**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      DC 20549**








**FORM
      10-Q**





(Mark
      One)


[X]
      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
      ACT
      OF 1934


For
      the
      quarterly period ended September 30, 2006





[  
      ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
      ACT OF 1934





Commission
      File Number: 0-16761





**HIGHLANDS
      BANKSHARES, INC.**


(Exact
      name of registrant as specified in its charter)





West
                Virginia
            55-0650793(State
                or Other Jurisdiction of Incorporation or Organization)
            (IRS
                Employer Identification No.)





P.O.
      Box
      929


Petersburg,
      WV 26847


(Address
      of Principal Executive Offices, Including Zip Code)





304-257-4111


(Registrant’s
      Telephone Number, Including Area Code)





Indicate
      by check mark whether the registrant (1) filed all reports required to be filed
      by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past
      12
      months (or for such shorter period that the registrant was required to file
      such
      reports), and (2) has been subject to such filing requirements for the past
      90
      days. Yes [X] No [ ]





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filed, or a non-accelerated filer. See definition of “accelerated
      filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
      One):





Large
                Accelerated Filer [   ]
            Accelerated
                Filer [   ]
            Non
                Accelerated filer [X]





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act). [   ] Yes  [X]
      No





Indicate
      the number of shares outstanding of each of the issuer’s classes of common stock
      as of the latest practicable date. As of October 31, 2006: 1,436,874 shares
      of
      Common Stock, $5 Par Value








HIGHLANDS
                BANKSHARES, INC.Quarterly
                Report on Form 10Q For The Period Ended September
                30,2006INDEXPagePART
                I
            FINANCIAL
                INFORMATIONItem
                1.
            Financial
                StatementsUnaudited
                Consolidated Statements of IncomeNine
                Months Ended September 30, 2006 and
                2005
            2Unaudited
                Consolidated Statements of IncomeThree
                Months Ended September 30, 2006 and
                2005
            3Unaudited
                Consolidated Balance Sheet for September 30,
                2006and
                Audited Consolidated Balance Sheet for December 31,
                2005
            4Unaudited
                Consolidated Statements of Changes in
                Stockholders’Equity
                for the Nine Months Ended September 30, 2006 and
                2005
            5Unaudited
                Consolidated Statements of Cash Flows for the
                NineMonths
                Ended September 30, 2006 and
                2005
            6Notes
                to Consolidated Financial Statements
            7Item
                2.
            Management’
Discussion
                and Analysis of Financial Conditionand
                Results of Operations
            10Item
                3.
            Quantitative
                and Qualitative Disclosures About Market
                Risk
            23Item
                4.
            Controls
                and Procedures
            23PART
                II
            OTHER
                INFORMATIONItem
                1.
            Legal
                Proceedings
            24Item
                1A.
            Risk
                Factors
            24Item
                2.
            Unregistered
                Sales of Equity Securities and Use of
                Proceeds
            24Item
                3.
            Defaults
                Upon Senior Securities
            24Item
                4.
            Submission
                of Matters to a Vote of Security
                Holders
            24Item
                5.
            Other
                Information
            24Item
                6.
            Exhibits
            24SIGNATURES
            
            25





*Index*





**PartI.**
            Page
                2**Item
                1. Financial Statements**








HIGHLANDS
                BANKSHARES, INC.CONSOLIDATED
                STATEMENTS OF INCOME(In
                Thousands of Dollars, Except Per Share Data)Nine
                Months Ended September 30,2006
            
            2005(unaudited)
            
            (unaudited)Interest
                IncomeInterest
                and fees on loans
            
            $
            16,149
            
            $
            13,620Interest
                on federal funds sold
            
            
            338
            
            
            202Interest
                on deposits in other banks
            
            
            39
            
            
            26Interest
                and dividends on securities
            
            
            891
            
            
            558Total
                Interest Income
            
            
            17,417
            
            
            14,406Interest
                ExpenseInterest
                on deposits
            
            
            5,043
            
            
            3,674Interest
                on borrowed money
            
            
            529
            
            
            476Total
                Interest Expense
            
            
            5,572
            
            
            4,150Net
                Interest Income
            
            
            11,845
            
            
            10,256Provision
                for Loan Losses
            
            
            508
            
            
            690Net
                Interest Income After Provision for Loan Losses
            
            
            11,337
            
            
            9,566Non-interest
                IncomeService
                Charges
            
            
            892
            
            
            625Investment
                in insurance contracts
            
            
            321
            
            
            200Other
                noninterest income
            
            
            343
            
            
            448Total
                Noninterest Income
            
            
            1,556
            
            
            1,273Non-interest
                ExpenseSalaries
                and employee benefits
            
            
            4,244
            
            
            3,692Equipment
                and occupancy expense
            
            
            984
            
            
            922Data
                processing expense
            
            
            580
            
            
            460Directors
                fees
            
            
            297
            
            
            256Legal
                and professional fees
            
            
            365
            
            
            338Other
                noninterest expense
            
            
            1,304
            
            
            1,088Total
                Noninterest Expense
            
            
            7,774
            
            
            6,756Income
                Before Provision For Income Taxes
            
            
            5,119
            
            
            4,083Provision
                for Income Taxes
            
            
            1,758
            
            
            1,372Net
                Income
            
            $
            3,361
            
            $
            2,711Per
                Share DataNet
                Income
            
            $
            2.34
            
            $
            1.89Cash
                Dividends
            
            $
            .69
            
            $
            .60Weighted
                Average Common Shares Outstanding
            
            
            1,436,874
            
            
            1,436,874The
                accompanying notes are an integral part of these
                statements.





*Index*


Page
      3





HIGHLANDS
                BANKSHARES, INC.CONSOLIDATED
                STATEMENTS OF INCOME(In
                Thousands of Dollars, Except Per Share Data)Three
                Months Ended September 30,2006
            
            2005(unaudited)
            
            (unaudited)Interest
                IncomeInterest
                and fees on loans
            
            $
            5,698
            
            $
            4,704Interest
                on federal funds sold
            
            
            124
            
            
            101Interest
                on deposits in other banks
            
            
            16
            
            
            15Interest
                and dividends on securities
            
            
            302
            
            
            188Total
                Interest Income
            
            
            6,140
            
            
            5,008Interest
                ExpenseInterest
                on deposits
            
            
            1,873
            
            
            1,326Interest
                on borrowed money
            
            
            174
            
            
            167Total
                Interest Expense
            
            
            2,047
            
            
            1,493Net
                Interest Income
            
            
            4,093
            
            
            3,515Provision
                for Loan Losses
            
            
            155
            
            
            255Net
                Interest Income After Provision for Loan Losses
            
            
            3,938
            
            
            3,260Non-interest
                IncomeService
                Charges
            
            
            317
            
            
            234Investment
                in insurance contracts
            
            
            37
            
            
            79Other
                noninterest income
            
            
            115
            
            
            138Total
                Noninterest Income
            
            
            469
            
            
            451Non-interest
                ExpenseSalaries
                and employee benefits
            
            
            1,429
            
            
            1,227Equipment
                and occupancy expense
            
            
            336
            
            
            316Data
                processing expense
            
            
            209
            
            
            155Directors
                fees
            
            
            100
            
            
            82Legal
                and professional fees
            
            
            127
            
            
            170Other
                noninterest expense
            
            
            418
            
            
            355Total
                Noninterest Expense
            
            
            2,619
            
            
            2,305Income
                Before Provision For Income Taxes
            
            
            1,788
            
            
            1,406Provision
                for Income Taxes
            
            
            632
            
            
            463Net
                Income
            
            $
            1,156
            
            $
            943Per
                Share DataNet
                Income
            
            $
            .80
            
            $
            .66Cash
                Dividends
            
            $
            .23
            
            $
            .20Weighted
                Average Common Shares Outstanding
            
            
            1,436,874
            
            
            1,436,874The
                accompanying notes are an integral part of these
                statements.





*Index*


Page
      4


HIGHLANDS
                BANKSHARES, INC.CONSOLIDATED
                BALANCE SHEETS(In
                Thousands of Dollars)September
                30, 2006
            
            December
                31, 2005(unaudited)
            
            (audited)ASSETSCash
                and due from banks—noninterest bearing
            
            $
            8,293
            
            $
            8,850Deposits
                in other banks—interest bearing
            
            
            2,136
            
            
            963Federal
                funds sold
            
            
            10,905
            
            
            10,808Securities
                held to maturity
            
            
            290
            
            
            491Securities
                available for sale, at market value
            
            
            24,452
            
            
            27,130Restricted
                investments
            
            
            1,448
            
            
            1,250Loans
            
            
            283,317
            
            
            270,020Allowance
                for loan losses
            
            
            (3,380
            )
            
            (3,129
            )Bank
                premises and equipment, net of depreciation
            
            
            7,926
            
            
            7,684Interest
                receivable
            
            
            2,044
            
            
            1,818Investment
                in life insurance contracts
            
            
            6,007
            
            
            6,396Goodwill
            
            
            1,534
            
            
            1,534Other
                intangible assets
            
            
            1,542
            
            
            1,674Other
                Assets
            
            
            2,666
            
            
            2,084Total
                Assets
            
            $
            349,180
            
            $
            337,573LIABILITIESNoninterest
                bearing deposits
            
            $
            48,670
            
            $
            47,753Savings
                and interest bearing demand deposits
            
            
            72,844
            
            
            80,597Time
                deposits
            
            
            171,257
            
            
            156,342Total
                Deposits
            
            
            292,771
            
            
            284,692Long
                term debt
            
            
            15,638
            
            
            15,063Accrued
                expenses and other liabilities
            
            
            4,376
            
            
            3,826Total
                Liabilities
            
            
            312,785
            
            
            303,581STOCKHOLDERS’
                EQUITYCommon
                   Stock, $5 par value, 3,000,000 shares authorized, 1,436,874 shares
                issued
                and outstanding
            
            
            7,184
            
            
            7,184Surplus
            
            
            1,662
            
            
            1,662Retained
                Earnings
            
            
            28,021
            
            
            25,651Other
                accumulated comprehensive loss
            
            
            (472
            )
            
            (505
            )Total
                Stockholders’ Equity
            
            
            36,395
            
            
            33,992Total
                Liabilities and Stockholders’ Equity
            
            $
            349,180
            
            $
            337,573The
                accompanying notes are an integral part of these
                statements.





*Index*


Page
      5


HIGHLANDS
                BANKSHARES, INC.CONSOLIDATED
                STATEMENTS OF CHANGES IN STOCKHOLDERS’
                EQUITY(In
                Thousands of Dollars)Common
              Stock
            
            Surplus
            
            Retained
              Earnings
            
            Accumulated
              Other
              Comprehensive
              Income
            
            TotalBalances
                at December 31, 2005
            
            $
            7,184
            
            $
            1,662
            
            $
            25,651
            
            $
            (505
            )
            $
            33,992Net
                Income
            
            
            
            
            
            
            
            
            3,361
            
            
            
            
            
            3,361Net
                change in unrealized appreciation on investment securities available
                for
                sale, net of taxes
            
            
            
            
            
            
            
            
            
            
            
            33
            
            
            33Total
                Comprehensive Income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            3,394Dividends
                Paid
            
            
            
            
            
            
            
            
            (991
            )
            
            
            
            
            (991
            )Balances
                September 30, 2006
            
            $
            7,184
            
            $
            1,662
            
            
            28,021
            
            $
            (472
            )
            $
            36,395








Common
              Stock
            
            Surplus
            
            Retained
              Earnings
            
            Accumulated
              Other
              Comprehensive
              Income
            
            TotalBalances
                at December 31, 2004
            
            $
            7,184
            
            $
            1,662
            
            $
            23,028
            
            $
            (219
            )
            $
            31,655Net
                Income
            
            
            
            
            
            
            
            
            2,711
            
            
            
            
            
            2,711Net
                change in unrealized appreciation on investment securities available
                for
                sale, net of taxes
            
            
            
            
            
            
            
            
            
            
            
            (26
            )
            
            (26
            )Total
                Comprehensive Income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            2,685Dividends
                Paid
            
            
            
            
            
            
            
            
            (862
            )
            
            
            
            
            (862
            )Balances
                September 30, 2005
            
            $
            7,184
            
            $
            1,662
            
            $
            24,877
            
            $
            (245
            )
            $
            33,478The
                accompanying notes are an integral part of these
                statements.
















*Index*


Page
      6


HIGHLANDS
                BANKSHARES, INC.CONSOLIDATEDSTATEMENTSOF CASH FLOWS(In
                Thousands of Dollars)Nine
                Months Ended September 30,2006
            
            2005(unaudited)
            
            (unaudited)Cash
                Flows From Operating ActivitiesNet
                Income
            
            $
            3,361
            
            $
            2,711Adjustments
                to reconcile net income to netcash
                provided by operating activitiesDepreciation
            
            
            496
            
            
            494Increase
                in cash value of life insurance contracts
            
            
            (166
            )
            
            (182
            )Net
                amortization of securities
            
            
            (112
            )
            
            47Provision
                for loan losses
            
            
            508
            
            
            690Amortization
                of intangibles
            
            
            132
            
            
            38Decrease
                (increase) in interest receivable
            
            
            (226
            )
            
            (202
            )Decrease
                (increase) in other assets
            
            
            (582
            )
            
            359Increase
                in accrued expenses
            
            
            550
            
            
            156Net
                Cash Provided by Operating Activities
            
            
            3,961
            
            
            4,111Cash
                Flows From Investing ActivitiesIncrease
                (decrease) in federal funds sold
            
            
            (97
            )
            
            (6,976
            )Proceeds
                from maturities of securities available for sale
            
            
            9,234
            
            
            7,380Purchase
                of securities available for sale
            
            
            (6,410
            )
            
            (6,186
            )Proceeds
                from maturities of securities held to maturity
            
            
            201
            
            
            670Increase
                in restricted investments
            
            
            (198
            )
            
            (118
            )Net
                change in interest bearing deposits in other banks
            
            
            (1,173
            )
            
            (797
            )Settlement
                on insurance contract
            
            
            555
            
            
            0Purchase
                of property and equipment
            
            
            (739
            )
            
            (153
            )Net
                Change in Loans
            
            
            (13,554
            )
            
            (7,658
            )Net
                Cash Used in Investing Activities
            
            
            (12,181
            )
            
            (13,891
            )Cash
                Flows From Financing ActivitiesNet
                change in deposits
            
            
            8,079
            
            
            4,945Additional
                long term debt
            
            
            2,300
            
            
            7,700Repayment
                of long term debt
            
            
            (1,725
            )
            
            (375
            )Additional
                short term borrowings
            
            
            0
            
            
            1,500Repayment
                of short term borrowings
            
            
            0
            
            
            (3,500
            )Dividends
                paid in cash
            
            
            (991
            )
            
            (862Net
                Cash Provided by Financing Activities
            
            
            7,663
            
            
            11,291Net
                Increase (Decrease) in Cash and Cash Equivalents
            
            
            (557
            )
            
            1,511Cash
                and Cash Equivalents, Beginning of Period
            
            
            8,850
            
            
            6,187Cash
                and Cash Equivalents, End of Period
            
            $
            8,293
            
            $
            7,698Supplemental
                DisclosuresCash
                paid for income taxes
            
            $
            1,766
            
            $
            911Cash
                paid for interest
            
            $
            5,355
            
            $
            3,972The
                accompanying notes are an integral part of these
                statements.





*Index*


Page
      7





**HIGHLANDS
      BANKSHARES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**NOTE
      1**  **ACCOUNTING
      PRINCIPLES**





The
      consolidated financial statements conform to U. S. generally accepted accounting
      principles and to general industry practices. In the opinion of management,
      the
      accompanying unaudited consolidated financial statements contain all
      adjustments, consisting solely of normal recurring adjustments, necessary to
      present fairly the financial position as of September 30, 2006 and the results
      of operations for the three and nine month periods ended September 30, 2006
      and
      2005.





The
      results of operations for the three and nine month periods ended September
      30,
      2006 and 2005 are not necessarily indicative of the results to be expected
      for
      the full year.





The
      notes
      included herein should be read in conjunction with the notes to financial
      statements included in the Company’s 2005 annual report on Form 10-K.




**NOTE
      2**  **SECURITIES
      AND RESTRICTED INVESTMENTS**





The
      Company’s securities portfolio serves several purposes. Portions of the
      portfolio secure certain public and trust deposits while the remaining portions
      are held as investments or used to assist the Company in liquidity and
      asset/liability management.





The
      amortized cost and market value of securities held to maturity as of September
      30, 2006 and December 31, 2005 are as follows (in thousands of
      dollars):





September
                30, 2006
            
            December
                31, 2005Amortized
            
            Market
            
            Amortized
            
            MarketCost
            
            Value
            
            Cost
            
            ValueHeld
                to Maturity SecuritiesObligations
                of states and municipalities
            
            $
            290
            
            $
            290
            
            $
            491
            
            $
            491Total
                Held to Maturity Securities
            
            $
            290
            
            $
            290
            
            $
            491
            
            $
            491Available
                For Sale SecuritiesU.S.
                Treasuries and Agencies
            
            $
            16,358
            
            $
            16,318
            
            $
            17,352
            
            $
            17,234Mortgage
                backed securities
            
            
            5,720
            
            
            5,693
            
            
            7,172
            
            
            7,163Obligations
                of states and municipalities
            
            
            2,432
            
            
            2,411
            
            
            2,719
            
            
            2,705Marketable
                equities
            
            
            30
            
            
            30
            
            
            28
            
            
            28Total
                Available For Sale Securities
            
            $
            24,540
            
            $
            24,452
            
            $
            27,271
            
            $
            27,130





Restricted
      investments consist of investments in the Federal Home Loan Bank and the Federal
      Reserve Bank. Investments are carried at face value and the level of investment
      is dictated by the level of participation with each institution. Amounts are
      restricted as to transferability. Investments in the Federal Home Loan Bank
      act
      as collateral against the outstanding borrowings from that
      institution.





**NOTE
      3**  **BRANCHES
      ACQUISITION**





During
      the fourth quarter of 2005, Highlands Bankshares purchased all of the
      outstanding shares of common stock of the National Bank of Davis (“Davis”),
      located in Davis, West Virginia. Shortly after the purchase, Davis offices
      became branches of The Grant County Bank. The net assets of Davis were recorded
      at fair value. Portions of the cost of acquisition, including certain expenses
      related to the purchase, were allocated as intangible assets. All results of
      operations subsequent to the purchase of the branches acquired are included
      in
      consolidated income totals.


*Index*





Page
      8


**HIGHLANDS
      BANKSHARES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**NOTE
      4**  **INVESTMENTS
      IN INSURANCE CONTRACTS**





Investments
      in insurance contracts consist of single premium insurance contracts which
      have
      the purpose of providing a rate of return to the Company and of providing life
      insurance and retirement benefits to certain executives.





During
      the second quarter of 2006, the Company received payment in settlement relating
      to two of these policies. This payment related to the death of an insured and
      resulted in a one-time, non-recurring income of $155,000.





**NOTE
      5**  **LOANS**





A
      summary
      of loans outstanding as of September 30, 2006 and December 31, 2005 is shown
      in
      the table below (in thousands of dollars):





September
                30,
            
            December
                31,Loan
                Type
            
            2006
            
            2005Commercial
            
            $
            64,942
            
            $
            57,908Real
                Estate construction
            
            
            17,848
            
            
            12,201Real
                Estate mortgage
            
            
            157,316
            
            
            153,646Consumer
            
            
            43,211
            
            
            46,265Total
                Loans
            
            $
            283,317
            
            $
            270,020





In
      addition to loans to fund construction and traditional mortgage loans, portions
      of the loan portfolio identified as commercial are also secured by real estate.
      At September 30, 2006, the total balance of loans in the portfolio secured
      by
      real estate was $218,826,000. ****





**NOTE
      6**  **ALLOWANCE
      FOR LOAN LOSSES**





A
      summary
      of the transactions in the allowance for loan losses for the nine month periods
      ended September 30, 2006 and 2005 is shown below (in thousands of
      dollars):





2006
            
            2005Balance,
                beginning of period
            
            $
            3,129
            
            $
            2,530Provisions
                charged to operations
            
            
            508
            
            
            690Loan
                recoveries
            
            
            171
            
            
            144Loan
                charge-offs
            
            
            (428
            )
            
            (445
            )Balance,
                end of period
            
            $
            3,380
            
            $
            2,919





**NOTE
      7**  **DEBT
      INSTRUMENTS**





The
      Company continues to borrow money from the Federal Home Loan Bank of Pittsburgh
      (FHLB) to meet specific  funding
      needs. The interest rates of the notes payable as of September 30, 2006, range
      from 3.30% to 6.12%. The weighted average interest rate was 4.51% at September
      30, 2006. The debt is secured by the general assets of the subsidiary
      banks.





During
      the first quarter of 2005, the Company initiated short term borrowings from
      the
      FHLB of $1,500,000 and made repayments of $3,500,000. No short term borrowings
      have been initiated subsequent to the first quarter of 2005.





*Index*


Page
      9


**HIGHLANDS
      BANKSHARES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**NOTE
      8**  **DEPOSITS**





Balances
      of time deposits over $100,000 and of all other time deposits at September
      30,
      2006 and December 31, 2005 are shown below (in thousands of
      dollars):





September
                30,
            
            December
                31,2006
            
            2005Time
                deposits over $100,000
            
            $
            51,761
            
            $
            45,455All
                other time deposits
            
            
            119,496
            
            
            110,887Total
                Time Deposits
            
            $
            171,257
            
            $
            156,342





Interest
      expense for time deposits over $100,000 for the three and nine month periods
      ended September 30, 2006 and 2005 is shown below (in thousands of
      dollars):




Nine
                Months Ended September 30,
            
            Three
                Months Ended September 30,2006
            
            2005
            
            2006
            
            2005$
            1,423
            
            $
            997
            
            $
            537
            
            $
            360




**NOTE
      9**  **EMPLOYEE
      BENEFITS**





The
      Company's two subsidiary banks each have separate retirement and profit sharing
      plans which cover substantially all full time employees at each bank.





The
      Capon
      Valley Bank has a defined contribution pension plan with 401(k) features that
      is
      funded with discretionary contributions by the Bank. The bank matches on a
      limited basis the contributions of the employees. Investment of employee
      balances is done through the direction of each employee. Employer contributions
      are vested over a six year period.





The
      Grant
      County Bank is a member of the West Virginia Bankers' Association Retirement
      Plan. Benefits under the plan are based on compensation and years of service
      with 100% vesting after seven years of service. Prior to 2002, the Plan's assets
      were in excess of the projected benefit obligations and thus the Bank was not
      required to make contributions to the Plan in 2003, 2002 or 2001. The bank
      was
      required to make contributions in 2004 and 2005, and made contributions in
      the
      first nine months of 2006. The
      Bank
      has recognized liabilities of $421,000 at September 30, 2006 relating to this
      plan. T he
      following table provides the components of the net periodic benefit cost for
      the
      plan for the nine month periods ended September 30, 2006 and 2005 (in thousands
      of dollars):





2006
            
            2005Service
                cost
            
            $
            94
            
            $
            92Interest
                cost
            
            
            138
            
            
            134Expected
                return on plan assets
            
            
            (152
            )
            
            (141
            )Amortization
                of unrecognized prior service costs
            
            
            8
            
            
            8Recognized
                net actuarial loss
            
            
            43
            
            
            20Net
                periodic expense
            
            $
            131
            
            $
            113








*Index*


Page
      10





**Item
      2.**  **Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations**





**Forward
      Looking Statements**





Certain
      statements in this report may constitute “forward-looking statements” within the
      meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking
      statements are statements that include projections, predictions, expectations
      or
      beliefs about future events or results or otherwise are not statements of
      historical fact. Such statements are often characterized by the use of qualified
      words (and their derivatives) such as “expect,” “believe,” “estimate,” “plan,”
“project,” “anticipate” or other similar words. Although the Company believes
      that its expectations with respect to certain forward-looking statements are
      based upon reasonable assumptions within the bounds of its existing knowledge
      of
      its business and operations, there can be no assurance that actual results,
      performance or achievements of the Company will not differ materially from
      any
      future results, performance or achievements expressed or implied by such
      forward-looking statements. Actual future results and trends may differ
      materially from historical results or those anticipated depending on a variety
      of factors, including, but not limited to, the effects of and changes in:
      general economic conditions, the interest rate environment, legislative and
      regulatory requirements, competitive pressures, new products and delivery
      systems, inflation, changes in the stock and bond markets, technology, downturns
      in the trucking and timber industries, effects of mergers and/or downsizing
      in
      the poultry industry in Hardy County, and consumer spending and savings habits.
      Additionally, actual future results and trends may differ from historical or
      anticipated results to the extent: (1) any significant downturn in certain
      industries, particularly the trucking and timber and coal extraction industries
      are experienced; (2) loan demand decreases from prior periods; (3) the Company
      may make additional loan loss provisions due to negative credit quality trends
      in the future that may lead to a deterioration of asset quality; (4) the Company
      may not continue to experience significant recoveries of previously charged-off
      loans or loans resulting in foreclosure; (5) increased liquidity needs may
      cause
      an increase in funding costs; and, (6) the Company is unable to control costs
      and expenses as anticipated. The Company does not update any forward-looking
      statements that may be made from time to time by or on behalf of the
      Company.





**Introduction**





The
      following discussion focuses on significant results of the Company’s operations
      and significant changes in our financial condition or results of operations
      for
      the periods indicated in the discussion. This discussion should be read in
      conjunction with the preceding financial statements and related notes, as well
      as the Company’s Report on Form 10-K for the period ended December 31, 2005.





Current
      performance does not guarantee, and may not be indicative of, similar
      performance in the future.





**Critical
      Accounting Policies**





The
      Company’s financial statements are prepared in accordance with accounting
      principles generally accepted in the United States (“GAAP”). The financial
      statements contained within these statements are, to a significant extent,
      financial information that is based on measures of the financial effects of
      transactions and events that have already occurred. A variety of factors could
      affect the ultimate value that is obtained either when earning income,
      recognizing an expense, recovering an asset or relieving a liability. In
      addition, GAAP itself may change from one previously acceptable method to
      another method. Although the economics of these transactions would be the same,
      the timing of events that would impact these transactions could change.


*Index*





Page
      11





**Item
      2.**  **Management’s
      Discussion and Analysis of Financial Condition and Results of Operations
      (continued)**





**Critical
      Accounting Policies (continued)**





Disclosure
      of the Company’s significant accounting policies is included in Note 2 to the
      Consolidated Financial Statements of the Company’s Annual Report on Form 10-K
      for the period ended December 31, 2005. Some of the policies are particularly
      sensitive, requiring significant judgments, estimates and assumptions by
      management.





The
      allowance for loan losses is an estimate of the losses that may be sustained
      in
      the loan portfolio. The allowance is based on two basic principles of
      accounting: (i) SFAS No. 5, Accounting for Contingencies, which requires that
      losses be accrued when they are probable of occurring and estimable and (ii)
      SFAS No. 114, Accounting by Creditors for Impairment of a Loan, which requires
      that losses be accrued based on the differences between the value of collateral,
      present value of future cash flows or values that are observable in the
      secondary market and the loan balance. Additional information pertaining to
      the
      allowance for loan losses and provision for loan losses is contained on pages
      15-17 of this report.





The
      Company has invested in and owns life insurance polices on certain officers.
      The
      policies are designed so that the company recovers the interest expenses
      associated with carrying the policies and the officer will, at the time of
      retirement, receive any earnings in excess of the amounts earned by the Company.
      The Company recognizes as an asset the net amount that could be realized under
      the insurance contract as of the balance sheet date. This amount represents
      the
      cash surrender value of the policies less applicable surrender charges. The
      portion of the benefits which will be received by the executives at the time
      of
      their retirement is considered, when taken collectively, to constitute a
      retirement plan. Therefore the Company accounts for these policies using
      guidance found in Statement of Financial Accounting Standards No. 106,
      "Employers' Accounting for Post Retirement Benefits Other Than Pensions.” SFAS
      No. 106 requires that an employer’s obligation under a deferred compensation
      agreement be accrued over the expected service life of the employee through
      their normal retirement date. Assumptions
      are used in estimating the present value of amounts due officers after their
      normal retirement date. These assumptions include the estimated income to be
      derived from the investments and an estimate of the Company’s cost of funds in
      these future periods. In addition, the discount rate used in the present value
      calculation will change in future years based on market conditions.





During
      2005, the Company purchased all the outstanding shares of the National Bank
      of
      Davis. The net assets of this purchase were recorded at fair value, including
      goodwill. Goodwill represents the cost in excess of the fair value of net assets
      acquired (including identifiable intangibles) in transactions accounted for
      as
      purchases. In accordance with provisions of SFAS No. 142, " *Goodwill
      and Other Intangible Assets* ",
      goodwill is not amortized over an estimated useful life, but rather will be
      tested at least annually for impairment. Core deposit and other intangible
      assets include premiums paid for acquisitions of core deposits (core deposit
      intangibles) and other identifiable intangible assets. Intangible assets other
      than goodwill, which are determined to have finite lives, are amortized based
      upon the estimated economic benefits received .


*Index*


Page
      12





**Item
      2.**  **Management’s
      Discussion and Analysis of Financial Condition and Results of Operations
      (continued)**





**Recent
      Accounting Pronouncements**





No
      recent
      accounting pronouncements had a material impact on the Company’s consolidated
      financial statements.





In
      September 2006, the FASB issued Statement of Financial Accounting Standards
      No.
      158, “Employers Accounting for Defined Benefit Pension and Other Postretirement
      Plans—an amendment of FASB Statements No. 87, 88, 106 and 132R” (SFAS 158). SFAS
      158 requires an employer to recognize the over-funded or under-funded status
      of
      a defined benefit postretirement plan as an asset of liability in its statement
      of financial position and to recognize changes in that funded status, through
      comprehensive income, in the year in which the changes occur. The funded status
      of a benefit plan will be measured as the difference between plan assets at
      fair
      value and benefit obligation. For any other postretirement plan, the benefit
      obligation is the accumulated postretirement benefit obligation. SFAS 158 also
      requires an employer to measure the funded status of a plan as of the date
      of
      its year-end statement of financial position. The Statement also requires
      additional disclosures in the notes to financial statements about certain
      effects on net periodic benefit cots for the next fiscal year that arise from
      delayed recognition of the gains or losses, prior service costs or credits,
      and
      transition asset or obligation. Under SFAS 158 a company is required to
      initially recognize the funded status of a defined benefit postretirement plan
      to to provide the required disclosures as of the end of the fiscal year ending
      after December 15, 2006. The requirement to measure plan assets and benefit
      obligations as of the date of the employer’s fiscal year end statement of
      financial position is effective for fiscal years ending after December 15,
      2008.
      The Grant County Bank is a member of the West Virginia Bankers' Association
      Retirement Plan, a defined benefit plan under SFAS 158. As such, certain aspects
      of SFAS 158 will most likely impact the financial position of Highlands
      Bankshares, Inc. at December 31, 2006. At present, this impact has not been
      determined.





**Overview**





Net
      income for the first nine months of 2006 increased 23.98% over the same period
      in 2005. Return on Average Assets for the period was 1.33% and Return on Average
      Equity was 12.76%.





Net
      income for the three-month period ended September 30, 2006 increased 22.59%
      over
      the same quarter in 2005. Return on Average Assets for the quarter was 1.34%
      and
      Return on Average Equity was 12.65%.





The
      Company experienced strong loan demand during the third quarter of 2006 and
      loan
      balances increased nearly $10,000,000 during the quarter to stand at
      $283,317,000 at September 30. After several periods of either decline or minimal
      growth, total deposits also increased during the third quarter by 4.27%, with
      the increase being concentrated in balances of time deposits. Owing in great
      part to the increases in loans and deposits, the Company’s total assets
      increased and stood at $349,180,000 at September 30. This expansion of the
      balance sheet contributed significantly to a 15.49% increase in net interest
      income for the first nine months of 2006 as compared to the same period in
      2005.





The
      provision for loan losses was reduced during 2006 as compared to 2005. Although
      the provision taken against operational results was $182,000 less during 2006
      than a year ago, the ratio of the allowance for loan losses as compared to
      gross
      loan balances increased from 1.16% at December 31, 2005 to 1.19% at September
      30, 2006.





Non
      interest income year to date was 22.23% greater than the first nine months
      of
      2005. The largest contributor to this increase was a rise in overdraft fees
      charged to demand deposit customers. This increase was a result of an increase
      in average balances of checking accounts and also the implementation by Capon
      Valley Bank, a subsidiary, of a program commonly referred to as “courtesy
      overdraft.” A non-recurring payment to the Company from a Company owned life
      insurance policy was a major contributor to an increase in earnings on
      investments in life insurance. Insurance related income continued to
      decline.


*Index*


Page
      13





**Item
      2.**  **Management’s
      Discussion and Analysis of Financial Condition and Results of Operations
      (continued)**





**Overview
      (continued)**





Non
      interest expense increased 15.07% during the first three quarters of 2006 as
      compared to last year. A large portion of this increase can be attributed to
      the
      expanded operations acquired as a result of the purchase of the National Bank
      of
      Davis, however some of the increase resulted from operational growth of legacy
      operations.




Highlands'
      results of operations are discussed in greater detail following this overview.
      Unless otherwise specifically noted, the underlying causes for changes in the
      results for the quarter ended September 30, 2006 as compared to the same quarter
      in 2005 are substantially the same as the causes discussed for the nine months
      ended September 30, 2006 as compared to the nine months ended September 30,
      2005.





**Impact
      of Acquisition on Operational Results**





During
      the fourth quarter of 2005, the Company acquired two additional branches through
      the purchase of the National Bank of Davis. Further information regarding this
      purchase can be found in the Company’s Annual Report on Form 10-K for 2005. This
      acquisition has significantly impacted the results of operations for the first
      nine months of 2006, both in revenues and costs.





The
      acquisition added significant balances of both earning assets and interest
      bearing liabilities to the Company’s operations. The addition of these assets
      and liabilities has impacted the asset/liability management strategy of the
      Company, specifically The Grant County Bank into which the branches were
      integrated. Because of the full integration of these assets and liabilities,
      determination of the exact dollar amount of the impact on the Company’s net
      interest income is difficult to determine. However, the addition has increased
      net interest income as compared to the first nine months of 2005 both because
      of
      the increased balances of earning assets and interest bearing liabilities and
      because of the increased options for asset/liability management resulting from
      the purchase.





The
      addition of two branches and eleven full time equivalent employees as the result
      of the purchase of the National Bank of Davis has also caused an increase in
      non-interest expense. Specifically, occupancy and equipment expense has
      increased because of the added physical locations. Salary and benefits expense
      have increased because of the additional employees, and data processing expense
      has increased because of the additional loan and deposit customers.
      Additionally, certain other non-interest expenses have increased because of
      the
      acquisition.





Non-interest
      income has also been impacted by the acquisition, but to a lesser degree than
      the impact of the acquisition on net interest income and non-interest expense.





**Net
      Interest Income**





Year
      To Date September 30, 2006 Compared to Same Period in 2005





The
      acquisition of the branches, as discussed earlier, has had significant impact
      on
      the Company’s net interest income. The following discussion highlights recent
      trends in the Company’s management of its net interest margin. The comparison of
      net interest income in 2006 as compared to 2005 as discussed below should be
      considered in conjunction with the comments relating to the impact on net
      interest income of the acquisition of the National Bank of Davis found earlier
      in Management’s Discussion and Analysis under the heading of “Impact of
      Acquisition on Operational Results.”





A
      continuation of increases by the Federal Reserve Board (“The Fed”) throughout
      2005 and continuing into early 2006 for the target rate on federal funds sold
      has caused both rates earned on assets and rates paid on liabilities to increase
      during 2006 as compared to 2005. Although these rate increases by the Fed have
      ceased during the later periods of 2006, as time deposits mature and renew,
      new
      time deposits are made, loans mature and new loans are made and adjustable
      rate
      loans re-price, average rates on both earning assets and interest bearing
      liabilities continue to increase as a result of the rate increases in 2005
      and
      early 2006.





*Index*


Page
      14





**Item
      2.**  **Management’s
      Discussion and Analysis of Financial Condition and Results of Operations
      (continued)**





**Net
      Interest Income (continued)**





Net
      interest income for the first nine months of 2006, on a fully taxable equivalent
      basis, increased 15.46% over the same period in 2005. Average balances of
      earning assets increased 9.03% while average balances of interest bearing
      liabilities increased 8.36%.





Over
      the
      past several years, the Company has followed a strategy of funding loan growth,
      when possible, through reductions in comparatively lower earning assets such
      as
      federal funds sold and securities rather than attempting to attract new deposits
      by offering above market rates on deposit products. This strategy continued
      through the early months of 2006. However, during the quarter ended September
      30, 2006, stronger loan demand and tightening liquidity needs necessitated
      a
      need for new deposits. In addition, rates on securities investments and federal
      funds sold have also increased during 2006, making it somewhat less attractive,
      as compared to recent years, to fund loan growth through reduction of balances
      of these investments. As such, the Company began offering higher rates on
      certain deposit products and balances of time deposits increased 8.82% from
      June
      30, 2006 to September 30, 2006. Over this same period, loan balances increased
      3.65%.





During
      the later months of 2005 and continuing into 2006, as The Fed increased rates,
      the Company experienced increases on average rates on paid on deposits greater
      than those experienced on earning assets. This appears to have occurred because
      of competitive market pressures for both loans and deposits. During the third
      quarter of 2006, the Company experienced a slowing of this trend as average
      rates earned on loans began to increase at a pace nearer to the increases in
      average rates on deposits. Much of the Company’s loan portfolio is comprised of
      adjustable rate loans, and as interest rates increase these loans have re-priced
      upward. This re-pricing, combined with increases in the marketplace rates for
      new loans and increases in loan balances have allowed the Company to increase
      its net interest margin. Included in the Company’s net interest margin
      calculations are fees on loans. These fees consist of both service fees, such
      as
      late charges, and also fees charged to customers upon loan origination. The
      volumes of these fees have significant impact on the average rates earned on
      loans and also on net interest margin percents.





Third
      Quarter of 2006





During
      the first six months of 2006, the Company experienced sluggish demand for new
      loans. Although loan balances grew slightly throughout the first two quarters
      of
      the year, the demand was less than experienced during recent prior years. This
      trend reversed in the third quarter of 2006 and the Company experienced a 3.65%
      increase in loans from June 30, 2006 to September 30, 2006. The balances of
      consumer loans continue to fall due largely to continual increases in
      competition for these loans from both other local financial institutions and
      non-traditional financing firms. In spite of the decline in consumer loans,
      during the third quarter the Company experienced strong growth in mortgage
      and
      commercial loans and overall loan balances increased.





Owing
      to
      the recent strategy of funding loan growth through reductions in comparatively
      lower earning assets, such as securities, investments and federal funds sold,
      balances of securities have decreased over the past periods. The acquisition
      of
      the National Bank of Davis mitigated this trend somewhat as this added balances
      to the securities portfolio. Because the rates earned on securities investments
      have increased and because Management felt that the Company had reduced
      securities balances enough, the Company began offering more competitive rates
      on
      deposits during the third quarter of 2006 to fund the increased loans. This
      caused balances of time deposits to increase during the quarter and impacted
      average rates paid on time deposits. However, this increase was offset by the
      increased rates and fees earned on loans, and net interest margin remained
      strong through the quarter.





While
      the
      Company expects loan demand to remain adequate, Management doesn’t anticipate
      the need to grow deposits significantly during the coming quarters, which would
      necessitate further paying of above market rates for deposits. Balances of
      federal funds sold at September 30, 2006 were nearly double the balances of
      federal funds sold at June 30, 2006. The Company views balances of federal
      funds
      sold as its indicator of short term liquidity and the first source of immediate
      funding for new loan growth. As such, the Company expects that net interest
      income will remain stable, if not increasing, in the coming quarters, although
      continued re-pricing trends of both loans and deposits and competitive
      marketplace pressures may cause net interest margin percents to decline.


*Index*





Page
      15





**Item
      2.**  **Management’s
      Discussion and Analysis of Financial Condition and Results of Operations
      (continued)**





**Net
      Interest Income (continued)**





The
      table
      below sets forth an analysis of net interest income for the nine-month periods
      ended September 30, 2006 and 2005 (Average balances and interest income/expense
      shown in thousands of dollars):





2006
            
            2005Average
            
            Income/
            
            
            
            Average
            
            Income/Balance
            
            Expense
            
            Rate
            
            Balance
            
            Expense
            
            RateInterest
                IncomeLoans1,2
            
            $
            274,230
            
            $
            16,149
            
            
            7.85
            %
            $
            252,118
            
            $
            13,620
            
            
            7.22
            %Federal
                funds sold
            
            
            9,695
            
            
            338
            
            
            4.65
            %
            
            8,675
            
            
            202
            
            
            3.11
            %Interest
                bearing deposits
            
            
            1,216
            
            
            39
            
            
            4.28
            %
            
            1,320
            
            
            26
            
            
            2.63
            %Taxable
                investment securities
            
            
            25,339
            
            
            807
            
            
            4.25
            %
            
            22,565
            
            
            481
            
            
            2.85
            %Nontaxable
                investment securities3
            
            
            3,076
            
            
            134
            
            
            5.81
            %
            
            2,921
            
            
            123
            
            
            5.63
            %Total
                Earning Assets3
            
            
            313,556
            
            
            17,467
            
            
            7.43
            %
            
            287,599
            
            
            14,452
            
            
            6.72
            %Cash
                and cash equivalents
            
            
            7,957
            
            
            
            
            
            
            
            
            6,949Allowance
                for loan losses
            
            
            (3,232
            )
            
            
            
            
            
            
            
            (2,716
            )Insurance
                contracts
            
            
            6,256
            
            
            
            
            
            
            
            
            5,898Nonearning
                assets
            
            
            14,615
            
            
            
            
            
            
            
            
            12,323Total
                Assets
            
            $
            339,152
            
            
            
            
            
            
            
            $
            310,053Interest
                ExpenseInterest
                bearing demand deposits
            
            $
            25,677
            
            $
            167
            
            
            .87
            %
            $
            25,244
            
            $
            133
            
            
            .70
            %Savings
                and money markets
            
            
            51,288
            
            
            402
            
            
            1.05
            %
            
            48,882
            
            
            307
            
            
            .84
            %Time
                deposits
            
            
            159,320
            
            
            4,474
            
            
            3.74
            %
            
            143,892
            
            
            3,234
            
            
            3.00
            %Short
                term borrowings
            
            
            0
            
            
            0
            
            
            
            
            
            38
            
            
            1
            
            
            2.40
            %Long
                term debt
            
            
            15,779
            
            
            529
            
            
            4.47
            %
            
            14,561
            
            
            475
            
            
            4.36
            %Total
                Interest Bearing Liabilities
            
            
            252,064
            
            
            5,572
            
            
            2.95
            %
            
            232,617
            
            
            4,150
            
            
            2.39
            %Demand
                deposits
            
            
            47,968
            
            
            
            
            
            
            
            
            39,973Other
                liabilities
            
            
            3,893
            
            
            
            
            
            
            
            
            4,744Stockholders’
                equity
            
            
            35,227
            
            
            
            
            
            
            
            
            32,719Total
                liabilities and stockholders’ equity
            
            $
            339,152
            
            
            
            
            
            
            
            $
            310,053Net
                Interest Income
            
            
            
            
            $
            11,895
            
            
            
            
            
            
            
            $
            10,302Net
                Yield on Earning Assets3
            
            
            
            
            
            
            
            
            5.06
            %
            
            
            
            
            
            
            
            4.79
            %1Balances
                of loans include loans in non-accrual status2Interest
                income on loans includes fees3Yields
                are on a fully taxable equivalent
                basis





*Index*


Page
      16





**Item
      2.**  **Management’s
      Discussion and Analysis of Financial Condition and Results of Operations
      (continued)**





**Net
      Interest Income (continued)**





The
      table
      below sets forth an analysis of net interest income for the three month periods
      ended September 30, 2006 and 2005 (Average balances and interest/expense shown
      in thousands of dollars):





2006
            
            2005Average
            
            Income/
            
            
            
            Average
            
            Income/Balance
            
            Expense
            
            Rate
            
            Balance
            
            Expense
            
            RateInterest
                IncomeLoans1,2
            
            $
            278,888
            
            $
            5,698
            
            
            8.17
            %
            $
            254,577
            
            $
            4,704
            
            
            7.33
            %Federal
                funds sold
            
            
            9,636
            
            
            124
            
            
            5.15
            %
            
            11,987
            
            
            101
            
            
            3.34
            %Interest
                bearing deposits
            
            
            1,497
            
            
            16
            
            
            4.28
            %
            
            1,560
            
            
            15
            
            
            3.81
            %Taxable
                investment securities
            
            
            23,620
            
            
            276
            
            
            4.67
            %
            
            22,195
            
            
            164
            
            
            2.93
            %Nontaxable
                investment securities3
            
            
            2,858
            
            
            42
            
            
            5.88
            %
            
            2,865
            
            
            38
            
            
            5.26
            %Total
                Earning Assets3
            
            
            316,499
            
            
            6,156
            
            
            7.78
            %
            
            293,184
            
            
            5,022
            
            
            6.80
            %Cash
                and cash equivalents
            
            
            8,015
            
            
            
            
            
            
            
            
            7,296Allowance
                for loan losses
            
            
            (3,330
            )
            
            
            
            
            
            
            
            (2,872
            )Insurance
                contracts
            
            
            5,976
            
            
            
            
            
            
            
            
            5,960Nonearning
                assets
            
            
            15,010
            
            
            
            
            
            
            
            
            10,120Total
                Assets
            
            $
            342,170
            
            
            
            
            
            
            
            $
            313,688Interest
                ExpenseInterest
                bearing demand deposits
            
            $
            25,218
            
            $
            55
            
            
            .87
            %
            $
            25,031
            
            $
            46
            
            
            .74
            %Savings
                and money markets
            
            
            48,696
            
            
            139
            
            
            1.14
            %
            
            48,626
            
            
            115
            
            
            .94
            %Time
                deposits
            
            
            164,822
            
            
            1,679
            
            
            4.04
            %
            
            145,867
            
            
            1,165
            
            
            3.17
            %Long
                term debt
            
            
            15,781
            
            
            174
            
            
            4.41
            %
            
            15,779
            
            
            167
            
            
            4.20
            %Total
                Interest Bearing Liabilities
            
            
            254,517
            
            
            2,047
            
            
            3.22
            %
            
            235,303
            
            
            1,493
            
            
            2.52
            %Demand
                deposits
            
            
            47,930
            
            
            
            
            
            
            
            
            41,073Other
                liabilities
            
            
            3,477
            
            
            
            
            
            
            
            
            3,906Stockholders’
                equity
            
            
            36,246
            
            
            
            
            
            
            
            
            33,407Total
                liabilities and stockholders’ equity
            
            $
            342,170
            
            
            
            
            
            
            
            $
            313,689Net
                Interest Income
            
            
            
            
            $
            4,109
            
            
            
            
            
            
            
            $
            3,529Net
                Yield on Earning Assets3
            
            
            
            
            
            
            
            
            5.19
            %
            
            
            
            
            
            
            
            4.78
            %1Balances
                of loans include loans in non-accrual status2Interest
                income on loans includes fees3Yields
                are on a fully taxable equivalent
                basis


*Index*





Page
      17





**Item
      2.**  **Management’s
      Discussion and Analysis of Financial Condition and Results of Operations
      (continued)**





**Non-interest
      Income**





Non-interest
      income increased 22.23% for the first nine months of 2006 as compared to the
      same period in 2005.





This
      increase was impacted most by an increase in income received from customer
      overdraft charges. During the fourth quarter of 2005, Capon Valley Bank
      instituted a program commonly referred to as “courtesy overdraft.” This program,
      coupled with an increase in the volume of checking accounts at both subsidiary
      banks, was the primary reason for the continued increase in income from
      overdraft charges.





Also
      contributing to the increase in non-interest income was an increase in earnings
      on investments in life insurance contracts brought about by the settlement
      of
      two policies due to the death of an insured (see Note 4).





These
      increases were offset by a decline in insurance earnings. Insurance income
      continues to decrease due to the fact that the volume of new installment loans,
      the primary market for credit life and accident and health insurance, continues
      to fall.





**Loan
      Portfolio**





The
      Company is an active residential mortgage and construction lender and generally
      extends commercial loans to small and medium sized businesses within its primary
      service area. The Company's commercial lending activity extends across its
      primary service areas of Grant, Hardy, Hampshire, Mineral, Randolph, Tucker,
      and
      northern Pendleton counties in West Virginia and Frederick County, Virginia.
      Consistent with its focus on providing community-based financial services,
      the
      Company does not attempt to diversify its loan portfolio geographically by
      making significant amounts of loans to borrowers outside of its primary service
      area.





**Loan
      Growth During the Third Quarter of 2006**





The
      Company, during the most recent quarter, experienced significant loan growth.
      The table below illustrates the change in loan balances between June 30, 2006
      and September 30, 2006 (in thousands of dollars):





Balance
            
            Balance
            
            (Decrease)
            
            PercentLoan
                Type
            
            June
                30, 2006
            
            September
                30, 2006
            
            Increase
            
            ChangeMortgage
                and Construction
            
            $
            171,007
            
            $
            175,164
            
            $
            4,157
            
            
            2.43
            %Commercial
            
            
            58,906
            
            
            64,942
            
            
            6,036
            
            
            10.25
            %Consumer
            
            
            43,437
            
            
            43,211
            
            
            (226
            )
            
            -.52
            %Total
            
            $
            273,350
            
            $
            283,317
            
            $
            9967
            
            
            3.65
            %





Management
      believes that the growth in its commercial loan portfolio has occurred for
      a
      number of reasons. As the Company grows it is better able to compete for large
      commercial loans. The local economy has continued to expand in recent years
      and
      the overall volume of commercial loans in our local area has increased. And,
      as
      the Company has expanded, the increase in the geographical footprint of
      operations has created opportunities for loans unavailable in the past.





Although
      commercial loans typically carry a larger degree of risk than the more
      traditional mortgage loans offered by community banks, the Company feels that
      the recent increase in balances in its commercial loan portfolio has not caused
      an abnormal increase in the amount of risk of the type which would cause
      significant losses. Management feels that the approval and underwriting process
      for new commercial loans is sufficient to mitigate abnormal risk. In most
      instances, new commercial loans underwritten by the Company, are secured by
      real
      estate; although the Company, as part of its underwriting process, determines
      that cash flows or projected cash flows for a new commercial customer are
      sufficient for loan repayment, there is typically an additional requirement
      that
      large commercial loans be adequately secured by real estate such that, in the
      event that cash flows for a commercial customer dissipate, the Company minimizes
      significant losses in the event of foreclosure.


*Index*


Page
      18





**Item
      2.**  **Management’s
      Discussion and Analysis of Financial Condition and Results of Operations
      (continued)**





**Credit
      Quality and Allowance for Loan Losses**





Nonperforming
      loans increased 11.80% from December 31, 2005 to September 30, 2006. Non
      performing loans represent .76% of gross loans at September 30, 2006, and .72%
      of gross loans at December 31, 2005.





Of
      the
      loans included below in the balances of nonperforming loans not adequately
      secured by real estate or other valuable assets, it is management’s opinion that
      amounts allowed for these loans in the allowance for loan losses is adequate
      to
      cover any potential loss and, as such, no loss material to operational results
      would occur.





The
      following table summarizes the Company’s nonperforming loans at September 30,
      2006 and December 31, 2005 (in thousands of dollars):





September
                30,
            
            December
                31,2006
            
            2005Non-accrual
                loans
            
            $
            650
            
            $
            743Loans
                past due 90 days and still accruing interest
            
            
            1,510
            
            
            1,189Total
                nonperforming loans
            
            $
            2,160
            
            $
            1,932





Nonperforming
      loans include non-accrual loans, loans 90 days or more past due and restructured
      loans. Non-accrual loans are loans on which interest accruals have been
      suspended or discontinued permanently. Restructured loans are loans on which
      the
      original interest rate or repayment terms have been changed due to financial
      hardship of the borrower.





Loans
      are
      typically placed on non-accrual status once they have reached certain levels
      of
      delinquency, depending on loan type, and it is no longer reasonable to expect
      collection of principal and interest because collateral is insufficient to
      cover
      both the principal and interest due. After loans are placed on non-accrual
      status, they are typically returned to accrual status if the obligation is
      brought current by the borrower, or they are charged off if payment is not
      made
      and management believes that collection of the amounts due is doubtful.
      Charged-off loans are charged against the allowance for loan losses. Any
      subsequent collection or sale of repossessed collateral is added to the
      allowance as a recovery.





The
      carrying value of foreclosed property at September 30, 2006 was $390,000. All
      foreclosed property held as of September 30, 2006 was in the Company's primary
      service area. The Company's practice is to value real estate acquired through
      foreclosure at the lower of (i) an independent current appraisal or market
      analysis less anticipated costs of disposal, or (ii) the existing loan balance.
      The Company is actively marketing all foreclosed real estate and does not
      anticipate material write-downs in value before disposition.





Because
      of its large impact on the local economy, management continuously monitors
      the
      economic health of the poultry industry. The Company has direct loans to poultry
      growers and the industry is a large employer in the Company’s trade area.





In
      recent
      years, the Company’s loan portfolio has begun to reflect a concentration in
      loans collateralized by heavy equipment, particularly in the trucking, timber
      and coal extraction industries. In part because of rising fuel costs, and
      because of continued slow economic growth, the trucking sector experienced
      a
      recent downturn, and profitability growth within this sector still appears
      to be
      sluggish. While close monitoring of this sector is necessary, management expects
      no significant losses in the foreseeable future .


*Index*


Page
      19





**Item
      2.**  **Management’s
      Discussion and Analysis of Financial Condition and Results of Operations
      (continued)**





**Credit
      Quality and Allowance for Loan Losses (continued)**





The
      Company has loans to a large commercial customer
      who is active in coal extraction. Recently, Management has had reason to believe
      that timely repayment of this customer’s loans may be in doubt because of
      financial difficulties. Management also believes that the financial difficulties
      of this customer are unique to this customer and not indicative of a downturn
      in
      the local coal market. The majority of the coal extracted in the Company’s
      primary service area is used to supply an electrical power plant, also located
      in the Company’s primary service area. All indications are that this electrical
      power plant will continue to operate at or near capacity into the foreseeable
      future. Therefore, it is management’s belief that the health of the coal
      extraction industry in the Company’s primary service area remains stable and,
      other than the impact of the customer discussed above, loans to this local
      industry will continue to perform.





An
      inherent risk in the lending of money is that the borrower will not be able
      to
      repay the loan under the terms of the original agreement. The allowance for
      loan
      losses provides for this risk and is reviewed periodically for adequacy. This
      review also considers concentrations of loans in terms of geography, business
      type or level of risk. While lending is geographically diversified within the
      service area, the Company does have some concentration of loans in the area
      of
      agriculture (primarily poultry farming), timber and related industries.
      Management recognizes these concentrations and considers them when structuring
      its loan portfolio.




Each
      of
      the Company's banking subsidiaries, Capon Valley Bank and The Grant County
      Bank,
      determines the adequacy of its allowance for loan losses independently. Although
      the loan portfolios of the two banks are similar to each other, some differences
      exist which result in divergent risk patterns and different charge-off rates
      amongst the functional areas of the banks’ portfolios. Each bank pays particular
      attention to individual loan performance, collateral values, borrower’s
      financial condition and economic conditions. The determination of an adequate
      allowance at each bank is done in a three step process. The first step is to
      identify impaired loans. Impaired loans are problem loans above a certain
      threshold which have estimated losses calculated based on collateral values
      and,
      to a lesser extent, projected cash flows. The second step is to identify loans
      above a certain threshold which are problem loans due to the borrower’s payment
      history or deteriorating financial condition. Losses in this category are
      determined based on historical loss rates adjusted for current economic
      conditions. The final step is to calculate a loss for the remainder of the
      portfolio using historical loss information for each type of loan
      classification. The determination of specific allowances and weighting is
      somewhat subjective and actual losses may be greater or less than the amount
      of
      the allowance. However, Management believes that the allowance represents a
      fair
      assessment of the losses that exist in the current loan portfolio.





The
      required level of the allowance for loan losses is computed quarterly and the
      allowance adjusted prior to the issuance of the quarterly financial statements.
      All loan losses charged to the allowance are approved by the boards of directors
      of each bank at their regular meetings. The allowance is reviewed for adequacy
      after considering historical loss rates, current economic conditions (both
      locally and nationally) and any known credit problems that have not been
      considered under the above formula.





Management
      has analyzed the potential risk of loss on the Company's loan portfolio given
      the loan balances and the value of the underlying collateral and has recognized
      losses where appropriate. Nonperforming loans are closely monitored on an
      ongoing basis as part of the Company's loan review process.


*Index*


Page
      20





**Item
      2.**  **Management’s
      Discussion and Analysis of Financial Condition and Results of Operations
      (continued)**





**Credit
      Quality and Allowance for Loan Losses (continued)**





The
      following table shows the allocation for loans in the loan portfolio and the
      corresponding amounts of the allowance allocated by loan type as of September
      30, 2006 and December 31, 2005 (in thousands of dollars):





September
                30, 2006
            
            December
                31, 2005Percent
                of
            
            
            
            Percent
                ofAmount
            
            Loans
            
            Amount
            
            LoansLoan
                TypeCommercial
            
            $
            1,380
            
            
            23
            %
            $
            900
            
            
            22
            %Mortgage
                and construction
            
            
            1,012
            
            
            62
            %
            
            1,139
            
            
            62
            %Consumer
            
            
            947
            
            
            15
            %
            
            1,082
            
            
            17
            %Unallocated
            
            
            41
            
            
            
            
            
            8Totals
            
            $
            3,380
            
            
            
            
            $
            3,129








As
      certain loans identified as impaired are paid current, collateral values
      increase or loans are removed from watch lists for other reasons, and as other
      loans become identified as impaired, and because delinquency levels within
      each
      of the portfolios change, the allocation of the allowance among the loan types
      may change. Management feels that the allowance is a fair representation of
      the
      losses present in the portfolio given historical loss trends, economic
      conditions and any known credit problems as of a given date. Management believes
      that the allowance is to be taken as a whole, and allocation between loan types
      is an estimation of potential losses within each type, given information known
      at the time.








The
      following table summarizes the Company’s net charge-offs by loan type for the
      nine month periods ended September 30, 2006 and 2005 (in thousands of
      dollars):





Quarter
                Ended
            
            Nine
                Months EndedSeptember
                30,
            
            September
                30,2006
            
            2005
            
            2006
            
            2005Charge-offs
            
            $
            (109
            )
            $
            (174
            )
            $
            (428
            )
            $
            (445
            )Recoveries
            
            
            42
            
            
            59
            
            
            171
            
            
            144Total
                net charge-offs
            
            
            (67
            )
            
            (115
            )
            
            (257
            )
            
            (301
            )Components
                of net charge-offsReal
                estate
            
            
            0
            
            
            (8
            )
            
            (1
            )
            
            (9
            )Commercial
            
            
            (44
            )
            
            18
            
            
            (23
            )
            
            (20
            )Consumer
            
            
            (23
            )
            
            (125
            )
            
            (233
            )
            
            (272
            )Total
            
            $
            (67
            )
            $
            (115
            )
            $
            (257
            )
            $
            (301
            )








The
      provision for loan losses taken during the first nine months of 2006 was
      $182,000 less than that taken during the same period in 2005. In spite of the
      decrease in the provision, the percentage of the allowance for loan losses
      to
      gross loans increased from 1.16% at December 31, 2005 to 1.19% at September
      30,
      2006. The ratio of allowance for loan losses to nonperforming loans was 1.56
      at
      September 30, 2006 compared to 1.62 at December 31, 2005.


*Index*


Page
      21





**Item
      2.**  **Management’s
      Discussion and Analysis of Financial Condition and Results of Operations
      (continued)**





**Non-interest
      Expense**





Non-interest
      expense increased 15.07% for the first nine months of 2006 as compared to
      2005.





The
      addition of operations and the physical assets acquired with the purchase of
      the
      National Bank of Davis had a significant impact on the increase in non-interest
      expense. This purchase added eleven full time employees and two banking
      locations, increasing both the costs of salaries and benefits and occupancy
      and
      equipment expense. Also, the increase in both loan and deposit customers as
      a
      result of this acquisition caused an increase in data processing expense.
      Additionally, costs related to the conversion of the Davis data processing
      systems into the existing systems of The Grant County Bank continued into the
      second quarter of 2006, but these conversion costs significantly reduced in
      the
      third quarter of 2006 and Management expects that in the coming quarters there
      will be no further significant additional costs related to this system
      conversion.





Not
      all
      of the increase in non-interest expense can be attributed to the increased
      operational size of the Company as a result of the purchase of the additional
      branches. Continued growth in the operations of the Company caused marginal
      increases in both data processing and other types of non-interest expenses.
      Also, customary annual pay increases contributed to the rise in salary and
      benefits expense. Directors’ fees increased as the result of an increase in the
      per-meeting fees earned by directors.





Legal
      and
      professional fees increased both from the impact of increased operational size
      and usual inflationary trends and also because of an increase in the number
      of
      on-site engagements of audit firms during 2006 as compared to 2005. The company
      experienced a decline in legal and professional fees in the third quarter of
      2006 as compared to the third quarter of last year. During the third quarter
      of
      2005, as a result of engagements related to certain regulatory compliance
      efforts, the Company experienced an abnormally high amount of on-site audit
      and
      consulting engagements, hence the decline in legal and professional fees during
      the third quarter of 2006 as compared to last year. Management does not expect
      these significant year over year decreases in quarterly legal and professional
      fees to continue, but anticipates stabilization in these types of costs.








**Borrowed
      Funds**





The
      Company borrows funds from the Federal Home Loan Bank (“FHLB”) to reduce market
      rate risks, provide liquidity, and to fund capital additions. These borrowings
      may have fixed or variable interest rates and are amortized over a period of
      one
      to twenty years, or may be comprised of single payment borrowings with periodic
      interest payments and principal amounts due at maturity. In an attempt to manage
      interest expense and interest rate risk and as the competition for deposits
      have
      increased, the Company has, during recent years, used these available debt
      vehicles to fund loan growth more frequently than was utilized in the past.





During
      the fourth quarter of 2003, the Company obtained a $2,500,000 open line of
      credit with another commercial bank. This line of credit was secured by an
      equity interest in Capon Valley Bank, a subsidiary company. This debt instrument
      was obtained as a precautionary device for funding should a need arise in the
      future. Since this line of credit was obtained, there have been no advances
      of
      funds on this debt facility. It is not anticipated that any borrowings from
      this
      debt facility will be used to fund operating or liquidity
      needs.


*Index*


Page
      22





**Item
      2.** **Management’s
      Discussion and Analysis of Financial Condition and Results of Operations
      (continued)**





**Liquidity**





Operating
      liquidity is the ability to meet present and future financial obligations.
      Short
      term liquidity is provided primarily through cash balances, deposits with other
      financial institutions, federal funds sold, non-pledged securities and loans
      maturing within one year. Additional sources of liquidity available to the
      Company include, but are not limited to, loan repayments, the ability to obtain
      deposits through the adjustment of interest rates and the purchasing of federal
      funds. To further meet its liquidity needs, the Company also maintains lines
      of
      credit with correspondent financial institutions, the Federal Reserve Bank
      of
      Richmond and the Federal Home Loan Bank of Pittsburgh.





Historically,
      the Company’s primary need for additional levels of operational liquidity has
      been to fund increases in loan balances. The
      Company has normally funded increases in loans by increasing deposits and by
      decreasing secondary liquidity sources, such as balances of Fed Funds sold
      and
      balances of securities. Although total deposit balances have decreased slightly
      in recent periods, the Company has substantially maintained or increased levels
      of these secondary liquidity resources and does not anticipate that an
      unexpectedly high level of loan demand in coming periods would impact liquidity
      to the extent that the Company would be required to pay above market rates
      to
      obtain deposits.





The
      parent Company’s operating funds, funds with which to pay shareholder dividends
      and funds for the exploration of new business ventures, have been supplied
      primarily through dividends paid by the Company’s subsidiary banks, Capon Valley
      Bank (CVB) and The Grant County Bank (GCB). The various regulatory authorities
      impose restrictions on dividends paid by a state bank. A state bank cannot
      pay
      dividends without the consent of the relevant banking authorities in excess
      of
      the total net profits of the current year and the combined retained profits
      of
      the previous two years. As of October 1, 2006, the subsidiary banks could pay
      dividends to Highlands Bankshares, Inc. of approximately $7,274,000 without
      permission of the regulatory authorities.








**Capital**





The
      Company seeks to maintain a strong capital base to expand facilities, promote
      public confidence, support current operations and grow at a manageable level.
      As
      of September 30, 2006, the Company was above the regulatory minimum levels
      of
      capital. The table below summarizes the capital ratios for the Company and
      its
      subsidiary banks as of September 30, 2006 and December 31, 2005:





September
                30, 2006
            
            December
                31, 2005Actual
            
            Regulatory
            
            Actual
            
            RegulatoryRatio
            
            Minimum
            
            Ratio
            
            MinimumTotal
                Risk Based Capital RatioHighlands
                Bankshares
            
            
            13.67
            %
            
            8.00
            %
            
            13.85
            %
            
            8.00
            %Capon
                Valley Bank
            
            
            14.39
            %
            
            8.00
            %
            
            13.45
            %
            
            8.00
            %The
                Grant County Bank
            
            
            12.77
            %
            
            8.00
            %
            
            13.67
            %
            
            8.00
            %Tier
                1 Leverage RatioHighlands
                Bankshares
            
            
            9.47
            %
            
            3.00
            %
            
            9.45
            %
            
            3.00
            %Capon
                Valley Bank
            
            
            9.49
            %
            
            3.00
            %
            
            8.87
            %
            
            3.00
            %The
                Grant County Bank
            
            
            9.03
            %
            
            3.00
            %
            
            8.81
            %
            
            3.00
            %Tier
                1 Risk Based Capital RatioHighlands
                Bankshares
            
            
            12.44
            %
            
            4.00
            %
            
            12.60
            %
            
            4.00
            %Capon
                Valley Bank
            
            
            13.13
            %
            
            4.00
            %
            
            12.20
            %
            
            4.00
            %The
                Grant County Bank
            
            
            11.55
            %
            
            4.00
            %
            
            12.47
            %
            
            4.00
            %





*Index*


Page
      23





**Item
      2.** **Management’s
      Discussion and Analysis of Financial Condition and Results of Operations
      (continued)**





**Effects
      of Inflation**





Inflation
      primarily affects industries having high levels of property, plant and equipment
      or inventories. Although the Company is not significantly affected in these
      areas, inflation does have an impact on the growth of assets. As assets grow
      rapidly, it becomes necessary to increase equity capital at proportionate levels
      to maintain the appropriate equity to asset ratios. Traditionally, the Company's
      earnings and high capital retention levels have enabled the Company to meet
      these needs. The
      Company's reported earnings results have been minimally affected by inflation.
      The different types of income and expense are affected in various ways. Interest
      rates are affected by inflation, but the timing and magnitude of the changes
      may
      not coincide with changes in the consumer price index. Management actively
      monitors interest rate sensitivity in order to minimize the effects of
      inflationary trends on interest rates. Other areas of non-interest expenses
      may
      be more directly affected by inflation.








**Item
      3.**  **Quantitative
      and Qualitative Disclosures About Market Risk**





There
      have been no material changes in Quantitative and Qualitative Disclosures about
      Market Risk as reported in the Company’s Annual Report on Form 10-K for the
      period ended December 31, 2005.





**Item
      4.**  **Controls
      and Procedures**





The
      Company’s management, with the participation of the Company’s Chief Executive
      Officer and Chief Financial Officer, has evaluated the effectiveness of the
      Company’s disclosure controls and procedures as of September 30, 2006. Based on
      this evaluation, the Company’s Chief Executive Officer and Chief Financial
      Officer concluded that the Company’s disclosure controls and procedures are
      effective as of September 30, 2006. The company has established procedures
      undertaken during the normal course of business in an effort to reasonably
      ensure that fraudulent activity of either an amount material to these results
      or
      in any amount is not occurring.





Changes
      in Internal Controls





During
      the period reported upon, there were no significant changes in internal controls
      of Highlands Bankshares, Inc. pertaining to its financial reporting and control
      of its assets or in other factors that materially affected or are reasonably
      likely to materially affect such control.





Contained
      within the Company’s Report on Form 10-Q for the period ended March 31, 2006 and
      Report on Form 10-K for the year ended December 31, 2005 and in both instances
      under PART I, Item 4, the Company reported a requirement for additional controls
      to reasonably ensure that fraud of a material, or of any, amount were not
      occurring in relation to the purchase of the National Bank of Davis (Davis).
      In
      early April, 2006, all legacy Davis systems were merged fully with the systems
      of The Grant County Bank (Grant). Therefore, the requirement for additional
      controls related to this purchase are no longer necessary as the controls
      inherent to Grant’s operations are now sufficient to reasonably ensure that
      fraud of a material, or of any, amount is detected or prevented.


*Index*


Page
      24





**PART
      II**  **OTHER
      INFORMATION**





**Item
      1.**  **Legal
      Proceedings**





Management
      is not aware of any material pending or threatened litigation in which the
      Company or its subsidiaries may be involved as a defendant. In the normal course
      of business, the banks periodically must initiate suits against borrowers as
      a
      final course of action in collecting past due loans. In addition, to
      management’s knowledge, no governmental authorities have initiated or
      contemplated legal action against the Company.





In
      late
      February of 2006, a third party alleged that an error had been made regarding
      the safekeeping of a deposit, specifically two certificates of deposit totaling
      $2,000,000 that had been assigned as collateral for a performance bond, had
      been
      released to the owners. It was alleged that the error was related to a trust
      account held by the now discontinued subsidiary of Highlands, Highlands
      Bankshares Trust Company. This third party indicated that if it experienced
      a
      loss relating to this bond, that it may pursue legal action as a potential
      remedy for this loss.  Highlands
      has determined that the funds represented by the certificate of deposit had
      previously been delivered to the third party complainant. At this time, the
      potential for legal action or the amount of any potential liability to Highlands
      Bankshares or its subsidiaries is unknown.








**Item1A.
      Risk Factors**





There
      have been no material changes to the Company’s risk factors since these factors
      were previously disclosed in the Company’s Annual Report on Form 10-K for the
      period ended December 31, 2005.





**Item
      2.**  **Unregistered
      Sales of Equity Securities and Use of Proceeds.**





None





**Item
      3.**  **Defaults
      Upon Senior Securities**





None





**Item
      4.**  **Submission
      of Matters to a Vote of Security Holders**





None





**Item
      5.**  **Other
      Information**





None





**Item
              6.**
            **Exhibits**3(i)
            Articles
                of Incorporation of Highlands Bankshares, Inc. are incorporated by
                reference to Appendix C to Highlands Bankhares, Inc.’s Form S-4 filed
                October 20, 1986.3(ii)
            Bylaws
                of Highlands Bankshares, Inc. are incorporated by reference to Exhibit
                3(ii) to Highlands Bankshares, Inc.’s Form 10-Q filed May 15,
                2003.31.1
            Certification
                of Chief Executive Officer Pursuant to section 302 of the Sarbanes-Oxley
                Act of 2002 Chapter 63, Title 18 U.S.C. Section 1350 (A) and
                (B).31.2
            Certification
                of Chief Financial Officer Pursuant to section 302 of the Sarbanes-Oxley
                Act of 2002 Chapter 63, Title 18 U.S.C. Section 1350 (A) and
                (B).32.1
            Statement
                of Chief Executive Officer Pursuant to 18 U.S.C. §
1350.32.2
            Statement
                of Chief Financial Officer Pursuant to 18 U.S.C. §
                1350.





*Index*


Page
      25




Signatures











Pursuant
      to the requirements of the Securities Exchange Act of 1934, the Registrant
      has
      duly caused this report to be signed on its behalf by the undersigned thereunto
      duly authorized.





HIGHLANDS
                BANKSHARES, INC./s/
                C.E. PorterC.E.
                PorterPresident
                & Chief Executive Officer/s/
                R. Alan MillerR.
                Alan MillerChief
                Financial OfficerChief
                Accounting OfficerNovember
                10, 2006