended December 31, 2006, 2005 and 2004,respectively.

61

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**(15) Income Taxes**

TheCompany files a consolidated U.S. Federal and State income tax return. Thecurrent and deferred portions of net income tax expense included in theconsolidated statements of income are presented below for the years ended December 31:

| ** **            | ** ** | **2006**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------|------------|--------------------------------------|------------|----------|------------|----------|------------|
| ** **            | ** ** | **(Dollars in Thousands)** | ** ** |
| Current               |       |                                 |       |     |       |     |       |
| U.S.                  |       | $                                    | 70,701     |     | $          | 48,151   |       | $ | 45,969 |   |
| State                 |       | 1,838                                |       | 452      |       | 523      |       |
| Foreign               |       | 36                                   |       | 15       |       | 35       |       |
| Total  current taxes  |       | 72,575                               |       | 48,618   |       | 46,527   |       |
| Deferred              |       |                                 |       |     |       |     |       |
| U.S.                  |       | (15,442                              | )          | 21,763   |       | 11,353   |       |
| State                 |       | (244                                 | )          | 989      |       | —   |       |
| Total  deferred taxes |       | (15,686                              | )          | 22,752   |       | 11,353   |       |
| Total  income taxes   |       | $                                    | 56,889     |     | $          | 71,370   |       | $ | 57,880 |   |

 

Total income tax expensediffers from the amount computed by applying the U.S. Federal income tax rateof 35% for 2006, 2005 and 2004 to income before income taxes. The reasons forthe differences for the years ended December 31 are as follows:

| ** **                              | ** ** | **2006**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------|------------|--------------------------------------|------------|----------|------------|----------|------------|
| ** **                              | ** ** | **(Dollars in Thousands)** | ** ** |
| Computed expected tax expense           |       | $                                    | 60,876     |     | $          | 74,252   |       | $ | 61,919 |   |
| Change in taxes resulting from:         |       |                                 |       |     |       |     |       |
| Tax-exempt interest income              |       | (1,681                               | )          | (1,800   | )          | (1,847   | )          |
| State tax, net of federal  income taxes |       | 1,037                                |       | 1,267    |       | 340      |       |
| Other investment income                 |       | (3,724                               | )          | (2,965   | )          | (2,522   | )          |
| Other                                   |       | 381                                  |       | 616      |       | (10      | )          |
| Actual tax expense                      |       | $                                    | 56,889     |     | $          | 71,370   |       | $ | 57,880 |   |

 

62

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**(15) Income Taxes(Continued)**

The tax effects oftemporary differences that give rise to significant portions of the deferredtax assets and deferred tax liabilities at December 31, 2006 and 2005 arereflected below:

| ** **                                                                   | ** ** | **2006**                             | ** ** | **2005** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------|------------|----------|------------|
| ** **                                                                   | ** ** | **(Dollars in Thousands)** | ** ** |
| Deferred tax assets:                                                         |       |                                 |       |     |       |
| Loans receivable,  principally due to the allowance for possible loan losses |       | $                                    | 26,796     |     | $          | 26,865 |   |
| Net unrealized losses on  available for sale investment securities           |       | 22,320                               |       | 22,598   |       |
| Other real estate owned                                                      |       | 13                                   |       | 152      |       |
| Goodwill                                                                     |       | 3,132                                |       | 3,147    |       |
| Accrued expenses                                                             |       | 5,829                                |       | 1,255    |       |
| State net operating loss  carryforwards                                      |       | 1,275                                |       | 1,633    |       |
| Other                                                                        |       | 1,893                                |       | 1,776    |       |
| Total deferred tax  assets                                                   |       | 61,258                               |       | 57,426   |       |
| Deferred tax liabilities:                                                    |       |                                 |       |     |       |
| Lease financing  receivable                                                  |       | (8,328                               | )          | (26,320  | )          |
| Bank premises and  equipment, principally due to differences on depreciation |       | (23,051                              | )          | (20,365  | )          |
| FHLB stock                                                                   |       | (5,975                               | )          | (4,520   | )          |
| Identified intangible assets                                                 |       | (19,157                              | )          | (19,015  | )          |
| Other                                                                        |       | (4,536                               | )          | (2,422   | )          |
| Total deferred tax  liabilities                                              |       | (61,047                              | )          | (72,642  | )          |
| Net deferred tax  liability                                                  |       | $                                    | 211        |     | $          | (15,216 | ) |

 

The net deferred tax asset at $211,000 atDecember 31, 2006 is included in other assets in the consolidatedstatements of condition. The net deferred tax liability of $15,216,000 atDecember 31, 2005 is included in other liabilities in the consolidatedstatements of condition.

**(16)Stock Options**

On April 1, 2005, the Board of Directors adoptedthe 2005 International Bancshares Corporation Stock Option Plan (the “2005Plan”). The 2005 Plan replaced the 1996 International Bancshares CorporationKey Contributor Stock Option Plan (the “1996 Plan”). Under the 2005 Plan bothqualified incentive stock options (“ISOs”) and nonqualified stock options(“NQSOs”) may be granted. Options granted may be exercisable for a period of upto 10 years from the date of grant, excluding ISOs granted to 10% shareholders,which may be exercisable for a period of up to only five years. As ofDecember 31, 2006, 130,200 shares were available for future grants underthe 2005 Plan.

Through December 31, 2006 the Company has grantednonqualified stock options exercisable for a total of 140,382 shares, adjustedfor stock dividends, of Common Stock to certain employees of the GulfStar Group.The grants were not made under either the 1996 Plan or the 2005 Plan. Theoptions are exercisable for a period of seven years and vest in equalincrements over a period of five years. All options granted to the GulfStarGroup employees had an option price of not less than the fair market value ofthe Common Stock on the date of grant.

63

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**(16)Stock Options (Continued)**

On January 1, 2006, the Company adopted theprovisions of Statement of Financial Accounting Standards No. 123R (“SFAS No. 123R”),“Share-Based Payment, (Revised 2004).” SFAS No. 123R sets accountingrequirements for “share-based” compensation to employees and non-employeedirectors, including employee stock purchase plans, and requires companies torecognize in the statement of operations the grant-date fair value of stockoptions and other equity-based compensation.

The Company chose the modified-prospective transitionalternative in adopting SFAS No. 123R. Under the modified-prospectivetransition method, compensation cost is recognized in financial statementsissued subsequent to the date of adoption for all stock-based payments granted,modified or settled after the date of adoption, as well as for any unvestedawards that were granted prior to the date of adoption.

Thefair value of each option award is estimated on the date of grant using aBlack-Sholes-Merton option valuation model that uses the assumptions noted inthe following table. Expected volatility is based on the historical volatilityof the price of the Company’s stock. The company uses historical data toestimate the expected dividend yield and employee termination rates within thevaluation model. The expected term of options is derived from the “simplified”method as prescribed by SEC Staff Accounting Bulletin No. 107. Therisk-free rate for periods within the contractual life of the option is basedon the U.S. Treasury yield curve in effect at the time of grant.

| ** **            | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------------|------------|----------|------------|----------|------------|
| Expected Life (Years) |       | 6.13     |       | 5.99     |       |
| Dividend yield        |       | 2.25     | %          | 2.50     | %          |
| Interest rate         |       | 4.94     | %          | 4.36     | %          |
| Volatility            |       | 21.05    | %          | 24.00    | %          |

 

A summary of optionactivity under the stock option plans for the twelve months ended December 31,2006 is as follows:

| ** **                                                       | ** ** | **Number of   options** | ** ** | **Weighted  average  exercise  price** | ** ** | **Weighted  average  remaining  contractual  term (years)** | ** ** | **Aggregate  intrinsic  value ($)** | ** ** |
|------------------------------------------------------------------|------------|-----------------------------------|------------|----------------------------------------|------------|------------------------------------------------------------------|------------|------------------------------------------|------------|
| Options outstanding at  December 31, 2005                   |       | 1,626,155                         |       |                                   | $          | 16.55                                                            |       |                                     |       |   |   |   |   |   |
| Plus: Options  granted                                           |       | 23,750                            |       |                                   | 29.70      |                                                             |       |                                     |       |   |   |   |   |
| Less:                                                            |       |                              |       |                                   |       |                                                             |       |                                     |       |   |   |   |   |
| Options exercised                                                |       | 164,925                           |       |                                   | 11.63      |                                                             |       |                                     |       |   |   |   |   |
| Options expired                                                  |       | —                            |       |                                   | —     |                                                             |       |                                     |       |   |   |   |   |
| Options forfeited                                                |       | 106,830                           |       |                                   | 18.41      |                                                             |       |                                     |       |   |   |   |   |
| Options  outstanding at December 31, 2006                   |       | 1,378,150                         |       |                                   | $          | 17.22                                                            |       |                                     |       | 3.02 |   |   | $ | 18,917,000 |   |
| Options fully vested and  exercisable at  December 31, 2006 |       | 1,029,299                         |       |                                   | $          | 13.45                                                            |       |                                     |       | 1.84 |   |   | $ | 18,017,000 |   |
|                                                                  |            |                                   |            |                                        |            |                                                                  |            |                                          |            |  |  |  |  |  |  |  |  |  |

 

Stock-based compensation expense included in theconsolidated statements of income for the twelve months ended December 31,2006 was approximately $874,000. As of December 31, 2006 there 

64

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**(16)Stock Options (Continued)**

was approximately $1,799,000of total unrecognized stock-based compensation cost related to non-vestedoptions granted under the Company plans that will be recognized over a weightedaverage period of 1.8 years.

Asummary of the status of the Company’s non-vested options as of December 31,2006, and changes during the twelve months ended December 31, 2006, ispresented below:

| **Non-vested Options**                   | ** ** | ** ** | ** ** | **Options** | ** ** | **Weighted average grant-  date fair value ($)** | ** ** |
|-----------------------------------------------|------------|------------|------------|-------------|------------|---------------------------------------------------------------------------|------------|
| Non-vested  options at December 31, 2005 |       | 549,131    |       |        | $          | 7.52                                                                      |       |   |
| Granted                                       |       | 23,750     |       |        | 7.08       |                                                                      |       |
| Vested                                        |       | 117,200    |       |        | 11.11      |                                                                      |       |
| Forfeited                                     |       | 106,830    |       |        | 8.54       |                                                                      |       |
| Non-vested options at  December 31, 2006 |       | 348,851    |       |        | $          | 7.37                                                                      |       |   |

 

Otherinformation pertaining to option activity during the twelve month period endingDecember 31, 2006 and December 31, 2005 is as follows:

| ** **                                                        | ** ** | **Twelve Months Ended** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                        | ** ** | **December 31,**             | ** ** |
| ** **                                                        | ** ** | **2006**                          | ** ** | **2005** | ** ** |
| Weighted average  grant date fair value of stock  options granted |       | $                                 | 7.08       |   | $ | 7.37 |   |
| Total fair value  of stock options vested                         |       | $                                 | 1,302,000  |   | $ | 1,515,186 |   |
| Total intrinsic value of  stock options exercised                 |       | $                                 | 2,907,000  |   | $ | 8,053,000 |   |

 

Awards granted prior to the Company’s adoption of SFASNo. 123R were accounted for under the recognition and measurementprinciples of APB Opinion 25, “Accounting for Stock Issued to Employees,” andrelated interpretations. Accordingly, no stock-based employee compensation costis reflected in net income in the accompanying unaudited consolidatedstatements of income for the twelve months ended December 31, 2005 and2004 because all options granted under the Company’s plans had exercise pricesequal to the market value of the underlying common stock on the date of grant.

65

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**(16)Stock Options (Continued)**

Pro forma net income andnet income per share, as if the Company had applied the fair value recognitionprovisions of SFAS 123 to stock-based compensation for the period presentedprior to the Company’s adoption of SFAS 123R is as follows:

| ** **                                                                                                                                   | ** ** | **Twelve Months Ended**                                           | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                                                                                                                                   | ** ** | **December 31,**                                                       | ** ** |
| ** **                                                                                                                                   | ** ** | **2005**                                                                    | ** ** | **2004** | ** ** |
| ** **                                                                                                                                   | ** ** | **(Dollars in Thousands,  except per share data)** | ** ** |
| Net income, as  reported                                                                                                                     |       | $                                                                           | 140,779    |   | $ | 119,032 |   |
| Deduct: Total  stock-based compensation expense determined under the fair value based method  for all awards, net of tax related tax effects |       | (345                                                                        | )          | (334 | ) |
| Pro forma net  income                                                                                                                        |       | $                                                                           | 140,434    |   | $ | 118,698 |   |
| Earnings per  share:                                                                                                                         |       |                                                                        |       |   |   |
| Basic earnings                                                                                                                               |       |                                                                        |       |   |   |
| As reported                                                                                                                                  |       | $                                                                           | 2.21       |   | $ | 1.92 |   |
| Pro forma                                                                                                                                    |       | 2.20                                                                        |       | 1.91 |   |
| Diluted earnings                                                                                                                             |       |                                                                        |       |   |   |
| As reported                                                                                                                                  |       | $                                                                           | 2.18       |   | $ | 1.88 |   |
| Pro forma                                                                                                                                    |       | 2.18                                                                        |       | 1.87 |   |
|                                                                                                                                              |            |                                                                             |            |  |  |  |  |  |  |  |  |  |  |

 

**(17)Commitments, Contingent Liabilities and Other Tax Matters**

The Company is involved in various legal proceedings thatare in various stages of litigation. Some of these actions allege “lenderliability” claims on a variety of theories and claim substantial actual andpunitive damages. The Company has determined, based on discussions with itscounsel that any material loss in such actions, individually or in theaggregate, is remote or the damages sought, even if fully recovered, would notbe considered material to the consolidated financial position or results ofoperations of the Company. However, many of these matters are in various stagesof proceedings and further developments could cause management to revise itsassessment of these matters.

The Company leases portions of its banking premises andequipment under operating leases. Total rental expense for the years endedDecember 31, 2006, 2005 and 2004 and non-cancellable lease commitments atDecember 31, 2006 were not significant.

Cash of approximately $57,272,000 and $50,625,000 at December 31,2006 and 2005, respectively, was maintained to satisfy regulatory reserverequirements.

The Company’s lead banksubsidiary has invested in partnerships, which have entered into severallease-financing transactions. The lease-financing transactions in two of thepartnerships have been examined by the Internal Revenue Service (“IRS”). Inboth partnerships, the lead bank subsidiary was the owner of a ninety-ninepercent (99%) limited partnership interest. The IRS has issued separate Noticeof Final Partnership Administrative Adjustments (“FPAA”) to the partnershipsand on September 25, 2001, and January 10, 2003, the Company filedlawsuits contesting the adjustments asserted in the FPAAs.

Prior to filing thelawsuits the Company was required to deposit the estimated tax due ofapproximately $4,083,000 with respect to the first FPAA and $7,710,606 withrespect to the second 

66

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**(17) Commitments, ContingentLiabilities and Other Tax Matters (Continued)**

FPAAwith the IRS pursuant to the Internal Revenue Code. If it is determined thatthe amount of tax due, if any, related to the lease-financing transactions isless than the amount of the deposits, the remaining amount of the depositswould be returned to the Company.

In order to curtail theaccrual of additional interest related to the disputed tax benefits and becauseinterest rates were unfavorable, on March 7, 2003, the Company submittedto the IRS a total of approximately $13.7 million, which constitutes theinterest that would have accrued based on the adjustments proposed in the FPAAsrelated to both of the lease-financing transactions. If it is determined thatthe amount of interest due, if any, related to the lease-financing transactionsis less than the approximate $13.7 million, the remaining amount of the prepaidinterest would be refunded to the Company, plus interest thereon.

Beginning August 29,2005, IBC proceeded to litigate one of the partnership tax cases in the FederalDistrict Court in San Antonio, Texas. The case was tried over nine daysbeginning August 29, 2005. On March 31, 2006, the trial courtrendered a judgment against the Company on the first FPAA. IBC timely filed itsnotice of appeal to the Fifth Circuit Court of Appeals. All appellate briefshave been filed and the parties are awaiting a decision on oral argument. Theother partnership tax case has been stayed by the same Court during thependency of the appeal.

The Company, through December 31, 2005, hadpreviously expensed approximately $12,000,000 in connection with the lawsuits. Becauseof the above-referenced trial court judgment against the Company on the firstFPAA, the uncertainty of the outcome at the appellate level, and the similaritybetween the two FPAAs, the Company, as of December 31, 2006 has expensed anadditional $13,700,000, approximately. The resultant approximately $25,700,000expensed is the total of the tax adjustments due and the interest due on suchadjustments for both FPAAs. Management intends to appeal the judgment in thefirst case and will continue to evaluate the merits of each lawsuit and makeany appropriate revisions to the amounts, as deemed necessary.

As part of the LFINacquisition, two tax matters were transferred to the Company. The first relatesto deductions taken on amended returns filed by LFIN during 2003 for the taxyears ended June 30, 1999 through December 31, 2001. The refundsrequested on the amended returns amounted to approximately $7,000,000. At December 31,2003, LFIN had received approximately $2,000,000 of the total refund requested.Because all the refunds are under review by the IRS, LFIN had established areserve equal to the $2,000,000 received and did not recognize any benefit forthe remaining $5,000,000. The second tax contingency reserve, of $7,000,000 wasresolved with the IRS in September 2006 and as a result, the second taxcontingency reserve is no longer required. The reserve was applied to thegoodwill acquired as part of the LFIN acquisition. The Company will continue tomonitor the IRS review of the remaining tax matter and any adjustments will bereflected in goodwill.

**(18)Transactions with Related Parties**

In the ordinary course of business, the subsidiariesof the Company make loans to directors and executive officers of theCorporation, including their affiliates, families and companies in which theyare principal owners. In the opinion of management, these loans are made onsubstantially the same terms, including interest rates and collateral, as thoseprevailing at the time for comparable transactions with other persons and donot involve more than normal risk of collectibility or present other 

67

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**(18)Transactions with Related Parties (Continued)**

unfavorable features. Theaggregate amounts receivable from such related parties amounted toapproximately $48,731,000 and $42,605,000 at December 31, 2006 and 2005,respectively.

**(19)Financial Instruments with Off-Statement of Condition Risk and Concentrationsof Credit Risk**

Inthe normal course of business, the bank subsidiaries are party to financialinstruments with off-statement of condition risk to meet the financing needs oftheir customers. These financial instruments include commitments to theircustomers. These financial instruments involve, to varying degrees, elements ofcredit risk in excess of the amounts recognized in the consolidated statementof condition. The contract amounts of these instruments reflect the extent ofinvolvement the bank subsidiaries have in particular classes of financialinstruments. At December 31, 2006, the following financial amounts ofinstruments, whose contract amounts represent credit risks, were outstanding:

| Commitments to extend credit  |   | $           | 1,860,382,000 |   |
|-------------------------------|--------|-------------|---------------|--------|
| Credit card lines             |   | 36,404,000  |          |
| Standby letters of credit     |   | 124,113,000 |          |
| Commercial  letters of credit |   | 22,314,000  |          |

 

TheCompany enters into a standby letter of credit to guarantee performance of acustomer to a third party. These guarantees are primarily issued to support publicand private borrowing arrangements. The credit risk involved is represented bythe contractual amounts of those instruments. Under the standby letters ofcredit, the Company is required to make payments to the beneficiary of theletters of credit upon request by the beneficiary so long as all performancecriteria have been met. At December 31, 2006, the maximum potential amountof future payments is $124,113,000. At December 31, 2006, the fair valueof these guarantees is not significant.

TheCompany enters into commercial letters of credit on behalf of its customerswhich authorize a third party to draw drafts on the Company up to a stipulatedamount and with specific terms and conditions. A commercial letter of credit isa conditional commitment on the part of the Company to provide payment ondrafts drawn in accordance with the terms of the commercial letter of credit.

Thebank subsidiaries’ exposure to credit loss in the event of nonperformance bythe other party to the above financial instruments is represented by thecontractual amounts of the instruments. The bank subsidiaries use the samecredit policies in making commitments and conditional obligations as they dofor on-statement of condition instruments. The bank subsidiaries control thecredit risk of these transactions through credit approvals, limits andmonitoring procedures. Commitments to extend credit are agreements to lend to acustomer as long as there is no violation of any condition established in thecontract. Commitments generally have fixed expiration dates normally less thanone year or other termination clauses and may require the payment of a fee.Since many of the commitments are expected to expire without being drawn upon,the total commitment amounts do not necessarily represent future cashrequirements. The bank subsidiaries evaluate each customer’s credit-worthinesson a case-by-case basis. The amount of collateral obtained, if deemed necessaryby the subsidiary banks upon extension of credit, is based on management’scredit evaluation of the customer. Collateral held varies, but may includeresidential and commercial real estate, bank certificates of deposit, accountsreceivable and inventory.

68

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**(19)Financial Instruments with Off-Statement of Condition Risk and Concentrationsof Credit Risk (Continued)**

Thebank subsidiaries make commercial, real estate and consumer loans to customersprincipally located in South, Central and Southeast Texas and the State ofOklahoma. Although the loan portfolio is diversified, a substantial portion ofits debtors’ ability to honor their contracts is dependent upon the economicconditions in these areas, especially in the real estate and commercialbusiness sectors.

**(20)Dividend Restrictions and Capital Requirements**

Bank regulatory agencies limit the amount ofdividends, which the bank subsidiaries can pay the Corporation, through IBCSubsidiary Corporation, without obtaining prior approval from such agencies. AtDecember 31, 2006, the subsidiary banks could pay dividends of up to $140,250,000to the Company without prior regulatory approval and without adverselyaffecting their “well capitalized” status. In addition to legal requirements,regulatory authorities also consider the adequacy of the bank subsidiaries’total capital in relation to their deposits and other factors. These capitaladequacy considerations also limit amounts available for payment of dividends.The Company historically has not allowed any subsidiary bank to pay dividendsin such a manner as to impair its capital adequacy.

The Company and the banksubsidiaries are subject to various regulatory capital requirementsadministered by the federal banking agencies. Failure to meet minimum capitalrequirements can initiate certain mandatory and possibly additionaldiscretionary actions by regulators that, if undertaken, could have a directmaterial effect on the Company’s consolidated financial statements. Undercapital adequacy guidelines and the regulatory framework for prompt correctiveaction, the Company must meet specific capital guidelines that involvequantitative measures of the Company’s assets, liabilities, and certainoff-statement of condition items as calculated under regulatory accountingpractices. The Company’s capital amounts and classification are also subject toqualitative judgments by the regulators about components, risk weightings, andother factors.

Quantitative measuresestablished by regulation to ensure capital adequacy require the Company tomaintain minimum amounts and ratios (set forth in the table on the followingpage) of Total and Tier 1 capital to risk-weighted assets and of Tier 1 capitalto average assets. Management believes, as of December 31, 2006, that theCompany and each of the bank subsidiaries met all capital adequacy requirementsto which it is subject.

As of December 31, 2006,the most recent notification from the Federal Deposit Insurance Corporationcategorized all the bank subsidiaries as well capitalized under the regulatoryframework for prompt corrective action. To be categorized as “well capitalized”the Company and the bank subsidiaries must maintain minimum Total risk-based,Tier 1 risk based, and Tier 1 leverage ratios as set forth in the table. Thereare no conditions or events since that notification that management believeshave changed the categorization of the Company or any of the bank subsidiariesas well capitalized.

69

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**(20)Dividend Restrictions and Capital Requirements (Continued)**

The Company’s and the banksubsidiaries’ actual capital amounts and ratios for 2006 are presented in thefollowing table:

| ** **                                   | ** ** | **Actual**                           | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Well  Capitalized Under  Prompt Corrective  Action Provisions** | ** ** |
|----------------------------------------------|------------|--------------------------------------|------------|----------------------------------------------|------------|--------------------------------------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **Amount**                           | ** ** | **Ratio**                                    | ** ** | **Amount**                                                                                       | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| ** **                                   | ** ** | ** **                           | ** ** | ** **                                   | ** ** | **(greater  than or  equal to)**                                                       | ** ** | **(greater  than or  equal to)** | ** ** | **(greater  than or  equal to)** | ** ** | **(greater  than or  equal to)** | ** ** |
| ** **                                   | ** ** | **(Dollars in Thousands)** | ** ** |
| As  of December 31, 2006:               |       |                                 |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |   |   |   |   |
| Total  Capital (to Risk Weighted Assets):    |       |                                 |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |   |   |   |   |
| Consolidated                                 |       | $                                    | 845,827    |                                         | 13.61      | %                                                                                                | $          | 497,044 |   |   | 8.00 | % |   | $ | 621,305 |   |   | 10.00 | % |   |
| International  Bank of Commerce, Laredo      |       | 639,892                              |       | 11.74                                        |       | 435,992                                                                                          |       |   | 8.00 |   |   | 544,990 |   |   | 10.00 |   |   |
| International  Bank of Commerce, Brownsville |       | 80,168                               |       | 20.64                                        |       | 31,080                                                                                           |       |   | 8.00 |   |   | 38,850 |   |   | 10.00 |   |   |
| International  Bank of Commerce, Zapata      |       | 37,345                               |       | 27.24                                        |       | 10,968                                                                                           |       |   | 8.00 |   |   | 13,711 |   |   | 10.00 |   |   |
| Commerce  Bank                               |       | 46,198                               |       | 22.54                                        |       | 16,398                                                                                           |       |   | 8.00 |   |   | 20,498 |   |   | 10.00 |   |   |
| Tier  1 Capital (to Risk Weighted Assets):   |       |                                 |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |   |   |   |   |
| Consolidated                                 |       | $                                    | 775,705    |                                         | 12.49      | %                                                                                                | $          | 248,522 |   |   | 4.00 | % |   | $ | 372,783 |   |   | 6.00 | % |   |
| International  Bank of Commerce, Laredo      |       | 578,414                              |       | 10.61                                        |       | 217,996                                                                                          |       |   | 4.00 |   |   | 326,994 |   |   | 6.00 |   |   |
| International  Bank of Commerce, Brownsville |       | 75,934                               |       | 19.55                                        |       | 15,540                                                                                           |       |   | 4.00 |   |   | 23,310 |   |   | 6.00 |   |   |
| International  Bank of Commerce, Zapata      |       | 35,847                               |       | 26.15                                        |       | 5,484                                                                                            |       |   | 4.00 |   |   | 8,226 |   |   | 6.00 |   |   |
| Commerce  Bank                               |       | 43,631                               |       | 21.29                                        |       | 8,199                                                                                            |       |   | 4.00 |   |   | 12,299 |   |   | 6.00 |   |   |
| Tier  1 Capital (to Average Assets):         |       |                                 |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |   |   |   |   |
| Consolidated                                 |       | $                                    | 775,705    |                                         | 7.36       | %                                                                                                | $          | 421,784 |   |   | 4.00 | % |   | $ | 527,230 |   |   | 5.00 | % |   |
| International  Bank of Commerce, Laredo      |       | 578,414                              |       | 6.56                                         |       | 352,484                                                                                          |       |   | 4.00 |   |   | 440,605 |   |   | 5.00 |   |   |
| International  Bank of Commerce, Brownsville |       | 75,934                               |       | 9.22                                         |       | 32,928                                                                                           |       |   | 4.00 |   |   | 41,160 |   |   | 5.00 |   |   |
| International  Bank of Commerce, Zapata      |       | 35,847                               |       | 9.50                                         |       | 15,086                                                                                           |       |   | 4.00 |   |   | 18,857 |   |   | 5.00 |   |   |
| Commerce Bank                                |       | 43,631                               |       | 8.40                                         |       | 20,778                                                                                           |       |   | 4.00 |   |   | 25,975 |   |   | 5.00 |   |   |

 

70

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**(20)Dividend Restrictions and Capital Requirements (Continued)**

The Company’s and the banksubsidiaries’ actual capital amounts and ratios for 2005 are also presented inthe following table:

| ** **                                   | ** ** | **Actual**                           | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Well  Capitalized Under  Prompt Corrective  Action Provisions** | ** ** |
|----------------------------------------------|------------|--------------------------------------|------------|----------------------------------------------|------------|--------------------------------------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **Amount**                           | ** ** | **Ratio**                                    | ** ** | **Amount**                                                                                       | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| ** **                                   | ** ** | ** **                           | ** ** | ** **                                   | ** ** | **(greater  than or  equal to)**                                                       | ** ** | **(greater  than or  equal to)** | ** ** | **(greater  than or  equal to)** | ** ** | **(greater  than or  equal to)** | ** ** |
| ** **                                   | ** ** | **(Dollars in Thousands)** | ** ** |
| As  of December 31, 2005:               |       |                                 |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |   |   |   |   |
| Total  Capital (to Risk Weighted Assets):    |       |                                 |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |   |   |   |   |
| Consolidated                                 |       | $                                    | 814,021    |                                         | 14.22      | %                                                                                                | $          | 457,889 |   |   | 8.00 | % |   | $ | 572,361 |   |   | 10.00 | % |   |
| International  Bank of Commerce, Laredo      |       | 628,370                              |       | 12.49                                        |       | 402,614                                                                                          |       |   | 8.00 |   |   | 503,267 |   |   | 10.00 |   |   |
| International  Bank of Commerce, Brownsville |       | 71,038                               |       | 20.82                                        |       | 27,294                                                                                           |       |   | 8.00 |   |   | 34,118 |   |   | 10.00 |   |   |
| International  Bank of Commerce, Zapata      |       | 33,584                               |       | 26.48                                        |       | 10,146                                                                                           |       |   | 8.00 |   |   | 12,683 |   |   | 10.00 |   |   |
| Commerce  Bank                               |       | 40,445                               |       | 20.85                                        |       | 15,515                                                                                           |       |   | 8.00 |   |   | 19,394 |   |   | 10.00 |   |   |
| Tier  1 Capital (to Risk Weighted Assets):   |       |                                 |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |   |   |   |   |
| Consolidated                                 |       | $                                    | 742,345    |                                         | 12.97      | %                                                                                                | $          | 228,944 |   |   | 4.00 | % |   | $ | 343,417 |   |   | 6.00 | % |   |
| International  Bank of Commerce, Laredo      |       | 565,312                              |       | 11.23                                        |       | 201,307                                                                                          |       |   | 4.00 |   |   | 301,960 |   |   | 6.00 |   |   |
| International  Bank of Commerce, Brownsville |       | 67,058                               |       | 19.65                                        |       | 13,647                                                                                           |       |   | 4.00 |   |   | 20,471 |   |   | 6.00 |   |   |
| International  Bank of Commerce, Zapata      |       | 32,367                               |       | 25.52                                        |       | 5,073                                                                                            |       |   | 4.00 |   |   | 7,610 |   |   | 6.00 |   |   |
| Commerce  Bank                               |       | 38,020                               |       | 19.60                                        |       | 7,757                                                                                            |       |   | 4.00 |   |   | 11,636 |   |   | 6.00 |   |   |
| Tier  1 Capital (to Average Assets):         |       |                                 |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |   |   |   |   |
| Consolidated                                 |       | $                                    | 742,345    |                                         | 7.26       | %                                                                                                | $          | 408,952 |   |   | 4.00 | % |   | $ | 511,190 |   |   | 5.00 | % |   |
| International  Bank of Commerce, Laredo      |       | 565,312                              |       | 6.55                                         |       | 345,319                                                                                          |       |   | 4.00 |   |   | 431,648 |   |   | 5.00 |   |   |
| International  Bank of Commerce, Brownsville |       | 67,058                               |       | 9.06                                         |       | 29,622                                                                                           |       |   | 4.00 |   |   | 37,028 |   |   | 5.00 |   |   |
| International  Bank of Commerce, Zapata      |       | 32,367                               |       | 9.21                                         |       | 14,053                                                                                           |       |   | 4.00 |   |   | 17,566 |   |   | 5.00 |   |   |
| Commerce Bank                                |       | 38,020                               |       | 8.13                                         |       | 18,698                                                                                           |       |   | 4.00 |   |   | 23,373 |   |   | 5.00 |   |   |

 

**(21)Fair Value of Financial Instruments**

The fair value estimates,methods, and assumptions for the Company’s financial instruments at December 31,2006 and 2005 are outlined below.

*Cash and Due FromBanks and Federal Funds Sold*

For these short-terminstruments, the carrying amount is a reasonable estimate of fair value.

71

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**(21) Fair Value of FinancialInstruments (Continued)**

*Investment Securities*

For investment securities,which include U. S. Treasury securities, obligations of other U. S. governmentagencies, obligations of states and political subdivisions and mortgage passthrough and related securities, fair values are based on quoted market pricesor dealer quotes. Fair values are based on the value of one unit without regardto any premium or discount that may result from concentrations of ownership ofa financial instrument, possible tax ramifications, or estimated transactioncosts. See disclosures of fair value of investment securities in Note 3.

*Loans*

Fair values are estimated for portfolios of loans withsimilar financial characteristics. Loans are segregated by type such ascommercial, real estate and consumer loans as outlined by regulatory reportingguidelines. Each category is segmented into fixed and variable interest rateterms and by performing and non-performing categories.

For variable rate performing loans, the carryingamount approximates the fair value. For fixed rate performing loans, exceptresidential mortgage loans, the fair value is calculated by discountingscheduled cash flows through the estimated maturity using estimated marketdiscount rates that reflect the credit and interest rate risk inherent in theloan. For performing residential mortgage loans, fair value is estimated bydiscounting contractual cash flows adjusted for prepayment estimates usingdiscount rates based on secondary market sources or the primary originationmarket. At December 31, 2006 and 2005, the carrying amount of fixed rateperforming loans was $1,259,870,000 and $1,398,838,000 respectively, and theestimated fair value was $1,237,409,000 and $1,382,409,000, respectively.

Fair value for significantimpaired loans is based on recent external appraisals. If appraisals are notavailable, estimated cash flows are discounted using a rate commensurate withthe risk associated with the estimated cash flows. Assumptions regarding creditrisk, cash flows and discount rates are judgmentally determined using availablemarket and specific borrower information. As of December 31, 2006 and2005, the net carrying amount of impaired loans was a reasonable estimate ofthe fair value.

*Deposits*

The fair value of deposits with no stated maturity,such as non-interest bearing demand deposit accounts, savings accounts andinterest bearing demand deposit accounts, was equal to the amount payable ondemand as of December 31, 2006 and 2005. The fair value of time depositsis based on the discounted value of contractual cash flows. The discount rateis based on currently offered rates. At December 31, 2006 and 2005, thecarrying amount of time deposits was $3,331,991,000 and $3,160,812,000,respectively, and the estimated fair value was $3,337,399,000 and$3,175,624,000, respectively.

72

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES**Notes to Consolidated Financial Statements (Continued)

**(21)Fair Value of Financial Instruments (Continued)**

*Securities Sold Under Repurchase Agreements and Other Borrowed Funds*

Dueto the contractual terms of these financial instruments, the carrying amountsapproximated fair value at December 31, 2006 and 2005.

*Junior Subordinated DeferrableInterest Debentures*

Dueto the contractual terms of these financial instruments, the carrying amountsapproximated fair value at December 31, 2006.

*Commitments to Extend Credit and Letters of Credit*

Commitments to extend creditand fund letters of credit are principally at current interest rates andtherefore the carrying amount approximates fair value.

*Limitations*

Fair value estimates are made at a point in time,based on relevant market information and information about the financialinstrument. These estimates do not reflect any premium or discount that couldresult from offering for sale at one time the Company’s entire holdings of aparticular financial instrument. Because no market exists for a significantportion of the Company’s financial instruments, fair value estimates are basedon judgments regarding future expected loss experience, current economicconditions, risk characteristics of various financial instruments and otherfactors. These estimates are subjective in nature and involve uncertainties andmatters of significant judgment and therefore cannot be determined withprecision. Changes in assumptions could significantly affect the estimates.

Fairvalue estimates are based on existing on-and off-statement of conditionfinancial instruments without attempting to estimate the value of anticipatedfuture business and the value of assets and liabilities that are not consideredfinancial instruments. Other significant assets and liabilities that are notconsidered financial assets or liabilities include the bank premises andequipment and core deposit value. In addition, the tax ramifications related tothe effect of fair value estimates have not been considered in the aboveestimates.

73

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES**Notes to Consolidated Financial Statements (Continued)

**(22)International Bancshares Corporation (Parent Company Only) FinancialInformation**

**Statements of Condition(Parent Company Only)**

**December 31,2006 and 2005(Dollars in Thousands)**

| ** **                                          | ** ** | **2006**  | ** ** | **2005**  | ** ** |
|-----------------------------------------------------|------------|-----------|------------|-----------|------------|
| **ASSETS**                                          |       |      |       |      |       |
| Cash                                                |       | $         | 655        |      | $          | 1,562 |   |
| Repurchase Agreements                               |       | 6,303     |       | 2,600     |       |
| Other investments                                   |       | 25,464    |       | 21,937    |       |
| Notes receivable                                    |       | 1,636     |       | 2,536     |       |
| Investment in subsidiaries                          |       | 1,022,959 |       | 1,003,878 |       |
| Other assets                                        |       | 1,938     |       | 1,277     |       |
| Total assets                                        |       | $         | 1,058,955  |      | $          | 1,033,790 |   |
| ** **                                          |       |      |       |      |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**       |       |      |       |      |       |
| Liabilities:                                        |       |      |       |      |       |
| Junior subordinated deferrable  interest debentures |       | $         | 210,908    |      | $          | 236,391 |   |
| Due to IBC Trading                                  |       | 21        |       | 21        |       |
| Other liabilities                                   |       | 5,970     |       | 4,511     |       |
| Total liabilities                                   |       | 216,899   |       | 240,923   |       |
| Shareholders’  equity:                         |       |      |       |      |       |
| Common shares                                       |       | 86,224    |       | 86,059    |       |
| Surplus                                             |       | 138,247   |       | 135,619   |       |
| Retained earnings                                   |       | 861,251   |       | 788,416   |       |
| Accumulated other  comprehensive loss               |       | (40,390   | )          | (41,968   | )          |
|                                                |       | 1,045,332 |       | 968,126   |       |
| Less cost of shares in treasury                     |       | (203,276  | )          | (175,259  | )          |
| Total shareholders’ equity                     |       | 842,056   |       | 792,867   |       |
| Total liabilities and shareholders’ equity     |       | $         | 1,058,955  |      | $          | 1,033,790 |   |

 

74

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES**Notes to Consolidated Financial Statements (Continued)

**(23)International Bancshares Corporation (Parent Company Only) FinancialInformation**

**Statements of Income(Parent Company Only)**

**Yearsended December 31, 2006, 2005 and 2004(Dollars in Thousands)**

| ** **                                                                                   | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Income:                                                                                      |       |     |       |     |       |     |       |
| Dividends from subsidiaries                                                                  |       | $        | 113,839    |     | $          | 51,450   |       | $ | 62,950 |   |
| Interest income on notes  receivable                                                         |       | 126      |       | 180      |       | 682      |       |
| Interest income on other  investments                                                        |       | 2,508    |       | 1,351    |       | 1,437    |       |
| Other interest income                                                                        |       | 1,339    |       | 498      |       | 511      |       |
| Gain on sale of other  securities                                                            |       | —   |       | —   |       | 151      |       |
| Gain on sale of assets                                                                       |       | —   |       | 67       |       | 1,659    |       |
| Other                                                                                        |       | 7        |       | 4,047    |       | 5,683    |       |
| Total income                                                                                 |       | 117,819  |       | 57,593   |       | 73,073   |       |
| Expenses:                                                                                    |       |     |       |     |       |     |       |
| Interest expense (Debentures)                                                                |       | 22,568   |       | 18,587   |       | 13,152   |       |
| Interest expense (Senior  Notes)                                                             |       | —   |       | —   |       | 383      |       |
| Other                                                                                        |       | 3,220    |       | 946      |       | 1,271    |       |
| Total expenses                                                                               |       | 25,788   |       | 19,533   |       | 14,806   |       |
| Income before federal income  taxes and equity  in undistributed  net income of subsidiaries |       | 92,031   |       | 38,060   |       | 58,267   |       |
| Income tax benefit                                                                           |       | (7,918   | )          | (4,716   | )          | (1,559   | )          |
| Income before equity in  undistributed net  income of  subsidiaries                          |       | 99,949   |       | 42,776   |       | 59,826   |       |
| Equity in undistributed net income of subsidiaries                                           |       | 17,052   |       | 98,003   |       | 59,206   |       |
| Net income                                                                                   |       | $        | 117,001    |     | $          | 140,779  |       | $ | 119,032 |   |

 

75

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES**Notes to Consolidated Financial Statements (Continued)

**(24)International Bancshares Corporation (Parent Company Only) FinancialInformation**

**Statements of Cash Flows(Parent Company Only)**

**Yearsended December 31, 2006, 2005 and 2004(Dollars in Thousands)**

| ** **                                                                          | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Operating activities:                                                               |       |     |       |     |       |     |       |
| Net income                                                                          |       | $        | 117,001    |     | $          | 140,779  |       | $ | 119,032 |   |
| Adjustments to reconcile net  income to net cash provided by operating  activities: |       |     |       |     |       |     |       |
| Gain on sale of other  investments                                                  |       | —   |       | —   |       | (151     | )          |
| Gain on sale of assets                                                              |       | —   |       | (67      | )          | (1,659   | )          |
| Accretion of junior  subordinated interest deferrable debentures                    |       | 548      |       | 996      |       | 1,026    |       |
| Depreciation of bank premises  and equipment                                        |       | —   |       | 93       |       | 15       |       |
| Stock compensation expense                                                          |       | 874      |       | —   |       | —   |       |
| Increase in other liabilities                                                       |       | 1,459    |       | 1,220    |       | 904      |       |
| Equity in undistributed net  income of subsidiaries                                 |       | (17,052  | )          | (98,003  | )          | (59,206  | )          |
| Net cash provided by operating  activities                                          |       | 102,830  |       | 45,018   |       | 59,961   |       |
| Investing activities:                                                               |       |     |       |     |       |     |       |
| Contributions to subsidiaries                                                       |       | (424     | )          | (4,034   | )          | (9,581   | )          |
| (Repurchase) proceeds of  repurchase agreement with banks                           |       | (3,703   | )          | (1,800   | )          | 300      |       |
| Purchase of available for sale  other securities                                    |       | —   |       | —   |       | (5,068   | )          |
| Proceeds of sales of available  for sale securities                                 |       | —   |       | —   |       | 5,010    |       |
| Proceeds from sales of bank  premises and equipment                                 |       | —   |       | 147      |       | 2,598    |       |
| Net decrease in notes  receivable                                                   |       | 900      |       | 3,239    |       | 5,750    |       |
| (Increase) decrease in other  assets                                                |       | (4,215   | )          | 2,629    |       | (2,982   | )          |
| Net cash (used in) provided by  investing activities                                |       | (7,442   | )          | 181      |       | (3,973   | )          |
| Financing activities:                                                               |       |     |       |     |       |     |       |
| Proceeds from issuance of  subordinated debentures                                  |       | 75,259   |       | —   |       | —   |       |
| Proceeds from payments of  subordinated debentures                                  |       | (101,290 | )          | —   |       | —   |       |
| Principal payments on senior  notes                                                 |       | —   |       | —   |       | (21,295  | )          |
| Proceeds from stock  transactions                                                   |       | 1,919    |       | 5,478    |       | 5,265    |       |
| Payments of cash dividends                                                          |       | (44,166  | )          | (40,808  | )          | (39,729  | )          |
| Payments of cash dividends in  lieu of fractional shares                            |       | —   |       | (25      | )          | (38      | )          |
| Purchase of treasury stock                                                          |       | (28,017  | )          | (8,669   | )          | (974     | )          |
| Net cash used in financing  activities                                              |       | (96,295  | )          | (44,024  | )          | (56,771  | )          |
| (Decrease) increase in cash                                                         |       | (907     | )          | 1,175    |       | (783     | )          |
| Cash at beginning of year                                                           |       | 1,562    |       | 387      |       | 1,170    |       |
| Cash  at end of year                                                                |       | $        | 655        |     | $          | 1,562    |       | $ | 387 |   |

 

76

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIESCondensed Average Statements of Condition(Dollars in Thousands, Except Per ShareAmounts)(Unaudited)**

Distribution of Assets, Liabilities and Shareholders’Equity

The following table sets forth a comparative summaryof average interest earning assets and average interest bearing liabilities andrelated interest yields for the years ended December 31, 2006, 2005, and2004:

| ** **                                          | ** ** | **2006**                             | ** ** | **2005**     | ** ** | **2004**               | ** ** |
|-----------------------------------------------------|------------|--------------------------------------|------------|--------------|------------|------------------------|------------|
| ** **                                          | ** ** | **Average  Balance**                 | ** ** | **Interest** | ** ** | **Average  Rate/Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Average  Rate/Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Average  Rate/Cost** | ** ** |
| ** **                                          | ** ** | **(Dollars in Thousands)** | ** ** |
| **Assets**                                          |       |                                 |       |         |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest earning assets:                            |       |                                 |       |         |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loan, net of unearned  discounts:                   |       |                                 |       |         |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Domestic                                            |       | $                                    | 4,507,583  |         | $          | 379,340                |       |   | 8.42 | % |   | $ | 4,573,634 |   | $ | 325,447 |   |   | 7.12 | % |   | $ | 3,757,015 |   | $ | 225,002 |   |   | 5.99 | % |   |
| Foreign                                             |       | 288,906                              |       | 20,680       |       |                   | 7.16       |   |   | 257,247 |   | 14,003 |   |   | 5.44 |   |   | 225,565 |   | 11,077 |   |   | 4.91 |   |   |
| Investment securities:                              |       |                                 |       |         |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Taxable                                             |       | 4,379,218                            |       | 200,474      |       |                   | 4.58       |   |   | 4,029,077 |   | 160,175 |   |   | 3.98 |   |   | 2,996,046 |   | 109,092 |   |   | 3.64 |   |   |
| Tax-exempt                                          |       | 93,776                               |       | 4,577        |       |                   | 4.88       |   |   | 100,441 |   | 4,862 |   |   | 4.84 |   |   | 111,671 |   | 5,071 |   |   | 4.54 |   |   |
| Federal funds sold                                  |       | 75,016                               |       | 3,596        |       |                   | 4.79       |   |   | 132,192 |   | 3,668 |   |   | 2.77 |   |   | 129,731 |   | 1,577 |   |   | 1.22 |   |   |
| Other                                               |       | 5,956                                |       | 406          |       |                   | 6.82       |   |   | 8,992 |   | 550 |   |   | 6.12 |   |   | 11,612 |   | 559 |   |   | 4.81 |   |   |
| Total  interest-earning assets                      |       | 9,350,455                            |       | 609,073      |       |                   | 6.51       | % |   | 9,101,583 |   | 508,705 |   |   | 5.59 | % |   | 7,231,640 |   | 352,378 |   |   | 4.87 | % |   |
| Non-interest earning assets:                        |       |                                 |       |         |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and due from  banks                            |       | 243,374                              |       |         |       |                   |       |   |   | 205,008 |   |   |   |   |   |   |   | 162,278 |   |   |   |   |   |   |   |
| Bank premises and  equipment, net                   |       | 369,058                              |       |         |       |                   |       |   |   | 323,946 |   |   |   |   |   |   |   | 260,671 |   |   |   |   |   |   |   |
| Other assets                                        |       | 764,330                              |       |         |       |                   |       |   |   | 749,044 |   |   |   |   |   |   |   | 552,880 |   |   |   |   |   |   |   |
| Less allowance for  possible loan losses            |       | (68,673                              | )          |         |       |                   |       |   |   | (84,256 | ) |   |   |   |   |   |   | (69,324 | ) |   |   |   |   |   |   |
| Total                                               |       | $                                    | 10,658,544 |         |       |                   |       |   |   |   | $ | 10,295,325 |   |   |   |   |   |   |   | $ | 8,138,145 |   |   |   |   |   |   |   |
| **Liabilities and Shareholders’**

**Equity**  |       |                                 |       |         |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest bearing liabilities:                       |       |                                 |       |         |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings and  interest bearing demand deposits       |       | $                                    | 2,122,302  |         | $          | 40,444                 |       |   | 1.91 | % |   | $ | 2,181,303 |   | $ | 26,936 |   |   | 1.23 | % |   | $ | 1,832,714 |   | $ | 13,797 |   |   | .75 | % |   |
| Time deposits:                                      |       |                                 |       |         |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Domestic                                            |       | 1,720,742                            |       | 65,597       |       |                   | 3.81       |   |   | 1,709,275 |   | 39,104 |   |   | 2.29 |   |   | 1,590,229 |   | 22,879 |   |   | 1.44 |   |   |
| Foreign                                             |       | 1,527,958                            |       | 57,480       |       |                   | 3.77       |   |   | 1,410,465 |   | 34,130 |   |   | 2.42 |   |   | 1,178,775 |   | 21,780 |   |   | 1.85 |   |   |
| Securities sold  under repurchase agreements        |       | 670,104                              |       | 30,137       |       |                   | 4.50       |   |   | 751,247 |   | 27,384 |   |   | 3.65 |   |   | 545,572 |   | 19,865 |   |   | 3.64 |   |   |
| Other borrowings                                    |       | 2,040,691                            |       | 103,362      |       |                   | 5.07       |   |   | 1,891,001 |   | 60,689 |   |   | 3.21 |   |   | 1,083,222 |   | 16,746 |   |   | 1.55 |   |   |
| Junior  subordinated interest deferrable debentures |       | 232,260                              |       | 22,568       |       |                   | 9.72       |   |   | 235,905 |   | 18,587 |   |   | 7.88 |   |   | 206,272 |   | 13,152 |   |   | 6.38 |   |   |
| Senior notes                                        |       | —                               |       | —       |       |                   | —     |   |   | — |   | — |   |   | — |   |   | 3,340 |   | 383 |   |   | 11.47 |   |   |
| Total interest  bearing liabilities                 |       | 8,314,057                            |       | 319,588      |       |                   | 3.84       | % |   | 8,179,196 |   | 206,830 |   |   | 2.53 | % |   | 6,440,124 |   | 108,602 |   |   | 1.69 | % |   |
| Non-interest bearing liabilities:                   |       |                                 |       |         |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Demand Deposits                                     |       | 1,364,611                            |       |         |       |                   |       |   |   | 1,253,694 |   |   |   |   |   |   |   | 988,659 |   |   |   |   |   |   |   |
| Other liabilities                                   |       | 145,538                              |       |         |       |                   |       |   |   | 79,178 |   |   |   |   |   |   |   | 54,261 |   |   |   |   |   |   |   |
| Shareholders’  equity                          |       | 834,338                              |       |         |       |                   |       |   |   | 783,257 |   |   |   |   |   |   |   | 655,101 |   |   |   |   |   |   |   |
| Total                                               |       | $                                    | 10,658,544 |         |       |                   |       |   |   |   | $ | 10,295,325 |   |   |   |   |   |   |   | $ | 8,138,145 |   |   |   |   |   |   |   |
| Net interest  income                                |       |                                 |       | $            | 289,485    |                   |       |   |   |   |   |   | $ | 301,875 |   |   |   |   |   |   |   | $ | 243,776 |   |   |   |   |   |
| Net yield on  interest earning assets               |       |                                 |       |         |       |                   | 3.10       | % |   |   |   |   |   |   | 3.32 | % |   |   |   |   |   |   | 3.37 | % |   |

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(Note1) The average balances for purposes of the above table are calculated on thebasis of month-end balances for 2005 and 2004.

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIESCondensed Quarterly Income Statements**(Dollarsin Thousands, Except Per Share Amounts)(Unaudited)

| ** **                                     | ** ** | **Fourth  Quarter(1)** | ** ** | **Third  Quarter** | ** ** | **Second  Quarter** | ** ** | **First  Quarter** | ** ** |
|------------------------------------------------|------------|------------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|
| **2006**                                       |       |                   |       |               |       |                |       |               |       |
| Interest income                                |       | $                      | 160,829    |               | $          | 156,552             |       | $                  | 149,374    |   | $ | 142,318 |   |
| Interest expense                               |       | 87,658                 |       | 86,600             |       | 77,325              |       | 68,005             |       |
| Net interest income                            |       | 73,171                 |       | 69,952             |       | 72,049              |       | 74,313             |       |
| (Recovery) provision for possible loan losses  |       | 1,216                  |       | 1,954              |       | 82                  |       | 597                |       |
| Non-interest income                            |       | 49,272                 |       | 40,058             |       | 47,022              |       | 40,619             |       |
| Non-interest expense                           |       | 73,070                 |       | 69,028             |       | 67,721              |       | 78,858             |       |
| Income before income taxes                     |       | 48,157                 |       | 39,028             |       | 51,268              |       | 35,477             |       |
| Minority interest in consolidated subsidiaries |       | 40                     |       | —             |       | —              |       | —             |       |
| Income taxes                                   |       | 16,342                 |       | 12,435             |       | 16,610              |       | 11,502             |       |
| Net income                                     |       | $                      | 31,775     |               | $          | 26,593              |       | $                  | 34,658     |   | $ | 23,975 |   |
| Per  common share:                             |       |                   |       |               |       |                |       |               |       |
| Basic                                          |       |                   |       |               |       |                |       |               |       |
| Net income                                     |       | $                      | .50        |               | $          | .42                 |       | $                  | .55        |   | $ | .38 |   |
| Diluted                                        |       |                   |       |               |       |                |       |               |       |
| Net income                                     |       | $                      | .50        |               | $          | .42                 |       | $                  | .54        |   | $ | .37 |   |

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(1)   Includesincome related to corrections of the Company’s accounting for mortgageservicing rights. The after tax effect of the item was $1.43 million,which is immaterial for the year to net earnings, cash flow and shareholders’equity.

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**INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIESCondensed Quarterly Income Statements**(Dollarsin Thousands, Except Per Share Amounts)(Unaudited)

| ** **                         | ** ** | **Fourth  Quarter** | ** ** | **Third  Quarter** | ** ** | **Second  Quarter** | ** ** | **First  Quarter** | ** ** |
|------------------------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|
| **2005**                           |       |                |       |               |       |                |       |               |       |
| Interest income                    |       | $                   | 134,258    |               | $          | 129,968             |       | $                  | 126,160    |   | $ | 118,319 |   |
| Interest expense                   |       | 62,678              |       | 54,745             |       | 48,201              |       | 41,206             |       |
| Net interest income                |       | 71,580              |       | 75,223             |       | 77,959              |       | 77,113             |       |
| Provision for possible loan losses |       | (1,675              | )          | (196               | )          | 221                 |       | 2,610              |       |
| Non-interest income                |       | 46,609              |       | 40,883             |       | 37,307              |       | 42,423             |       |
| Non-interest expense               |       | 66,355              |       | 64,620             |       | 64,989              |       | 60,024             |       |
| Income before income taxes         |       | 53,509              |       | 51,682             |       | 50,056              |       | 56,902             |       |
| Income taxes                       |       | 19,230              |       | 16,214             |       | 16,684              |       | 19,242             |       |
| Net income                         |       | $                   | 34,279     |               | $          | 35,468              |       | $                  | 33,372     |   | $ | 37,660 |   |
| Per  common share:                 |       |                |       |               |       |                |       |               |       |
| Basic                              |       |                |       |               |       |                |       |               |       |
| Net income                         |       | $                   | .54        |               | $          | .56                 |       | $                  | .52        |   | $ | .59 |   |
| Diluted                            |       |                |       |               |       |                |       |               |       |
| Net income                         |       | $                   | .53        |               | $          | .55                 |       | $                  | .52        |   | $ | .58 |   |

 

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**INTERNATIONALBANCSHARES CORPORATION**OFFICERS AND DIRECTORS

| OFFICERS                             | ** ** | **DIRECTORS**                              |
|--------------------------------------|------------|--------------------------------------------|
|                                 |       | ** **                                 |
| DENNIS  E. NIXON                     |       | DENNIS E. NIXON                            |
| Chairman  of the Board and President |       | President, International Bank  of Commerce |
|                                 |       | ** **                                 |
| R.  DAVID GUERRA                     |       | LESTER AVIGAEL                             |
| Vice  President                      |       | Retail Merchant                            |
|                                 |       | Chairman of the Board                      |
| EDWARD  J. FARIAS                    |       | International Bank of Commerce             |
| Vice  President                      |       | ** **                                 |
|                                 |       | IRVING GREENBLUM                           |
| RICHARD  CAPPS                       |       | International Investments/Real  Estate     |
| Vice  President                      |       | ** **                                 |
|                                 |       | R. DAVID GUERRA                            |
| IMELDA  NAVARRO                      |       | President                                  |
| Treasurer                            |       | International Bank of Commerce             |
|                                 |       | Branch in McAllen, TX                      |
| WILLIAM  CUELLAR                     |       | ** **                                 |
| Auditor                              |       | DANIEL B. HASTINGS, JR.                    |
|                                 |       | Licensed U. S. Custom Broker               |
| MARISA  V. SANTOS                    |       | President                                  |
| Secretary                            |       | Daniel B. Hastings, Inc.              |
|                                 |       | ** **                                 |
| HILDA  V. TORRES                     |       | RICHARD E. HAYNES                          |
| Assistant  Secretary                 |       | Attorney at Law                            |
|                                 |       | Real Estate Investments                    |
|                                 |       | ** **                                 |
|                                 |       | IMELDA NAVARRO                             |
|                                 |       | Senior Executive Vice  President           |
|                                 |       | International Bank of Commerce             |
|                                 |       | ** **                                 |
|                                 |       | SIOMA NEIMAN                               |
|                                 |       | International Entrepreneur                 |
|                                 |       | ** **                                 |
|                                 |       | PEGGY J. NEWMAN                            |
|                                 |       | Investments                                |
|                                 |       | ** **                                 |
|                                 |       | LEONARDO SALINAS                           |
|                                 |       | Investments                                |
|                                 |       | ** **                                 |
|                                 |       | ANTONIO R. SANCHEZ, JR.                    |
|                                 |       | Chairman of the Board                      |
|                                 |       | Sanchez Oil & Gas  Corporation    |
|                                 |       | Investments                                |

 

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