|UNITED STATES                     
|----------------------------------
|SECURITIES AND EXCHANGE COMMISSION
|Washington, D.C. 20549            
|                                  
|FORM 10-Q                         
|                                  
|[X]                               
|                                  

|For the quarterly period ended | June 30, 2006                                                                           
|------------------------------ | ----------------------------------------------------------------------------------------
|                               |                                                                                         
|                              
|or                            
|                              
|[   ]                          | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
|                              

|For the transition period from                                                                                                                                                                                                                                                                                                                                                      |         | to                                   | 
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------- | ------------------------------------ | 
|                                                                                                                                                                                                                                                                                                                                                                                    |         |                                      | 
|                                                                                                                                                                                                                                                                                                                                                                                   
|Commission file number:                                                                                                                                                                                                                                                                                                                                                             | 0-11595
|                                                                                                                                                                                                                                                                                                                                                                                    |        
|                                                                                                                                                                                                                                                                                                                                                                                   
|Merchants Bancshares, Inc.                                                                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                                                                                                   
|(Exact name of registrant as specified in its charter)                                                                                                                                                                                                                                                                                                                             
|                                                                                                                                                                                                                                                                                                                                                                                   
|Delaware                                                                                                                                                                                                                                                                                                                                                                            |         | 03-0287342                          
|                                                                                                                                                                                                                                                                                                                                                                                    |         |                                     
|(State or other jurisdiction of incorporation
or organization)                                                                                                                                                                                                                                                                                                                      |         | (I.R.S. Employer Identification No.)
|                                                                                                                                                                                                                                                                                                                                                                                   
|275 Kennedy Drive, South Burlington, Vermont                                                                                                                                                                                                                                                                                                                                        |         | 05403                               
|                                                                                                                                                                                                                                                                                                                                                                                    |         |                                     
|(Address of principal executive offices)                                                                                                                                                                                                                                                                                                                                            |         | (Zip Code)                          
|                                                                                                                                                                                                                                                                                                                                                                                   
|802-658-3400                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                   
|(Registrant's telephone number, including area code)                                                                                                                                                                                                                                                                                                                               
|                                                                                                                                                                                                                                                                                                                                                                                   
|                                                                                                                                                                                                                                                                                                                                                                                   
|(Former name, former address and former fiscal year, if changed since last report)                                                                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                                   
|Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 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.    [X]  Yes      [   ]  No
|                                                                                                                                                                                                                                                                                                                                                                                   
|Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a nonaccelerated filer. See the definition of "accelerated filer" and "large accelerated filer" in Rule 12b-2 of the Exchange Act.                                                                                                                                             
|                                                                                                                                                                                                                                                                                                                                                                                   
|Large Accelerated Filer  [   ]      Accelerated Filer  [X]      Nonaccelerated Filer  [   ]                                                                                                                                                                                                                                                                                        
|                                                                                                                                                                                                                                                                                                                                                                                   
|Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).                                                                                                                                                                                                                                                                   
|[   ]  Yes      [X]  No                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                   
|As of July 26, 2006, there were 6,263,952 shares of the registrant's Common stock, par value $0.01 per share, outstanding.                                                                                                                                                                                                                                                         

<PAGE>

|MERCHANTS BANCSHARES, INC.    
|------------------------------
|FORM 10-Q                     
|TABLE OF CONTENTS             
|                              
|PART I - FINANCIAL INFORMATION
|                              
|Item  1.                      
|                              
|                              
|                              
|                              
|                              
|                              
|                              
|                              
|                              
|Item  2.                      
|                              
|Item  3.                      
|Item  4.                      
|                              
|PART II - OTHER INFORMATION   
|                              
|Item  1.                      
|Item  1A.                     
|Item  2.                      
|Item  3.                      
|Item  4.                      
|Item  5.                      
|Item  6.                      
|Signatures                    
|Exhibits                      

<PAGE>

|MERCHANTS BANCSHARES, INC.                                              
|------------------------------------------------------------------------
|PART I - FINANCIAL INFORMATION                                          
|                                                                        
|ITEM 1. Financial Statements                                            
|                                                                        
|Merchants Bancshares, Inc.                                              
|Consolidated Balance Sheets                                             
|                                                                        
|                                                                        
|(In thousands except share data)                                        
|                                                                        
|ASSETS                                                                  
|Cash and due from banks                                                 
|Investments:                                                            
|Securities available for sale                                           
|Securities held to maturity (fair value of $6,674 and $8,001)           
|                                                                        
|Total investments                                                       
|                                                                        
|Loans                                                                   
|Less: Allowance for loan losses                                         
|                                                                        
|Net loans                                                               
|                                                                        
|Federal Home Loan Bank stock                                            
|Bank premises and equipment, net                                        
|Investment in real estate limited partnerships                          
|Other real estate owned                                                 
|Other assets                                                            
|                                                                        
|Total assets                                                            
|                                                                        
|LIABILITIES                                                             
|Deposits:                                                               
|Demand deposits                                                         
|Savings, NOW and money market accounts                                  
|Time deposits $100 thousand and greater                                 
|Other time deposits                                                     
|                                                                        
|Total deposits                                                          
|                                                                        
|Demand note due U.S. Treasury                                           
|Other short-term borrowings                                             
|Other liabilities                                                       
|Long-term debt                                                          
|Securities sold under agreement to repurchase                           
|Junior subordinated debentures issued to unconsolidated subsidiary trust
|                                                                        
|Total liabilities                                                       
|                                                                        
|Commitments and contingencies (Note 6)                                  
|SHAREHOLDERS' EQUITY                                                    
|Preferred stock Class A non-voting                                      
|Shares authorized - 200,000, none outstanding                           
|Preferred stock Class B voting                                          
|Shares authorized - 1,500,000, none outstanding                         
|Common stock, $.01 par value                                            
|Shares authorized                                                       
|Issued                                                                  
|                                                                        
|Outstanding                                                             
|                                                                        
|Capital in excess of par value                                          
|Retained earnings                                                       
|Treasury stock, at cost                                                 
|                                                                        
|                                                                        
|Deferred compensation arrangements                                      
|Accumulated other comprehensive loss                                    
|                                                                        
|Total shareholders' equity                                              
|                                                                        
|Total liabilities and shareholders' equity                              
|                                                                        
|                                                                        
|See accompanying notes to interim consolidated financial statements     

<PAGE>  1

|Merchants Bancshares, Inc.                                         
|-------------------------------------------------------------------
|Consolidated Statements of Income                                  
|(Unaudited)                                                        
|                                                                   
|                                                                   
|                                                                   
|(In thousands except per share data)                               
|                                                                   
|INTEREST AND DIVIDEND INCOME                                       
|Interest and fees on loans                                         
|Interest and dividends on investments                              
|U.S. Treasury and Agency obligations                               
|Other                                                              
|                                                                   
|Total interest and dividend income                                 
|                                                                   
|INTEREST EXPENSE                                                   
|Savings, NOW and money market accounts                             
|Time deposits $100 thousand and greater                            
|Other time deposits                                                
|Other borrowed funds                                               
|Long-term debt                                                     
|                                                                   
|Total interest expense                                             
|                                                                   
|Net interest income                                                
|Provision for loan losses                                          
|                                                                   
|Net interest income after provision for loan losses                
|                                                                   
|NONINTEREST INCOME                                                 
|Trust company income                                               
|Service charges on deposits                                        
|Gains on sales of investment securities, net                       
|Equity in losses of real estate limited partnerships, net          
|Other                                                              
|                                                                   
|Total noninterest income                                           
|                                                                   
|NONINTEREST EXPENSE                                                
|Salaries and wages                                                 
|Employee benefits                                                  
|Occupancy expense, net                                             
|Equipment expense                                                  
|Legal and professional fees                                        
|Marketing                                                          
|State franchise taxes                                              
|Other                                                              
|                                                                   
|Total noninterest expense                                          
|                                                                   
|Income before provision for income taxes                           
|Provision for income taxes                                         
|                                                                   
|NET INCOME                                                         
|                                                                   
|                                                                   
|Basic earnings per common share                                    
|Diluted earnings per common share                                  
|                                                                   
|See accompanying notes to interim consolidated financial statements

<PAGE>  2

|Merchants Bancshares, Inc.                                             
|-----------------------------------------------------------------------
|Consolidated Statements of Comprehensive Income                        
|(Unaudited)                                                            
|                                                                       
|                                                                       
|                                                                       
|(In thousands)                                                         
|                                                                       
|Net income                                                             
|Change in net unrealized loss on securities                            
|available for sale, net of taxes of $(684), $1,139, $(1,828) and $(624)
|Reclassification adjustments for net securities gains                  
|included in net income, net of taxes of $0, $(8), $0 and $(29)         
|                                                                       
|Comprehensive income before transfers                                  
|Impact of transfer of securities from available for sale               
|to held to maturity, net of taxes of $0, $(1), $0 and $(2)             
|                                                                       
|Comprehensive income                                                   
|                                                                       
|                                                                       
|See accompanying notes to interim consolidated financial statements    

<PAGE>  3

|Merchants Bancshares, Inc.                                          
|--------------------------------------------------------------------
|Consolidated Statements of Cash Flows                               
|(Unaudited)                                                         
|                                                                    
|For the three months ended June 30,                                 
|                                                                    
|(In thousands)                                                      
|CASH FLOWS FROM OPERATING ACTIVITIES:                               
|Net income                                                          
|Adjustments to reconcile net income to net cash provided by         
|Operating activities:                                               
|Depreciation and amortization                                       
|Net gains on sales of investment securities                         
|Net losses on disposition of premises and equipment                 
|Equity in losses of real estate limited partnerships                
|Changes in assets and liabilities:                                  
|Increase in interest receivable                                     
|Decrease in other assets                                            
|(Decrease) increase in interest payable                             
|Increase in other liabilities                                       
|                                                                    
|Net cash provided by operating activities                           
|                                                                    
|                                                                    
|CASH FLOWS FROM INVESTING ACTIVITIES:                               
|Proceeds from sales of investment securities available for sale     
|Proceeds from maturities of investment securities available for sale
|Proceeds from maturities of investment securities held to maturity  
|Proceeds from sale of Federal Home Loan Bank stock                  
|Purchases of investment securities available for sale               
|Loan originations in excess of principal payments                   
|Purchases of Federal Home Loan Bank stock                           
|Investments in real estate limited partnerships                     
|Purchases of bank premises and equipment                            
|                                                                    
|Net cash used in investing activities                               
|                                                                    
|                                                                    
|CASH FLOWS FROM FINANCING ACTIVITIES:                               
|Net increase in deposits                                            
|Net decrease in short-term borrowings                               
|Proceeds from long-term debt                                        
|Net increase in securities sold under agreement to repurchase       
|Principal payments on long-term debt                                
|Cash dividends paid                                                 
|Purchases of treasury stock                                         
|Sale of treasury stock                                              
|Increase (decrease) in deferred compensation arrangements           
|Proceeds from exercise of stock options                             
|Tax benefit from exercise of stock options                          
|                                                                    
|Net cash provided by financing activities                           
|                                                                    
|                                                                    
|Decrease in cash and cash equivalents                               
|Cash and cash equivalents beginning of year                         
|                                                                    
|Cash and cash equivalents end of period                             
|                                                                    
|                                                                    
|SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:                   
|Total interest payments                                             
|Total income tax payments                                           
|SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND                   
|FINANCING ACTIVITIES                                                
|Distribution of stock under deferred compensation arrangements      
|Distribution of treasury stock in lieu of cash dividend             
|Transfer of loans to other real estate owned                        
|                                                                    
|See accompanying notes to interim consolidated financial statements 

<PAGE>  4

|Notes To Interim Consolidated Financial Statements                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|See Merchants Bancshares, Inc. ("Merchants") 2005 Annual Report on Form 10-K for additional information.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|Note 1: Financial Statement Presentation                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements. All adjustments necessary for a fair presentation of the interim consolidated financial statements of Merchants as of June 30, 2006, and for the three and six months ended June 30, 2006 and 2005, have been included. The information was prepared from the unaudited financial statements of Merchants and its subsidiaries, Merchants Bank, Merchants Trust Company, Merchants Properties, Inc. and MBVT Statutory Trust I.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|Note 2: Stock-based Compensation                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|Merchants has granted stock options to certain key employees. The options are exercisable immediately after the two-year vesting period. Nonqualified stock options may be granted at any price determined by the Nominating and Governance Committee of Merchants' Board of Directors. All stock options have been granted at or above fair market value at the date of grant.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|On January 1, 2006, Merchants adopted the provisions of FASB's revised statement No. 123 ("FAS 123R"), "Share-Based Payment," using a modified prospective application. Based on the fact that Merchants has not granted options since August 2001, and all options previously granted have vested, the adoption of FAS 123R did not have any impact on Merchants' financial position or results of operations. However, Merchants may grant stock options in the future.                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|The fair value of each option grant is estimated on the grant date using the Black-Scholes option-pricing model. Under SFAS No. 123R, Merchants' net income and earnings per share for the three and six month periods ended June 30, 2006 and 2005 would have been the same as the amounts reported in the accompanying interim consolidated financial statements as all options are already vested. Pro forma compensation expense for options granted is reflected over the vesting period; therefore, future pro forma compensation expense may be greater if additional options are granted. A summary of option activity as of June 30, 2006, and changes during the six months then ended is presented below:                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           

| |                                |                |          | Weighted     |                 | 
| | ------------------------------ | -------------- | -------- | ------------ | --------------- | 
| |                                |                | Weighted | Average      |                 | 
| |                                | Number Of      | Average  | Remaining    | Aggregate       | 
| |                                | Shares         | Exercise | Contractual  | Intrinsic Value | 
| | Options                        | (in thousands) | Price    | Term (years) | (in thousands)  | 
| |                                |               
| | Outstanding at January 1, 2006 | 204            | $17.96   | --           | --              | 
| | Granted                        | --             | --       | --           | --              | 
| | Exercised                      | 33             | 15.00    | --           | --              | 
| | Forfeited or expired           | --             | --       | --           | --              | 
| |                                |               
| | Outstanding at June 30, 2006   | 171            | $18.52   | 2.4          | $964            | 
| |                                |               
| | Exercisable at June 30, 2006   | 171            | $18.52   | 2.4          | $964            | 
| |                                |               

|The total intrinsic value of options exercised during the six months ended June 30, 2006 and 2005, was $293 thousand and $772 thousand, respectively.
|-----------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                     
|Note 3: Earnings Per Share                                                                                                                           
|The following tables present reconciliations of the calculations of basic and diluted earnings per common share for the periods indicated:           

<PAGE>  5

| |                                                |   |                                  | Weighted  |   |          
| | ---------------------------------------------- | - | -------------------------------- | --------- | - | ---------
| |                                                |   | Net                              | Average   |   | Per Share
| | (In thousands except share and per share data) |   | Income                           | Shares    |   | Amount   
| |                                               
| |                                                |   | Three months ended June 30, 2006
| | Basic earnings per common share:               |   |                                  |           |   |          
| | Net income available to common                 |   |                                  |           |   |          
| | shareholders                                   | $ | 2,671                            | 6,289,468 | $ | 0.42     
| | Diluted earnings per common share:             |   |                                  |           |   |          
| | Effect of dilutive stock options               |   | --                               | 25,736    |   | --       
| | Net income available to common                 |   |                                  |           |   |          
| | shareholders and stock option exercise         |   | 2,671                            | 6,315,204 |   | 0.42     
| |                                                |   |                                  |           |   |          
| |                                                |   | Three months ended June 30, 2005
| | Basic earnings per common share:               |   |                                  |           |   |          
| | Net income available to common                 |   |                                  |           |   |          
| | shareholders                                   | $ | 3,057                            | 6,316,227 | $ | 0.48     
| | Diluted earnings per common share:             |   |                                  |           |   |          
| | Effect of dilutive stock options               |   | --                               | 42,279    |   | --       
| | Net income available to common                 |   |                                  |           |   |          
| | shareholders and stock option exercise         |   | 3,057                            | 6,358,506 |   | 0.48     
| |                                                |   |                                  |           |   |          
| |                                                |   | Six months ended June 30, 2006  
| | Basic earnings per common share:               |   |                                  |           |   |          
| | Net income available to common                 |   |                                  |           |   |          
| | shareholders                                   | $ | 5,393                            | 6,295,759 | $ | 0.85     
| | Diluted earnings per common share:             |   |                                  |           |   |          
| | Effect of dilutive stock options               |   | --                               | 25,825    |   | --       
| | Net income available to common                 |   |                                  |           |   |          
| | shareholders and stock option exercise         |   | 5,393                            | 6,321,584 |   | 0.85     
| |                                                |   |                                  |           |   |          
| |                                                |   | Six months ended June 30, 2005  
| | Basic earnings per common share:               |   |                                  |           |   |          
| | Net income available to common                 |   |                                  |           |   |          
| | shareholders                                   | $ | 5,957                            | 6,322,872 | $ | 0.94     
| | Diluted earnings per common share:             |   |                                  |           |   |          
| | Effect of dilutive stock options               |   | --                               | 43,270    |   | --       
| | Net income available to common                 |   |                                  |           |   |          
| | shareholders and stock option exercise         |   | 5,957                            | 6,366,142 |   | 0.94     
| |                                                |   |                                  |           |   |          

|Basic earnings per common share were computed by dividing net income by the weighted average number of shares of common stock outstanding for the three and six month periods ended June 30, 2006 and 2005. As of June 30, 2006 and 2005, there were no anti-dilutive stock options outstanding.                                                                                                                                                                                                                                                                                                                                                                                               
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Note 4: Pension                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|Prior to January 1995 Merchants maintained a noncontributory defined benefit plan (the "Plan") covering all eligible employees. The Plan was a final average pay plan with benefits based on the average salary rates over the last five of ten consecutive Plan years that produce the highest average. It was Merchants' policy to fund the cost of benefits expected to accrue during the year plus amortization of any unfunded accrued liability that had accumulated prior to the valuation date based on IRS regulations for funding. During 1995 the Plan was curtailed. Accordingly, all accrued benefits were fully vested and no additional years of service or age will be accrued.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|The following table summarizes the components of net periodic benefit costs for the periods indicated:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         

<PAGE>  6

| |                                | Pension Benefits
| | ------------------------------ | ----------------
| |                                |                 
| |                                | Three months    
| |                                | ended June 30,  
| | (In thousands)                 | 2006            
| |                               
| | Interest cost                  | $               
| | Expected return on Plan assets |                 
| | Amortization of net loss       |                 
| |                                |                 
| | Net periodic benefit cost      | $               
| |                                |                 
| |                                |                 

|No contributions have been made to the pension plan during 2006 to date. Merchants has no required contribution for 2006.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|Note 5: Stock Repurchase Program                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|In October 2005 Merchants' Board of Directors approved a stock repurchase program, pursuant to which Merchants may repurchase 200,000 shares of its common stock from time to time through October 2006. Merchants has purchased 70,006 shares of its common stock on the open market under the plan, at an average per share price of $24.25, of which 67,900 shares were purchased during the first six months of 2006.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|Note 6: Commitments and Contingencies                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Merchants is a party to financial instruments with off balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments primarily include commitments to extend credit and financial guarantees. Such instruments involve, to varying degrees, elements of credit and interest rate risk that are not recognized in the accompanying consolidated balance sheets.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|Merchants does not issue any guarantees that would require liability recognition or disclosure, other than its standby letters of credit. Standby letters of credit are conditional commitments issued by Merchants to guarantee the performance of a customer to a third party. Standby letters of credit generally arise in connection with lending relationships. The credit risk involved in issuing these instruments is essentially the same as that involved in extending loans to customers. Contingent obligations under standby letters of credit totaled approximately $6.13 million at June 30, 2006 and represent the maximum potential future payments Merchants could be required to make. Typically, these instruments have terms of 12 months or less and expire unused; therefore, the total amounts do not necessarily represent future cash requirements. Each customer is evaluated individually for creditworthiness under the same underwriting standards used for commitments to extend credit for on balance sheet instruments. Merchants' policies governing loan collateral apply to standby letters of credit at the time of credit extension. Loan-to-value ratios are generally consistent with loan-to-value requirements for other commercial loans secured by similar types of collateral. The fair value of Merchants' standby letters of credit at June 30, 2006 was insignificant.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|Merchants is involved in routine legal proceedings that occur in the ordinary course of business, which, in the aggregate, are believed by management to be immaterial to its financial condition and results of operations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|Note 7: Reclassifications                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|Amounts reported for prior periods are reclassified, where necessary, to be consistent with the current period presentation.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|Note 8: Accounting Pronouncements                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|In July 2006 the Financial Accounting Standards Board ("FASB") issued Financial Accounting Standards Interpretation No. 48 ("FIN 48"), "Accounting for Uncertainty in Income Taxes." FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with FASB Statement No. 109, "Accounting for Income Taxes." FIN 48 prescribes a recognition threshold and measurement attributable for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosures and transitions. FIN 48 is effective for fiscal years beginning after December 15, 2006. Merchants is currently analyzing the potential effects of FIN 48.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       

<PAGE>  7

|In March 2006, the FASB also issued Statement of Financial Accounting Standards No. 156 ("SFAS 156"), "Accounting for Servicing of Financial Assets." This statement amends Financial Accounting Standards No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," with respect to the accounting for separately recognized servicing assets and servicing liabilities. SFAS 156 requires companies to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract. The statement permits a company to choose either the amortized cost method or fair value measurement method for each class of separately recognized servicing assets. This statement is effective as of the beginning of a company's first fiscal year after September 15, 2006. Merchants is in the process of analyzing the impact of SFAS 156.
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|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|Forward Looking Statements                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|Except for the historical information contained herein, this Quarterly Report on Form 10-Q of Merchants may contain forward looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Investors are cautioned that forward looking statements are inherently uncertain. Actual performance and results of operations may differ materially from those projected or suggested in the forward looking statements due to certain risks and uncertainties, including, without limitation:                                                                                                                                                                                                                                                                                                                                                                
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|(i)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|(ii)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|(iii)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|(iv)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|(v)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|(vi)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|(vii)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|(viii)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 

<PAGE>  8

|(ix)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |  | the fact that Merchants actively evaluates acquisition and other expansion opportunities and strategies, the implementation of which could affect Merchants' financial performance.                                                                                               
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|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|These factors, as well as general economic and market conditions in the United States, may materially and adversely affect the market price of shares of Merchants' common stock. Because of these and other factors, including, without limitation, those set forth in Merchants' filings with the Securities Exchange Commission, past financial performance should not be considered an indicator of future performance. The forward looking statements contained herein represent Merchants' judgment as of the date of this Form 10-Q; Merchants cautions readers not to place undue reliance on such statements.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|General                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|All adjustments necessary for a fair presentation of the interim consolidated financial statements of Merchants as of June 30, 2006, and for the three and six months ended June 30, 2006 and 2005, have been included. The information was prepared from the unaudited financial statements of Merchants and its subsidiaries, Merchants Bank, Merchants Trust Company, Merchants Properties, Inc. and MBVT Statutory Trust I.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Results of Operations                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|Overview                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|Net income for the second quarter of 2006 was $2.67 million, and was $5.39 million for the first six months of 2006, compared to net income of $3.06 million for the second quarter and $5.96 million for the first six months of 2005. The return on average assets and return on average equity for the second quarter of 2006 were 0.96% and 16.62%, respectively, compared to 1.15% and 18.89%, respectively, for the second quarter of 2005. The return on average assets and return on average equity for the first six months of 2006 were 0.98% and 16.55%, respectively, compared to 1.13% and 18.29% for the first six months of 2005. The following were the major factors contributing to the results for the first six months of 2006 compared to the first six months of 2005:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|*                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |  | The decrease in net income was primarily driven by a decrease in net interest income, which decreased $466 thousand for the second quarter of 2006 compared to 2005, and $851 thousand for the first six months of 2006 compared to 2005, reflecting continued margin compression;
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |  |                                                                                                                                                                                                                                                                                   
|*                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |  | Noninterest income increased $174 thousand for the second quarter of 2006 compared to 2005, and $286 thousand for the first half of 2006 compared to 2005. Merchants experienced increases in both its overdraft fee income and in fees generated by electronic banking;          
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |  |                                                                                                                                                                                                                                                                                   
|*                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |  | Average quarterly loans increased $49.26 million, or 8.3%, over the second quarter of 2005;                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |  |                                                                                                                                                                                                                                                                                   
|*                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |  | Average quarterly deposits increased $13.49 million, or 1.6%, over the second quarter of 2005.                                                                                                                                                                                    
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Net Interest Income                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|Merchants' net interest income decreased $466 thousand for the second quarter of 2006 compared to 2005 and $851 thousand for the first six months of 2006 compared to 2005. This decrease is attributable to several factors. Merchants' liability sensitivity increased over the past year while short-term interest rates continued to climb and the yield curve flattened further, leading to additional margin compression. Merchants' combined commercial mortgage and commercial loan portfolio continued to shift from variable rate to fixed rate as customers locked in their rates in the current flat yield curve environment. Additionally, out of Merchants' approximately $180 million in variable rate commercial mortgage and commercial loans, $102 million have interest rate caps and $69 million have hit those caps. These factors have mitigated Merchants' ability to take advantage of increases in the prime rate over the past year. At the same time, as shown in the table on pages 12-13, Merchants' deposits have shifted from lower cost savings, NOW and money market accounts to higher rate time deposits as Merchants has responded to competitive pressures by offering higher rate time deposit and CD specials instead of making even greater changes in money market account rates. Merchants' short-term borrowing position consists primarily of borrowings from the Federal Home Loan Bank of Boston ("FHLB"). Increases in rates on these borrowings mirror movements in the federal funds rate, and the average cost of this funding source has increased 190 basis points over the past year. Merchants' net interest income was also negatively impacted by a change in the dividend policy at the FHLB. In response to new proposed regulations by the Federal Housing Finance board, the FHLB changed its dividend declaration schedule such that the dividend for the second quarter, which historically has been declared in June, is scheduled to be declared in August and paid in September; as a result, $108 thousand in dividend income that would have been recognized during the second quarter of 2006 was not recognized during the quarter, negatively impacting the net interest margin for the quarter by approximately four basis points. Although the FHLB has announced that it anticipates "grossing up" the

<PAGE>  9

|dividend to include both the second and third quarters, there is no guarantee that a dividend will be declared and paid, or that it will cover two quarters. The combination of these factors, along with the flat to inverted yield curve environment, has resulted in decreased net interest income in spite of overall balance sheet growth.                                                                                                 
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|                                                                                                                                                                                                                                                                                                                                                                                                                                                
|Merchants is working to mitigate the effect of the current interest rate environment by taking advantage of alternative funding sources, and has rolled out a new cash management sweep product utilizing a repurchase agreement arrangement at a lower cost of funds than other short term borrowing alternatives. Balances in this product are now in excess of $50 million. Merchants continues to evaluate other lower cost funding sources.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                
|The following table attributes changes in Merchants' net interest income (on a fully taxable equivalent basis) to changes in either average balances or average rates for the three and six months ended June 30, 2006.  Changes due to both interest rate and volume have been allocated to change due to balance and change due to rate in proportion to the relationship of the absolute dollar amounts of the change in each:               



<PAGE>  10

|Analysis of Changes in Fully Taxable Equivalent Net Interest Income
|-------------------------------------------------------------------
|                                                                   
|Three Months Ended June 30, 2006                                   
|                                                                   
|                                                                   
|                                                                   
|(In thousands)                                                     
|                                                                   
|Fully Taxable Equivalent Interest Income:                          
|Loans                                                              
|Investments                                                        
|Federal Funds Sold, Securities Sold Under                          
|Agreements to Repurchase and Interest                              
|Bearing Deposits with Banks                                        
|                                                                   
|Total Interest Income                                              
|                                                                   
|Less Interest Expense:                                             
|Savings, Money Market & NOW Accounts                               
|Time Deposits                                                      
|Short-term Borrowings                                              
|Long-term Debt                                                     
|Securities sold under agreement to repurchase                      
|Junior Subordinated debt                                           
|                                                                   
|Total Interest Expense                                             
|                                                                   
|Net Interest Income                                                
|                                                                   
|                                                                   
|Six Months Ended June 30, 2006                                     
|                                                                   
|                                                                   
|                                                                   
|(In thousands)                                                     
|                                                                   
|Fully Taxable Equivalent Interest Income:                          
|Loans                                                              
|Investments                                                        
|Federal Funds Sold, Securities Sold Under                          
|Agreements to Repurchase and Interest                              
|Bearing Deposits with Banks                                        
|                                                                   
|Total Interest Income                                              
|                                                                   
|Less Interest Expense:                                             
|Savings, Money Market & NOW Accounts                               
|Time Deposits                                                      
|Short-term Borrowings                                              
|Long-term Debt                                                     
|Securities sold under agreement to repurchase                      
|Junior Subordinated debt                                           
|                                                                   
|Total Interest Expense                                             
|                                                                   
|Net Interest Income                                                
|                                                                   
|                                                                   

|The following tables set forth certain information regarding net interest margin for the three and six months ended June 30, 2006 and 2005. For the periods indicated, the total dollar amount of interest income from average earning assets and the resultant yields, as well as the interest expense on average interest bearing liabilities, are expressed both in dollars and rates, and on a tax equivalent basis.
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<PAGE>  11

|Merchants Bancshares, Inc.                                            
|----------------------------------------------------------------------
|Average Balance Sheets and Average Rates                              
|(Unaudited)                                                           
|                                                                      
|                                                                      
|                                                                      
|                                                                      
|                                                                      
|                                                                      
|                                                                      
|(In thousands, fully taxable equivalent)                              
|                                                                      
|ASSETS:                                                               
|Loans, including fees on loans (1)                                    
|Taxable investments                                                   
|Federal funds sold, securities purchased under                        
|agreements to resell and interest bearing                             
|deposits with banks                                                   
|                                                                      
|Total interest earning assets                                         
|                                                                      
|Allowance for loan losses                                             
|Cash and due from banks                                               
|Premises and equipment, net                                           
|Other assets                                                          
|                                                                      
|Total assets                                                          
|                                                                      
|                                                                      
|LIABILITIES AND SHAREHOLDERS'                                         
|EQUITY:                                                               
|Interest bearing deposits:                                            
|Savings, NOW & money market accounts                                  
|Time deposits                                                         
|                                                                      
|Total interest bearing deposits                                       
|                                                                      
|Short-term borrowings                                                 
|Long-term debt                                                        
|Securities sold under agreement to repurchase                         
|Junior subordinated debentures issued to                              
|Unconsolidated subsidiary trust                                       
|                                                                      
|Total interest bearing liabilities                                    
|                                                                      
|Noninterest bearing deposits                                          
|Other liabilities                                                     
|Shareholders' equity                                                  
|                                                                      
|Total liabilities and shareholders' equity                            
|                                                                      
|                                                                      
|Net interest earning assets                                           
|                                                                      
|                                                                      
|Net interest income (fully taxable equivalent)                        
|                                                                      
|Tax equivalent adjustment                                             
|                                                                      
|Net interest income per book                                          
|                                                                      
|                                                                      
|Net interest rate spread                                              
|                                                                      
|                                                                      
|Net interest margin                                                   
|                                                                      
|                                                                      
|                                                                      
|(1) Includes principal balance of non-accrual loans and fees on loans.

<PAGE>  12

|Merchants Bancshares, Inc.                                            
|----------------------------------------------------------------------
|Average Balance Sheets and Average Rates                              
|(Unaudited)                                                           
|                                                                      
|                                                                      
|                                                                      
|                                                                      
|                                                                      
|                                                                      
|                                                                      
|(In thousands, fully taxable equivalent)                              
|                                                                      
|ASSETS:                                                               
|Loans, including fees on loans (1)                                    
|Taxable investments                                                   
|Federal funds sold, securities purchased under                        
|agreements to resell and interest bearing                             
|deposits with banks                                                   
|                                                                      
|Total interest earning assets                                         
|                                                                      
|Allowance for loan losses                                             
|Cash and due from banks                                               
|Premises and equipment, net                                           
|Other assets                                                          
|                                                                      
|Total assets                                                          
|                                                                      
|                                                                      
|LIABILITIES AND SHAREHOLDERS'                                         
|EQUITY:                                                               
|Interest bearing deposits:                                            
|Savings, NOW & Money Market accounts                                  
|Time deposits                                                         
|                                                                      
|Total interest bearing deposits                                       
|                                                                      
|Short-term borrowings                                                 
|Long-term debt                                                        
|Securities sold under agreement to repurchase                         
|Junior subordinated debentures issued to                              
|Unconsolidated subsidiary trust                                       
|                                                                      
|Total interest bearing liabilities                                    
|                                                                      
|Noninterest bearing deposits                                          
|Other liabilities                                                     
|Shareholders' equity                                                  
|                                                                      
|Total liabilities and shareholders' equity                            
|                                                                      
|                                                                      
|Net interest earning assets                                           
|                                                                      
|                                                                      
|Net interest income (fully taxable equivalent)                        
|                                                                      
|Tax equivalent adjustment                                             
|                                                                      
|Net interest income per book                                          
|                                                                      
|                                                                      
|Net interest rate spread                                              
|                                                                      
|                                                                      
|Net interest margin                                                   
|                                                                      
|                                                                      
|(1) Includes principal balance of non-accrual loans and fees on loans.

<PAGE>  13

|Provision for Loan Losses: No provision for loan losses was recorded during the first six months of 2006 or for the first six months of 2005. Net recoveries during 2006 have totaled $94 thousand compared to a net charge off of $15 thousand for the first six months of 2005. Internally classified loans totaled $16.00 million at June 30, 2006 compared to $14.48 million at December 31, 2005 and $26.34 million at June 30, 2005. The decline since June 30, 2005 is attributable to loan sales in the fourth quarter of 2005, principal paydowns, and upgrades. Loan payoffs and upgrades did not offset the downgrade of several commercial borrowers during the quarter. In early July 2006, a $1.7 million classified relationship paid off, reducing internally classified loans to approximately $14.3 million. All of these factors are taken into consideration during management's quarterly review of the allowance for credit losses which management continues to deem adequate under current market conditions. See the discussion of Nonperforming Assets on pages 16-18 for additional information on the allowance for credit losses.                                                                                                                                                                                                                                                                           
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|Noninterest Income: Total noninterest income increased $174 thousand to $2.06 million for the second quarter of 2006 from $1.88 million for the second quarter of 2005, and increased $286 thousand to $3.93 million for the first six months of 2006 from $3.64 million for the first six months of 2005. This increase was primarily driven by increased service charges on deposits which increased $108 thousand to $1.23 million compared to $1.13 million for the second quarter of 2005, and increased to $2.35 million from $2.20 million for the first six months of 2006 compared to the same period in 2005. Merchants' net overdraft fee income, a component of service charges on deposits, continued to trend upward during the first half of 2006 due to higher volumes and a recent price increase. Commercial DDA service charges declined as increases in the earnings credit rate allowed business to offset hard dollar charges. Other noninterest income increased to $813 thousand in the second quarter of 2006 from $740 thousand for the second quarter of 2005, and increased to $1.53 million for the first six months of 2006 compared to $1.37 million for the first six months of 2005. Electronic transactions have continued to increase, leading to increases in net revenue for ATM and debit cards.                                                                                                   
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|Noninterest Expense: Total noninterest expense was $8.04 million for the second quarter of 2006 compared to $7.81 million for the second quarter of 2005, and was $15.98 million for the first six months of 2006 compared to $15.77 million for the first six months of 2005. Salaries and wages decreased slightly for both the quarter and six months ended June 30, 2006 compared to the same periods in 2005. This change was the result of a high number of vacant positions during the first half of 2006, the outsourcing of the item processing function during July of 2005 and decreases in estimated incentive payouts to back office and branch staff as a result of decreased profitability and low deposit growth. These factors helped to offset the effect of normal salary increases. Employee benefits increased 14.1% quarter-over-quarter, and 7.8% year over year, primarily a result of projected increased pension costs for 2006. Legal and professional fees increased $106 thousand to $578 thousand for the second quarter of 2006 compared to the same period in 2005; and increased $218 thousand to $1.12 million for the first six months of 2006 compared to 2005. Legal and professional fees incurred during the first six months of 2006 related to the outsourcing of the item processing function were $355 thousand, which displaced a similar amount of salary and equipment associated expenses.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|Merchants started construction of its newest full service branch in Waterbury, VT during the second quarter of this year with occupancy targeted for September 2006. Merchants has started to hire and train the staff for this branch and has incurred a small amount of expense related to this branch in 2006. Annual occupancy, equipment and staff expenses for this location are expected to be approximately $425 thousand per year.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
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|Merchants adopted FAS 123R effective January 1, 2006. As all options have vested as of December 31, 2005, and Merchants has not granted options since 2001, adoption of FAS 123R had no financial statement impact.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
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|Balance Sheet Analysis                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|Average loans for the second quarter of 2006 were $639.66 million compared to $590.40 million for the second quarter of 2005, and $598.16 million for the fourth quarter of 2005. The second quarter results continued the strong growth exhibited in the first quarter of 2006. Residential and commercial real estate loan growth made up the bulk of the increase since the second quarter of 2005. Merchants continues to meet the competition on pricing to retain strong existing relationships and obtain high quality new business. Success in growing commercial real estate and commercial loans has required a sustained development program. Most of the growth during the first half of 2006 can be attributed to the successful conclusion of several long-term prospecting efforts.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|The following table summarizes the components of Merchants' loan portfolio as of June 30, 2006 and December 31, 2005:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    

<PAGE>  14

| | (In thousands)                         | June 30, 2006 |         | December 31, 2005
| | -------------------------------------- | ------------- | ------- | -----------------
| |                                       
| | Commercial, financial and agricultural | $             | 76,159  |                  
| | Real estate loans - residential        |               | 306,456 |                  
| | Real estate loans - commercial         |               | 236,013 |                  
| | Real estate loans - construction       |               | 25,238  |                  
| | Installment loans                      |               | 5,590   |                  
| | All other loans                        |               | 975     |                  
| |                                       
| | Total loans                            | $             | 650,431 |                  
| |                                       
| |                                       

|Average deposits for the second quarter of 2006 were $853.13 million compared to $839.64 million for the second quarter of 2005, and $854.59 million for the fourth quarter of 2005. Merchants started to experience more robust deposit growth toward the end of the second quarter of 2006; average balances for the month of June were approximately $9 million higher than for December of 2005. Merchants' deposits generally experience some seasonal declines during the first half of a year, and start to rebound toward the end of the second quarter. Deposits ended the second quarter of 2006 at an artificially high level as one of Merchants' customers made an approximately $20 million deposit on June 30 that was withdrawn shortly after the end of the quarter. Merchants continues to focus on generating low cost transaction accounts with a new packaged offering featuring the historically popular free checking as the anchor product. At the same time, Merchants has responded to competitive pressure by offering competitive rates on a hybrid time deposit. This product has proven to be successful at stemming the potential outflow of core funding within Merchants' money market category. Although average savings, NOW and money market balances have decreased by $18.60 million since December 2005, average time deposit categories have increased by $23.52 million, primarily in this hybrid product.
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|Merchants' quarter-end investment portfolio has increased $2.82 million since year-end.  Because of the current flat to inverted yield curve, and the fact that Merchants supports a portion of its asset growth with borrowings from the FHLB, Merchants has decided not to increase the investment portfolio further at this time, and is using current cash flow from the portfolio to pay down debt instead of reinvesting in the investment portfolio. Although Merchants' total wholesale funding position has increased since year end, the make-up of that position has changed. Merchants has rolled out its new cash management sweep product utilizing a repurchase agreement arrangement priced at a lower cost of funds than other short-term borrowing alternatives. Balances in this product totaled just over $50 million at June 30, 2006, and are included with "Securities sold under agreements to repurchase" on the accompanying balance sheet. As a result of these changes, quarter-end short-term borrowings from the FHLB decreased to $20 million compared to $50 million at December 31, 2005.                                                                                                                                                                                                                                                                                                                         
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|In the ordinary course of business, Merchants makes commitments for possible future extensions of credit. On June 30, 2006, Merchants was obligated to fund $6.13 million of standby letters of credit. No losses are anticipated in connection with these commitments.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
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|Income Taxes                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|Merchants and its subsidiaries are taxed on income by the Internal Revenue Service at the federal level. The State of Vermont levies franchise taxes on banks based upon average deposit levels in lieu of taxing income. Franchise taxes are included in noninterest expenses in the consolidated statements of income. Total income tax expense was $802 thousand for the quarter ended June 30, 2006, and $1.63 million for the first half of the current year; compared to $934 thousand for the quarter ended June 30, 2005 and $1.85 million for the first half of last year. Merchants recognized favorable tax benefits from federal affordable housing tax credits of $413 thousand for the second quarter of 2006, and $825 thousand for the first six months of 2006, compared to $425 thousand for the second quarter of 2005, and $850 thousand for the first six months of 2005.  Merchants' statutory tax rate was 35% for all periods. The recognition of affordable housing tax credits is the principal reason for Merchants' effective tax rate of 23.1% and 23.2% for the quarter and six months ended June 30, 2006, and 23.4% and 23.7% for the quarter and six months ended June 30, 2005.                                                                                                                                                                                                                                  
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|Liquidity and Capital Resources                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|Merchants' liquidity is monitored by the Asset and Liability Committee of its Board of Directors ("ALCO"), based upon policies approved by Merchants' Board of Directors. For this purpose, liquidity means the ability to generate cash in the most economical way to satisfy loan demand, deposit withdrawal demand, and to fund other business opportunities which require cash. Merchants has an overnight line of credit with the FHLB of $5 million and an estimated additional borrowing capacity with the FHLB of $110 million. Additionally, Merchants has $28 million in available federal funds lines of credit at June 30, 2006 and the ability to borrow through the use of repurchase agreements, collateralized by Merchants' investments, with certain approved counterparties. Merchants' investment portfolio, which is managed by Merchants' ALCO, totaled $393.28 million at June 30, 2006, and is a reliable source of cash flow for Merchants.                                                                                                                                                                                                                                                                                                                                                                                                                                                                               

<PAGE>  15

|In October 2005 Merchants' Board of Directors approved a new stock repurchase program, pursuant to which Merchants may repurchase 200,000 shares of its common stock from time to time through October 2006. Merchants purchased 67,900 shares at an average price of $24.25 during the first half of 2006.
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|                                                                                                                                                                                                                                                                                                           
|As of June 30, 2006, Merchants exceeded all applicable regulatory capital requirements. The following table represents the actual capital ratios and capital adequacy requirements for Merchants as of June 30, 2006 and 2005:                                                                             
|                                                                                                                                                                                                                                                                                                           

| |                           |  |                     |         |  | For Capital      
| | ------------------------- |  | ------------------- | ------- |  | -----------------
| |                           |  | Actual              |         |  | Adequacy Purposes
| |                           |  |                     |         |  |                  
| | (In thousands)            |  | Amount (1)          | Percent |  |                  
| |                          
| |                           |  | As of June 30, 2006
| | Tier 1 leverage capital   |  | $91,551             | 8.21%   |  |                  
| | Tier 1 risk-based capital |  | 91,551              | 12.64%  |  |                  
| | Total risk-based capital  |  | 98,728              | 13.63%  |  |                  
| |                           |  |                     |         |  |                  
| |                           |  |                     |         |  |                  
| |                           |  | As of June 30, 2005
| | Tier 1 leverage capital   |  | $86,690             | 8.19%   |  |                  
| | Tier 1 risk-based capital |  | 86,690              | 12.70%  |  |                  
| | Total risk-based capital  |  | 94,187              | 13.80%  |  |                  
| |                           |  |                     |         |  |                  

|(1)                                                                                                                                                                                                                                                                                                                                                                                                              | Amounts include $20 million in trust preferred securities issued in December 2004. These hybrid securities qualify as regulatory capital up to certain limits.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------
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|Nonperforming Assets and the Allowance for Credit Losses                                                                                                                                                                                                                                                                                                                                                        
|Stringent credit quality is a major strategic focus of Merchants. Although Merchants has been successful to date in minimizing its problem assets, Merchants cannot assure that problem assets will remain at current levels, particularly in light of current or future economic conditions. There is also no assurance that Merchants will not need to increase the allowance for credit losses in the future.
|                                                                                                                                                                                                                                                                                                                                                                                                                
|The following table summarizes Merchants' nonperforming assets at the dates indicated:                                                                                                                                                                                                                                                                                                                          
|                                                                                                                                                                                                                                                                                                                                                                                                                



|(In thousands)                     | June 30, 2006 | March 31, 2006 | December 31, 2005 | June 30, 2005
|---------------------------------- | ------------- | -------------- | ----------------- | -------------
|                                  
|Nonaccrual loans                   | $  1,770      | $  1,797       | $  2,284          | $  3,416     
|Loans past due 90 days or more and |               |                |                   |              
|still accruing interest            | --            | --             | --                | 100          
|Restructured loans                 | 96            | 79             | 80                | 81           
|                                  
|Total nonperforming loans ("NPL")  | $  1,866      | $  1,876       | $  2,364          | 3,597        
|Other Real Estate Owned ("OREO")   | 312           | 312            | --                | --           
|                                  
|Total nonperforming assets ("NPA") | $  2,178      | $  2,188       | $  2,364          | $  3,597     
|                                  
|                                  

|The level of nonperforming assets declined by $186 thousand during the second quarter of 2006 from December 31, 2005.
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<PAGE>  16

|The allowance for credit losses comprises the allowance for loan losses and the reserve for unfunded credit commitments. The following table summarizes year-to-date activity in Merchants' allowance for credit losses through the dates indicated:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                    

|(In thousands)                       |  | June 30, 2006 |  | March 31, 2006 |  | December 31, 2005 |         | June 30, 2005
|------------------------------------ |  | ------------- |  | -------------- |  | ----------------- | ------- | -------------
|                                    
|Balance, beginning of year           |  | $ 7,083       |  | $ 7,083        |  |                   | $ 7,512 |              
|Charge-offs :                        |  |               |  |                |  |                   |         |              
|Commercial, lease financing          |  |               |  |                |  |                   |         |              
|and all other                        |  | (2)           |  | (2)            |  |                   | (336)   |              
|Real estate - construction           |  | --            |  | --             |  |                   | --      |              
|Real estate - commercial             |  | --            |  | --             |  |                   | --      |              
|Real estate - mortgage               |  | --            |  | --             |  |                   | (339)   |              
|Installment and other consumer       |  | (3)           |  | (3)            |  |                   | (18)    |              
|                                    
|Total charge-offs                    |  | (5)           |  | (5)            |  |                   | (693)   |              
|                                    
|Recoveries:                          |  |               |  |                |  |                   |         |              
|Commercial, lease financing          |  |               |  |                |  |                   |         |              
|and all other                        |  | 97            |  | 47             |  |                   | 144     |              
|Real estate - commercial             |  | --            |  | --             |  |                   | --      |              
|Real estate - mortgage               |  | 0             |  | --             |  |                   | 115     |              
|Installment and other consumer       |  | 2             |  | 1              |  |                   | 5       |              
|                                    
|Total recoveries                     |  | 99            |  | 48             |  |                   | 264     |              
|                                    
|Net recoveries (charge-offs)         |  | 94            |  | 43             |  |                   | (429)   |              
|                                    
|Provision for loan losses            |  | --            |  | --             |  |                   | --      |              
|                                    
|Balance end of period                |  | $ 7,177       |  | $ 7,126        |  |                   | $ 7,083 |              
|                                    
|                                     |  |               |  |                |  |                   |         |              
|Components:                          |  |               |  |                |  |                   |         |              
|Allowance for loan losses            |  | $ 6,688       |  | $ 6,637        |  |                   | $ 7,083 |              
|Reserve for unfunded commitments (1) |  | 489           |  | 489            |  |                   | --      |              
|                                    
|Allowance for Credit Losses          |  | $ 7,177       |  | $ 7,126        |  |                   | $ 7,083 |              
|                                    
|                                    

|(1)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   | Effective March 31, 2006 Merchants transferred the portion of the allowance for loan losses related to commercial lending commitments and letters of credit to other liabilities.
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|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |                                                                                                                                                                                  
|The allowance for loan losses is based on management's estimate of the amount required to reflect the inherent losses in the loan portfolio, based on circumstances and conditions at each reporting date. Merchants reviews the adequacy of the allowance for loan losses at least quarterly. Factors considered in evaluating the adequacy of the allowance for loan losses include previous loss experience, current economic conditions and their effect on the borrowers, the performance of individual loans in relation to contract terms and estimated fair values of properties to be foreclosed. The method used in determining the amount of the allowance for loan losses is not based on maintaining a specific percentage of allowance for loan losses to total loans or total NPA. Rather, the methodology is a comprehensive analytical process of assessing the credit risk inherent in the loan portfolio. This assessment incorporates a broad range of factors, which indicate both general and specific credit risk, as well as a consistent methodology for quantifying probable credit losses.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|Losses are charged against the allowance for loan losses when management believes that the collectibility of principal is doubtful. To the extent management determines the level of anticipated losses in the portfolio has significantly increased or diminished, the allowance for loan losses is adjusted through current earnings. As part of Merchants' analysis of specific credit risk, detailed and extensive reviews are performed on larger credits and problematic credits identified on the watched asset list, nonperforming asset listings and internal credit rating reports. An outside loan review firm examines portions of Merchants' commercial loan portfolio three times per year. Over the course of the year, approximately 70% of commercial loan balances are reviewed, including all relationships over $1.0 million and criticized and classified loans over $500 thousand. Issues addressed by the loan review process include the accuracy of Merchants' internal risk ratings system, loan quality, and adequacy of the allowance for loan losses.                                   
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|Loans deemed impaired at June 30, 2006 totaled $1.69 million.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|The allowance for credit losses reflects management's current strategies and efforts to maintain the allowance for credit losses at a level adequate to provide for losses based on an evaluation of known and inherent risks in the loan portfolio, as well as the potential risk from unfunded loan commitments and letters of credit. Among the factors that management considers in establishing the level of the allowance for credit losses are overall findings from an analysis of individual                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                

<PAGE>  17

|loans, the overall risk characteristics and size of the loan portfolio, past credit loss history, management's assessment of current economic and real estate market conditions and estimates of the current value of the underlying collateral. Management considered the balance of the allowance for credit losses adequate at June 30, 2006.
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|                                                                                                                                                                                                                                                                                                                                                
|The following table reflects Merchants' nonperforming asset and coverage ratios as of the dates indicated:                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                

|                                 | June 30, 2006 | March 31, 2006 | December 31, 2005 | June 30, 2005
|-------------------------------- | ------------- | -------------- | ----------------- | -------------
|                                
|NPL to total loans               | 0.29%         | 0.30%          | 0.39%             | 0.60%        
|NPA to total loans plus OREO     | 0.33%         | 0.35%          | 0.39%             | 0.60%        
|Allowance for loan losses        |               |                |                   |              
|to total loans                   | 1.03%         | 1.07%          | 1.17%             | 1.26%        
|Allowance for credit losses      |               |                |                   |              
|to total loans                   | 1.10%         | 1.15%          | 1.17%             | 1.26%        
|Allowance for loan losses to NPL | 358%          | 354%           | 300%              | 208%         
|Allowance for loan losses to NPA | 307%          | 303%           | 300%              | 208%         
|                                 |               |                |                   |              

|Item 3. Quantitative and Qualitative Disclosures About Market Risk                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
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|General                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|Management and Merchants' Board of Directors are committed to sound risk management practices throughout the organization. Merchants has developed and implemented a centralized risk management monitoring program. Risks associated with Merchants' business activities and products are identified and measured as to probability of occurrence and impact on Merchants (low, moderate, or high), and the control or other activities in place to manage those risks are identified and assessed. Periodically, department-level and senior managers re-evaluate and report on the risk management processes for which they are responsible. This documented program provides management with a comprehensive framework for monitoring Merchants' risk profile from a macro perspective; it also serves as a tool for assessing internal controls over financial reporting as required under the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), and the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
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|Market Risk                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|Market risk is defined as the risk of loss in a financial instrument arising from adverse changes in market rates and prices such as interest rates, foreign currency exchange rates, commodity prices, and equity prices. Merchants' primary market risk exposure is interest rate risk. An important component of Merchants' asset and liability management process is the ongoing monitoring and management of this risk, which is governed by established policies that are reviewed and approved annually by Merchants' Board of Directors. The Board of Directors delegates responsibility for carrying out the asset and liability management policies to the ALCO. In this capacity the ALCO develops guidelines and strategies impacting Merchants' asset and liability management related activities based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends. Merchants has an outside investment advisory firm which provides assistance in identifying opportunities for increased yield without significantly increasing risk in the investment portfolio.                                                                                                                                                                                                                                                                                                                                                                                                  
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|Interest Rate Risk                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|The ALCO is responsible for evaluating and managing the interest rate risk which arises naturally from imbalances in repricing, maturity and cash flow characteristics of Merchants' assets and liabilities. It is also responsible for ensuring that the Board of Directors receives accurate information regarding Merchants' interest rate risk position at least quarterly. The ALCO uses an outside consultant to perform rate shocks of Merchants' balance sheet, and to perform a variety of other analyses. The consultant's most recent review was as of May 31, 2006. At that time Merchants' one-year gap position was a $249.13 million liability-sensitive position compared to a $137.23 million liability-sensitive position at the end of 2005. This large increase in Merchants' liability sensitivity is attributable to several factors. On the asset side Merchants continues to experience migration from its variable rate loans to fixed rate categories, and new originations are almost exclusively fixed rate. At the same time, on the liability side, Merchants' short-term, variable rate funding sources have increased since year-end as loan and investment growth has exceeded deposit growth. Additionally, although most of Merchants' deposit growth during 2006 has been in its time deposit category, the growth within that category has been concentrated in short maturities and in its flexible one-year CD product, a portion of which reprices prior to its final one-year maturity.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|The consultant ran a base simulation assuming no changes in rates or balance sheet mix at the May 31,2006 review. Additionally, the consultant modeled a 200 basis point rising and falling interest rate scenario which assumes a parallel and pro rata shift of the yield curve over a one-year period and assumes no changes or growth in the balance sheet. Assuming                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        

<PAGE>  18

|interest rates and Merchants' balance sheet and mix remain similar to what they were as of May 31, 2006, net interest income is projected to trend gradually upward from the May 31, 2006 levels during the simulation period as replacement asset yields increase sufficiently to offset funding rate increases. If money market balances continue to migrate toward time deposits, and regular time deposits continue to migrate into CD specials, this benefit will be mitigated. If rates fall net interest income is projected to increase during the first year as the large short-term funding position provides an immediate benefit, however this trend is projected to reverse in year two as funding rates stabilize while asset yields continue to fall. If rates rise net interest income is expected to decrease during the first year as funding costs increase more quickly than the asset base. This trend starts to reverse itself in the second year as asset yield improvements outpace slowing funding rate increases.
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|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|The change in net interest income for the next twelve months from Merchants' expected or "most likely" forecast at the May 31, 2006 review is shown in the following table. The degree to which this exposure materializes will depend, in part, on Merchants' ability to manage deposit rates as interest rates rise or fall.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
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|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|The analysis discussed above includes no growth assumptions. Merchants' consultant ran additional simulations, which modeled a downward movement in rates with a steepening yield curve and a simulation using Merchants' current growth assumptions. The growth model showed that margin dollars increase in both rising and falling rate environments as Merchants continues to grow its balance sheet. Falling rates, accompanied by a yield curve that steepens in the short end, resulted in a modest net interest income increase during the first year of the simulation, followed by a substantial increase in the second year. These types of dynamic analyses give the ALCO a more thorough understanding of how Merchants' balance sheet will perform in a variety of rate environments.                                                                                                                                                                                                                                        
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|The preceding sensitivity analysis does not represent Merchants' forecast and should not be relied upon as indicative of expected operating results. These estimates are based upon numerous assumptions, including without limitation: the nature and timing of interest rate levels including yield curve shape, prepayments on loans and securities, deposit run-off rates, pricing decisions on loans and deposits and reinvestment/replacement of asset and liability cash flows, among others. While assumptions are developed based upon current economic and local market conditions, Merchants cannot make any assurances as to the predictive nature of these assumptions, including how customer preferences or competitor influences might change.                                                                                                                                                                                                                                                                             
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|The model used to perform the balance sheet simulation assumes a parallel shift of the yield curve over twelve months and reprices every interest bearing asset and liability on Merchants' balance sheet. The model uses contractual repricing dates for variable products, contractual maturities for fixed rate products, and product-specific assumptions for deposits such as Free Checking for LifeÒ
 accounts and money market accounts which are subject to repricing based on current market conditions. Investment securities with call provisions are examined on an individual basis in each rate environment to estimate the likelihood of a call. The model also assumes that the rate at which certain mortgage related assets prepay will vary as rates rise and fall, based on prepayment estimates derived from the Office of Thrift Supervision's Net Portfolio Value Model.                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|As market conditions vary from those assumed in the sensitivity analysis, actual results will likely differ due to: the varying impact of changes in the balances and mix of loans and deposits differing from those assumed, the impact of possible off balance sheet hedging strategies, and other internal/external variables. Furthermore, the sensitivity analysis does not reflect all actions that the ALCO might take in responding to or anticipating changes in interest rates.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
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|Merchants periodically, if deemed appropriate, uses interest rate swaps, floors and caps, which are common derivative financial instruments, to hedge its interest rate risk position. Merchants' Board of Directors has approved hedging policy statements governing Merchants' use of these instruments. As of June 30, 2006 Merchants had no derivative instruments. The risks associated with entering into such transactions are the risk of default from the counterparty with whom Merchants has entered into agreement and a poor correlation between the item being hedged and the derivative instrument. Merchants' risk from default of a counterparty is limited to the expected cash flow anticipated from the counterparty, not the notional value.                                                                                                                                                                                                                                                                          

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|Credit Risk                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
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|Merchants' Board of Directors reviews and approves Merchants' loan policy on an annual basis. Among other things, the loan policy establishes restrictions regarding the types of loans that may be granted, and the distribution of loan types within Merchants' portfolio. Merchants' Board of Directors grants each loan officer the authority to originate loans on behalf of Merchants, subject to certain limitations. These authorized lending limits are reviewed at least annually and are based upon the lender's knowledge and experience. Loan requests that exceed a lender's authority require the signature of Merchants' credit division manager, senior loan officer, and/or president. All extensions of credit of $2.5 million or greater to any one borrower or related party are reviewed and approved by the Loan Committee of Merchants' Board of Directors. Merchants' loan portfolio is continuously monitored for performance, creditworthiness and strength of documentation through the use of a variety of management reports and with the assistance of an external loan review firm. Credit ratings are assigned to commercial loans and are routinely reviewed. Loan officers or the loan workout function take remedial actions to assure full and timely payment of loan balances when necessary. Merchants' policy is to discontinue the accrual of interest on loans when scheduled payments become contractually past due 90 or more days and the ultimate collectibility of principal or interest becomes doubtful.
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|Item 4. Controls and Procedures                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
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|The principal executive officer, principal financial officer, and other members of senior management of Merchants have evaluated the disclosure controls and procedures of Merchants as of the end of the period covered by this quarterly report. Based on this evaluation, Merchants' principal executive officer and principal financial officer have concluded that the disclosure controls and procedures effectively ensure that information required to be disclosed in Merchants' filings and submissions with the Securities and Exchange Commission under the Securities Exchange Act of 1934 as amended (the "Exchange Act") is accumulated and communicated to Merchants' management (including the principal executive officer and principal financial officer) and is recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commission. In addition, Merchants has reviewed its internal controls over financial reporting and there have been no significant changes in its internal controls during the quarter ended June 30, 2006 that have materially affected, or are reasonably likely to materially affect, those controls.                                                                                                                                                                                                                                                                                                                                                

<PAGE>  20

|MERCHANTS BANCSHARES, INC.                                                                                                                                                                                                                                                                                                                                                                      
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|PART II - OTHER INFORMATION                                                                                                                                                                                                                                                                                                                                                                     
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|Item 1. Legal Proceedings                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                
|None.                                                                                                                                                                                                                                                                                                                                                                                           
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|Item 1A. Risk Factors                                                                                                                                                                                                                                                                                                                                                                           
|                                                                                                                                                                                                                                                                                                                                                                                                
|Please read "Risk Factors" in Merchants' Annual Report on Form 10-K for the fiscal year ended December 31, 2005. These risks are not the only ones facing Merchants. Additional risks and uncertainties not currently known to Merchants or that Merchants currently deems to be immaterial also may materially adversely effect Merchants' business, financial condition and operating results.
|                                                                                                                                                                                                                                                                                                                                                                                                
|Item 2. Unregistered Sales of Equity Securities and Use of Proceeds                                                                                                                                                                                                                                                                                                                             
|                                                                                                                                                                                                                                                                                                                                                                                                
|Issuer Purchases of Equity Securities by the Issuer                                                                                                                                                                                                                                                                                                                                             
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|                         |                     |                   |                     | (d) Maximum     
|------------------------ | ------------------- | ----------------- | ------------------- | ----------------
|                         |                     |                   | (c) Total Number of | Number of Shares
|                         |                     |                   | Shares Purchased    | that May Yet Be 
|                         |                     |                   | as Part of Publicly | Purchased Under 
|                         | (a) Total Number of | (b) Average Price | Announced Plans     | the Plans or    
|Period                   | Shares Purchased    | Paid per Share    | or Programs         | Programs        
|                        
|April 1 through April 30 | -                   | $       -         | -                   | 175,994         
|May 1 through May 31     | 21,000              | $ 23.99           | 21,000              | 154,994         
|June 1 through June 30   | 25,000              | $ 24.32           | 25,000              | 129,994         
|                         |                    
|Total                    | 46,000              | $ 24.17           | 46,000              | -               
|                         |                    
|                         |                    

|In October 2005 Merchants' Board of Directors approved a stock repurchase program, pursuant to which Merchants may repurchase 200,000 shares of its common stock from time to time through October 2006. Under the plan, Merchants has purchased 70,006 shares of its common stock on the open market, at an average per share price of $24.25 through June 30, 2006.                                                                                                                                                                                                                        
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|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|Item 3. Defaults Upon Senior Securities                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|None.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
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|Item 4. Submission of Matters to a Vote of Security Holders                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|The Company held its Annual Meeting of Shareholders on Tuesday, May 2, 2006, for the purpose of electing three directors, Joseph L. Boutin, Peter A. Bouyea and Charles A. Davis, each to serve for a three-year term expiring on the date of the Annual Meeting of Shareholders in 2009, and until their successors are duly elected and qualified in accordance with Merchants' Bylaws. Shares voted either in person or by proxy totaled 5,737,113, or 91.04% of the shares entitled to vote. The following table sets forth the results of the voting for the directors who were elected:
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             

| |            |           | Votes    | % Votes
| | ---------- | --------- | -------- | -------
| | Name       | Votes For | Withheld | For    
| | Mr. Boutin | 5,584,082 | 153,031  | 88.61  
| | Mr. Bouyea | 5,599,046 | 138,068  | 88.85  
| | Mr. Davis  | 5,022,795 | 714,319  | 79.70  
| |            |           |          |        

|Item 5. Other Information
|-------------------------
|                         
|None.                    

<PAGE>  21

|Item 6. Exhibits
|----------------
|                
|(a) Exhibits:   
|31.1 -          
|31.2 -          
|32.1 -          
|32.2 -          

<PAGE>  22

|MERCHANTS BANCSHARES, INC.                                                                                                                                                              
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|SIGNATURES                                                                                                                                                                              
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|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.
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