|UNITED STATES                     
|----------------------------------
|SECURITIES AND EXCHANGE COMMISSION
|Washington, D.C. 20549            
|                                  
|FORM 10-Q                         
|                                  
|[X]                               
|                                  
|For the quarterly period ended    
|                                  
|                                  
|or                                
|                                  
|[   ]                             
|                                  

|For the transition period from __________________________________ to __________________________________
|-------------------------------------------------------------------------------------------------------
|                                                                                                       
|Commission file number:                                                                                
|                                                                                                       
|                                                                                                       
|Merchants Bancshares, Inc.                                                                             
|                                                                                                       
|(Exact name of registrant as specified in its charter)                                                 
|                                                                                                       
|Delaware                                                                                               
|                                                                                                       
|(State or other jurisdiction of incorporation or organization)                                         
|                                                                                                       
|275 Kennedy Drive, South Burlington, Vermont                                                           
|                                                                                                       
|(Address of principal executive offices)                                                               
|                                                                                                       
|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 an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).                                                                                                                                                                                                                                                           
|[X] Yes      [   ] No                                                                                                                                                                                                                                                                                                                                                           
|                                                                                                                                                                                                                                                                                                                                                                                
|Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: As of July 29, 2005, the registrant had outstanding 6,299,202 shares of Common Stock, par value $0.01 per share.                                                                                                                                  

<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 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                                    
|(Unaudited)                                                    
|                                                               
|                                                               
|(In thousands except share and per share data)                 
|                                                               
|ASSETS                                                         
|Cash and due from banks                                        
|Investments:                                                   
|Securities available for sale                                  
|Securities held to maturity (fair value of $18,398 and $20,574)
|                                                               
|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 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                                                 
|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 consolidated financial statements    

<PAGE>  1

|Merchants Bancshares, Inc.                                 
|-----------------------------------------------------------
|Consolidated Statements of Income                          
|(Unaudited)                                                
|                                                           
|                                                           
|                                                           
|                                                           
|(In thousands except per share data)                       
|                                                           
|                                                           
|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 (losses) on sales of investment securities, net      
|Other                                                      
|                                                           
|Total noninterest income                                   
|                                                           
|NONINTEREST EXPENSE                                        
|Salaries and wages                                         
|Employee benefits                                          
|Occupancy expense, net                                     
|Equipment expense                                          
|Legal and professional fees                                
|Marketing                                                  
|Equity in losses of real estate limited partnerships, net  
|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 consolidated financial statements

<PAGE>  2

|Merchants Bancshares, Inc.                                        
|------------------------------------------------------------------
|Consolidated Statements of Comprehensive Income (Loss)            
|(Unaudited)                                                       
|                                                                  
|                                                                  
|                                                                  
|(In thousands)                                                    
|                                                                  
|Net income                                                        
|Change in net unrealized appreciation (depreciation) of securities
|available for sale, net of taxes of $1,139, $(2,452), $(624)      
|and $(1,378)                                                      
|Reclassification adjustments for net securities losses (gains)    
|included in net income, net of taxes of $(8), $23, $(29) and $1   
|                                                                  
|Comprehensive income before transfers                             
|Impact of transfer of securities from available for sale          
|to held to maturity, net of taxes of $(1), $3, $(2) and $6        
|                                                                  
|Comprehensive income (loss)                                       
|                                                                  
|                                                                  
|See accompanying notes to consolidated financial statements       

<PAGE>  3

|Merchants Bancshares, Inc.                                                       
|---------------------------------------------------------------------------------
|Consolidated Statements of Cash Flows                                            
|(Unaudited)                                                                      
|                                                                                 
|For the six 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:
|Deferred Tax Expense                                                             
|Depreciation and Amortization                                                    
|Net (Gains) Losses on Sales of Investment Securities                             
|Equity in Losses of Real Estate Limited Partnerships                             
|Changes in Assets and Liabilities:                                               
|(Increase) Decrease in Interest Receivable                                       
|Decrease in Other Assets                                                         
|Increase (Decrease) 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               
|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                                                     
|Principal Payments on Long-term Debt                                             
|Cash Dividends Paid                                                              
|Purchases of Treasury Stock                                                      
|Proceeds from Sale of Treasury Stock                                             
|(Decrease) Increase in Deferred Compensation Arrangements                        
|Proceeds 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                          
|                                                                                 
|See accompanying notes to consolidated financial statements                      

<PAGE>  4

|Notes To Interim Consolidated Financial Statements:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|See Merchants Bancshares, Inc. ("Merchants") 2004 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 with 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, 2005, and for the three and six months ended June 30, 2005 and 2004, have been included. The information was prepared from the unaudited financial statements of Merchants Bancshares, Inc. 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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|Merchants accounts for its stock-based compensation plans in accordance with the provisions of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. Merchants has adopted SFAS No. 123, "Accounting for Stock-Based Compensation," which permits entities to recognize the fair value of all stock-based awards measured on the date of the grant as expense over the vesting period. Merchants has also adopted SFAS No. 148 "Accounting for Stock-Based Compensation - Transition and Disclosure - an Amendment of FASB Statement No. 123," which, among other things, amends the disclosure requirements of SFAS No. 123. Alternatively, SFAS No. 123 allows entities to continue to apply the provisions of APB Opinion No. 25 and provide pro forma net income and earnings per share disclosures for employee stock-based grants made in 1995 and future years as if the fair value based method defined in SFAS No. 123 had been applied. In December 2004, the FASB issued revised statement No. 123 ("FAS 123R"), "Share-Based Payment", which requires companies to expense the estimated fair value of employee stock options and similar awards. Since the December 2004 issuance of FAS 123R, the SEC has elected to defer the effective date. The accounting provisions of FAS 123R will be effective for public companies at the beginning of the first annual period beginning after June 15, 2005. Merchants will adopt the provisions of FAS 123R using a modified prospective application. Under the modified prospective application, the provisions of FAS 123R, will apply to new awards, awards that are outstanding on the effective date that have yet to vest, and to awards that are outstanding on the effective date and are subsequently modified or cancelled. Compensation expense for outstanding awards for which the requisite service has not been rendered as of the effective date will be recognized over the remaining service period using the compensation cost calculated for pro forma disclosure purposes under FAS 123. Based on the fact that Merchants has not granted options since 2001, and all options have vested, Merchants does not expect FAS 123R to have a material impact on the Company's financial position or results of operations.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|The fair value of each option grant is estimated on the grant date using the Black-Scholes option-pricing model. No options have been granted since August 2001. Under SFAS No. 123, Merchants' net income and earnings per share for the three and six month periods ended June 30, 2005 and 2004 would have been the same as the amounts reported in the accompanying interim consolidated financial statements. 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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            

<PAGE>  5

|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:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|(In thousands except share and per share data)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Basic earnings per common share:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Net income available to common shareholders                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|Diluted earnings per common share:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|Effect of dilutive stock options                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Net income available to common shareholders and stock                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|option exercise                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Basic earnings per common share:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Net income available to common shareholders                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|Diluted earnings per common share:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|Effect of dilutive stock options                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Net income available to common shareholders and stock                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|option exercise                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Basic earnings per common share:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Net income available to common shareholders                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|Diluted earnings per common share:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|Effect of dilutive stock options                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Net income available to common shareholders and stock                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|option exercise                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Basic earnings per common share:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Net income available to common shareholders                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|Diluted earnings per common share:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|Effect of dilutive stock options                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Net income available to common shareholders and stock                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|option exercise                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|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, 2005 and 2004. As of June 30, 2005 and 2004, 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.

<PAGE>  6

|The following table summarizes the components of net periodic benefit costs for the periods indicated:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|Merchants contributed $150 thousand to its pension plan on April 5, 2005. No further contributions are required during 2005, but Merchants may make a discretionary contribution during the second half of the year.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|Note 5: Stock Repurchase Program                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|In January 2001, Merchants' Board of Directors approved a stock repurchase program. In January 2005, the Board of Directors voted to extend the program until January 2006. Under the program, Merchants is authorized to repurchase up to 300,000 shares of its own common stock. Under the plan, Merchants has purchased 275,781 shares of its own common stock on the open market, at an average per share price of $23.29 through June 30, 2005; 97,900 of these shares were purchased during the first two quarters of 2005 at an average price of $26.50.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|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 $8.66 million at June 30, 2005 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 and 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, 2005 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 have been reclassified, where necessary, to be consistent with the current period presentation.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|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 (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:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      

<PAGE>  7

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | (ii)   | the fact that Merchants' earnings depend to a great extent upon the level of net interest income (the difference between interest income earned on loans and investments and the interest expense paid on deposits and other borrowings) generated by Merchants and thus Merchants' results of operations may be adversely affected by increases or decreases in interest rates;                                                                                                                      
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------ | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | (iii)  | the fact that the banking business is highly competitive and the profitability of Merchants depends upon Merchants' ability to attract loans and deposits in Vermont, where Merchants competes with a variety of traditional banking and nontraditional institutions such as credit unions and finance companies;                                                                                                                                                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | (iv)   | the fact that at June 30, 2005, a significant portion of Merchants' loan portfolio was comprised of commercial loans, exposing Merchants to the risks inherent in financings based upon analyses of credit risk, the value of underlying collateral, including real estate, and other more intangible factors, which are considered in making commercial loans;                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | (v)    | the fact that at June 30, 2005, approximately 84% of Merchants' loan portfolio was comprised of real estate loans, exposing Merchants to the risks inherent in financings based upon analyses of credit risk and the value of underlying collateral. Accordingly, Merchants' profitability may be negatively impacted by errors in risk analyses, by loan defaults, and the ability of certain borrowers to repay such loans may be adversely affected by any downturn in general economic conditions;
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | (vi)   | the fact that acts or threats of terrorism and actions taken by the United States or other governments as a result of such acts or threats, including possible military action, could further adversely affect business and economic conditions in the United States of America generally and in Merchants' markets, which could adversely affect Merchants' financial performance and that of Merchants' borrowers and on the financial markets and the price of Merchants' common stock;            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | (vii)  | the fact that changes in the extensive laws, regulations and policies governing bank holding companies and their subsidiaries could alter Merchants' business environment or affect Merchants' operations;                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | (viii) | the fact that the potential need to adapt to industry changes in information technology systems, on which Merchants is highly dependent to secure bank and customer financial information, could present operational issues, require significant capital spending or impact Merchants' reputation; and                                                                                                                                                                                                
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | (ix)   | the fact that Merchants actively evaluates acquisition and other expansion opportunities and strategies, the implementation of which could affect Merchants' financial performance.                                                                                                                                                                                                                                                                                                                   
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|These factors, as well as general economic and market conditions in the United States of America, may materially and adversely affect the market price of shares of Merchants' common stock. Because of these and other factors, 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, 2005, and for the three and six months ended June 30, 2005 and 2004, have been included. The information was prepared from the unaudited financial statements of Merchants Bancshares, Inc. 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 2005 was $3.06 million, an 8% increase over net income of $2.84 million for the second quarter of 2004. The return on average assets and return on average equity for the second quarter of 2005 were 1.15% and 18.89% respectively, compared to 1.15% and 12.96%, respectively, for the second quarter of 2004. Net income for the first six months of 2005 was $5.96 million, compared to $5.66 million for the same period last year. The return on average assets and return on average equity for the first six months of 2005 were 1.13% and 18.29% respectively, compared to 1.14% and 12.91%, respectively, for the first six months of 2004. The following were the major factors contributing to the results for the first half of 2005 compared to 2004:
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | *      | Net interest income increased $447 thousand, or 2.3%, in spite of continued margin compression;                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | *      | Noninterest income increased $124 thousand, or 2.8%. Merchants continued to experience increases in fees generated by electronic banking; these increases were offset by decreases in monthly service charge revenue;                                                                                                                                                                                                                                                                                 

<PAGE>  8

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | * | Noninterest expense increased $312 thousand, or 1.9%, primarily due to increases in anticipated incentive payouts, rising health insurance costs and increased occupancy and equipment expenses;
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |   |                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | * | Average loans have increased $10.43 million, or 1.8%, over the same quarter last year;                                                                                                          
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |   |                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | * | Average deposits have increased $25.70 million, or 3.2%, over the same quarter last year.                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |   |                                                                                                                                                                                                 
|Net Interest Income: Merchants' net interest income, on a fully taxable equivalent basis, increased $213 thousand, or 2.2%, for the second quarter of this year compared to last year, and $451 thousand, or 2.3% for the first six months of 2005, primarily due to higher levels of interest earning assets. Interest income on loans was $9.03 million for the second quarter, a 12.5% increase over the $8.03 million earned for the second quarter of last year, and was $17.60 million for the first half of the year, a 9.5% increase over the first half of last year. These increases are the result of an increased loan portfolio size, and increases in the Prime rate which positively impacted the adjustable portion of the portfolio. Merchants also experienced an increase in income earned on its investment portfolio; the portfolio earned $4.26 million for the second quarter of 2005, a 22.6% increase over the second quarter of last year. Investment income for the first six months of 2005 was $8.48 million, a 20.0% increase over the same period in 2004. Increases in investment income were driven by an overall larger investment portfolio, and higher yields as new investments have been brought on at higher yields than maturing investments.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|These increases in interest income were offset by increases in interest expense. Interest expense on deposits was $2.07 million for the second quarter of 2005, and was $3.72 million for the first half of the year, representing a 40.3% and 21.8% respective increase over the same periods in 2004. Merchants' deposits are generally priced at the short end of the yield curve which has experienced large increases over the last year. The Federal funds rate increased 2.25% from 1.00% to 3.25% over the last year; at the same time the two-year treasury increased 95 basis points, a 35% increase, to 3.63% at June 30, 2005 from 2.68% at June 30, 2004, leading to the large percentage increase in interest expense on deposits. Increases in costs for borrowings have been even more dramatic as short-term rates have risen. The average cost of short-term borrowings for the second quarter of 2005 was 3.10%, compared to 1.16% for the same period in 2004. These rate increases, coupled with a 62% increase in average short-term and long-term borrowings for the second quarter and 49% for the first six months of the year, have caused interest expense on short and long-term borrowings to increase to $993 thousand for the second quarter of 2005 compared to $319 thousand for the same quarter of last year; and $1.81 million for the first six months of the year compared to $599 thousand for the same period last year. Merchants closed its private placement of an aggregate of $20 million in trust preferred securities on December 15, 2004, which has also contributed to increases in interest expense. The interest cost incurred on the trust preferred securities during the second quarter of 2005 was $298 thousand, and was $595 thousand for the first six months of 2005.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Merchants' net interest spread for the second quarter of 2005 compared to 2004 decreased 25 basis points to 3.80% from 4.05%, and was 17 basis points lower than the first quarter of 2005. Merchants' net interest spread decreased 18 basis points to 3.88% from 4.06% when comparing the first six months of the current year to last year. The net interest margin also decreased over the same period and was 3.99% for the second quarter of this year compared to 4.14% for the first quarter of 2005 and 4.20% for the same period last year, and was 4.06% compared to 4.21% for the first six months of 2005 and 2004 respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|The following tables set forth certain information for the three and six months ended June 30, 2005 and 2004. 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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       

<PAGE>  9

|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                          
|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)                             
|                                        
|                                        
|Net interest rate spread                
|                                        
|                                        
|Net interest margin                     
|                                        
|                                        
|(1)                                     

<PAGE>  10

|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                          
|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)                             
|                                        
|                                        
|Net interest rate spread                
|                                        
|                                        
|Net interest margin                     
|                                        
|                                        
|(1)                                     

<PAGE>  11

|Provision for Loan Losses: No provision for loan losses was recorded during the first six months of 2005 or for the same period last year. Total nonperforming assets increased slightly to $3.60 million at the end of the second quarter of 2005 compared to $3.34 million at the end of 2004; and were $2.70 million higher than June 30, 2004 balances of $893 thousand. The large year over year increase in nonperforming loans can be attributed primarily to a single customer that was placed in nonaccrual during the third quarter of 2004. Although nonaccrual loans have trended upward over the last year, these loans have been charged down to their estimated net realizable value. Additionally net charge-offs during 2005 were very small, totaling $15 thousand. All of these factors are taken into consideration during Management's quarterly review of the Allowance for Loan Losses ("Allowance"). The Allowance continues to be deemed adequate under current market conditions. See the discussion of Nonperforming Assets on pages 14 and 15 for additional information on the Allowance.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|Noninterest Income: Total noninterest income increased 4.1% to $2.30 million from $2.21 million for the second quarter of 2005 compared to 2004; and increased 2.8% to $4.49 million from $4.36 million for the first half of the year. Net gains on sales of investments totaled $23 thousand for the second quarter of 2005 compared to a loss of $67 thousand for the second quarter of last year, and were $84 thousand for the first half of this year compared to a $4 thousand loss for the first half of last year. Merchants Trust Company income continued to increase and is 8.7% higher for the first six months of this year compared to the same period for last year, attributable to an increase in new business during 2005 resulting in an overall increase in fee income during the first half of this year. Merchants experienced an 8.3% decrease in service charges on deposits during the first half of 2005 compared to 2004. This decrease was driven by the fact that increases in the earnings credit rate have allowed business customers to decrease the amount of hard dollar charges they incur each month, reducing the overall level of service charge revenue. Additionally, although Merchants continues to experience increases in overdraft service charge revenue, the rate of the increase has slowed down as more customers use their debit cards for purchases; electronic transactions are not approved unless the customer has sufficient funds in their account to pay for the transaction. Other noninterest income increased 14.0% when comparing the first six months of 2005 to 2004. As mentioned above, Merchants is experiencing increases in electronic transactions, leading to increases in net revenue for ATM and debit cards.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|Noninterest Expenses: Total noninterest expense increased 1.3% to $8.23 million from $8.13 million for the second quarter of 2005 compared to 2004; and 1.9% to $16.62 million from $16.31 million for the first half of the year. Merchants continues to actively work toward controlling expenses, as evidenced by these small percentage increases. Salaries and wages increased 6.8% for the second quarter of 2005 compared to 2004 and by 5.2% year to date. This increase was primarily driven by higher incentive payouts for 2005 when compared to 2004. Merchants experienced a slight decrease in its employee benefits costs both for the second quarter and year to date when comparing 2005 to 2004. This decrease is primarily a result of decreased pension plan expenses for 2005 as a result of strong asset performance and changes in the retiree population. At the same time, Merchants continues to experience increases in health and group insurance related expenses as those costs continue to rise. Occupancy and equipment expenses have increased 4.4% for the second quarter of 2005 compared to 2004, and 5.8% for the first six months of the year. This increase is primarily a result of the branch office network server infrastructure upgrade and service center desktop upgrade completed during 2004. Merchants' marketing expenses have decreased 25.7% for the second quarter and 16.3% for the first half of this year compared to last year. There are several marketing initiatives planned for the third and fourth quarters. Budgeted marketing dollars have been allocated for those campaigns, and Merchants expects increased marketing expenses in the second half of the year.                                                    
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|Balance Sheet Analysis                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|Average loans for the second quarter of 2005 were $590.40 million, a 1.8% increase over the same quarter last year, and a less than 1% increase over average balances for the fourth quarter of last year. Period-end loans increased 1.03% over the same quarter of last year, and 1.8% over year end balances.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|Total period end-loans grew approximately $10 million during the second quarter. About $4 million of this growth came through the residential portfolio. Merchants' residential loan balances are predominately in intermediate-term fixed rate loans, which amortize more quickly than longer-term loans. Merchants generates mortgage loans for its own portfolio, focusing primarily on smaller conventional mortgage refinancing opportunities. The typical loan in the portfolio has a lower average balance and shorter maturity than loans that are packaged and sold in the secondary market. Merchants is currently generating sufficient volumes to replenish amortization in its residential mortgage portfolio and to provide some modest growth. Merchants' commercial loan categories (commercial, commercial real estate and construction loans) have grown $5.81 million from the end of the first quarter to the end of the second quarter of this year, reversing the slight decline experienced during the first quarter. But competitive factors and accelerated amortization are still impediments to more rapid growth. The squeeze on spreads across all lending and investment instruments has worked its way through the commercial loan arena. Merchants has chosen to meet the competition to retain strong existing customers and to solicit new                                                                                                                                                                                                                                                                                                                                                                                                          

<PAGE>  12

|relationships. There are many instances where pricing does not reflect the underlying credit risks and management has chosen not to compete as aggressively for this business.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|The following table summarizes the components of Merchants' loan portfolio as of June 30, 2005 and December 31, 2004:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|Average deposits for the quarter were $839.64 million, a 3.2% increase over the same quarter of last year, and a slight decrease from average balances at December 31, 2004. The first half of the year is generally a time when Merchants experiences seasonal decreases in deposits. Merchants continued to focus most of its resources on the development of transaction accounts rather than higher cost time deposits. Currently 38% of its deposits are comprised of transaction accounts (excluding money market accounts). Merchants' goal is to build this to 40%. As interest rates rise the cost of funds should favorably reflect this emphasis on low cost core deposits. Merchants has continued its emphasis on increasing its marquee Free Checking for Life® product. Average quarterly balances grew at an annualized rate of 8.3% from the fourth quarter of 2004 through the first quarter of 2005, and 10.5% when compared to average balances as of June 30, 2004. At the same time Merchants responded to competitive pressures during the second quarter of 2005 by introducing a hybrid two-year fixed rate CD which provides for additions to and withdrawals from the account during the term. The rate on the product was priced between competitive rates on money market accounts and two-year certificates of deposit. Merchants generated $47 million in this product during its initial 60 day introduction, approximately $10 million of that growth was attributed to deposits that had not been transferred from other Merchants' accounts. Merchants has closed the product line to new accounts but continues to accept funds into existing accounts up to certain limits. Additionally, Merchants revamped the pricing on its CommerceLYNX II commercial deposit offering for small business in the fall of 2004; the average balance in this product type has grown by an annualized 20% since December 2004.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|Merchants' quarterly average investment portfolio increased 16.9% year-over-year; average balances for the second quarter of 2005 were $406.87 million compared to $348.11 million for the first quarter of 2004. Merchants has continued to leverage its balance sheet; its average total borrowing position with the Federal Home Loan Bank ("FHLB") was $124.97 million for the second quarter of 2005 compared to $76.34 million for the same quarter one year ago. This leverage strategy has helped Merchants continue to increase its net interest income dollars in spite of continued pressure on its net interest margin. However, the flattening of the yield curve over the last year, combined with leverage that has been partially funded with short-term borrowings, has further challenged Merchants' ability to continue generating these additional net interest income dollars.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|In the ordinary course of business, Merchants makes commitments for possible future extensions of credit. On June 30, 2005, Merchants was obligated to fund $8.66 million of standby letters of credit. No losses are anticipated in connection with these commitments.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|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 $934 thousand and $1.85 million for the second quarter and first six months of 2005, respectively, compared to $948 thousand and $1.88 million for the same periods in 2004. Merchants recognized favorable tax benefits of $425 thousand and $850 thousand for the second quarter and first six months of 2005, compared to $400 thousand and $800 thousand for the same periods in 2004, representing the amount of the federal tax credits earned during these periods. Merchants' statutory tax rate was 35% for all periods. The recognition of low income housing tax credits is the principal reason for Merchants' effective tax rate of 24% for the first six months of 2005.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|Liquidity and Capital Resources                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|Merchants' liquidity is monitored by the Asset and Liability Committee ("ALCO"), based upon policies approved by the Board of Directors. Liquidity can be defined as the ability to generate cash in the most economical way to satisfy loan demand, deposit withdrawal demand, and to meet other business opportunities which require cash. Merchants has an                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        

<PAGE>  13

|overnight line of credit with the FHLB of $5 million and an estimated additional borrowing capacity with the FHLB of $41 million. Additionally, Merchants has $28 million in available Federal Funds lines of credit at June 30, 2005 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 $388.73 million at June 30, 2005, and is a strong source of cash flow for Merchants.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|During the first quarter of 2005 Merchants sold 99,601 shares out of treasury to the 401(k) and directors' deferred compensation plans. The plans used the cash received from the special dividend paid in December 2004 to purchase the treasury stock from Merchants. Merchants has been active in its stock buyback plan during the first six months of 2005 and has purchased 97,900 shares at an average price of $26.50.                                                                                                                              
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|As of June 30, 2005, 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, 2005 and 2004:                                                                                                                                                                                                                                                                                                                              
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|(In thousands)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|Tier 1 leverage capital                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|Tier 1 risk-based capital                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|Total risk-based capital                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|Tier 1 leverage capital                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|Tier 1 risk-based capital                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|Total risk-based capital                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|(1)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|Nonperforming Assets and the Allowance for Loan 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 these levels, particularly in light of current or future economic conditions. There is also no assurance that Merchants will not need to increase the Allowance in the future.                                                                                                                                                                
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|The following table summarizes Merchants' nonperforming assets at the dates indicated:                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            

|(In thousands)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | June 30, 2005 |  | March 31, 2005 |  | December 31, 2004 |  | June 30, 2004
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | ------------- |  | -------------- |  | ----------------- |  | -------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|Nonaccrual loans                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               | $ 3,416       |  | $ 3,638        |  | $ 3,233           |  | $ 807        
|Loans past due 90 days or more and                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |               |  |                |  |                  
|still accruing interest                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | 100           |  | --             |  | 20                |  | -            
|Restructured loans                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | 81            |  | 82             |  | 83                |  | 86           
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|Total nonperforming assets ("NPA")                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | $ 3,597       |  | $ 3,720        |  | $ 3,336           |  | $ 893        
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|The level of nonperforming assets dropped during the second quarter. Nonaccrual loans decreased $222 thousand during the quarter which can largely be attributed to paydowns on several nonaccrual loans. This, coupled with the fact that there were no significant additions to NPA during the quarter, generated the overall decrease. Total Nonperforming Loans ("NPL") decreased $123 thousand from March 31, 2005 to June 30, 2005. During the second quarter of this year, restructured loans were virtually unchanged.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|The following table summarizes year-to-date activity in Merchants' Allowance through the dates indicated:                                                                                                                                                                                                                                                                                                                                                                                                                     

<PAGE>  14

|(In thousands)                 |  | June 30, 2005 |  | March 31, 2005 |  | December 31, 2004 |  | June 30, 2004
|------------------------------ |  | ------------- |  | -------------- |  | ----------------- |  | -------------
|                              
|Allowance beginning of year    |  | $ 7,512       |  | $ 7,512        |  | $ 7,954           |  | $ 7,954      
|Charge-offs :                  |  |               |  |                |  |                   |  |              
|Commercial, lease financing    |  |               |  |                |  |                   |  |              
|and all other                  |  | (102)         |  | (64)           |  | (56)              |  | (17)         
|Real estate - commercial       |  | --            |  | --             |  | --                |  | --           
|Real estate - mortgage         |  | (1)           |  | (1)            |  | (703)             |  | (26)         
|Installment and other consumer |  | (17)          |  | --             |  | (17)              |  | (13)         
|                              
|Total charge-offs              |  | (120)         |  | (65)           |  | (776)             |  | (56)         
|                              
|Recoveries:                    |  |               |  |                |  |                   |  |              
|Commercial, lease financing    |  |               |  |                |  |                   |  |              
|and all other                  |  | 57            |  | 14             |  | 34                |  | 6            
|Real estate - commercial       |  | 30            |  | --             |  | --                |  | 64           
|Real estate - mortgage         |  | 16            |  | 15             |  | 297               |  | 29           
|Installment and other consumer |  | 2             |  | 1              |  | 3                 |  | 2            
|                              
|Total recoveries               |  | 105           |  | 30             |  | 334               |  | 101          
|                              
|Net (charge-offs) recoveries   |  | (15)          |  | (35)           |  | (442)             |  | 45           
|                              
|Provision for loan losses      |  | --            |  | --             |  | --                |  | --           
|                              
|Allowance end of period        |  | $ 7,497       |  | $ 7,477        |  | $ 7,512           |  | $ 7,999      
|                              
|                               |  |               |  |                |  |                   |  |              

|The Allowance is based on management's estimate of the amount required to reflect the risks in the loan portfolio, based on circumstances and conditions at each reporting date. Merchants reviews the adequacy of the Allowance at least quarterly. Factors considered in evaluating the adequacy of the Allowance 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 is not based on maintaining a specific percentage of Allowance 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 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 is adjusted through current earnings. As part of Merchants' analysis of specific credit risk, detailed and extensive reviews are done 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.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|Loans deemed impaired at June 30, 2005 totaled $3.6 million; of this total $3.5 million are included as nonperforming assets in the table above. This compares to impaired loans of $3.8 million at March 31, 2005 and $3.3 million at December 31, 2004.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|The Allowance level reflects management's current strategies and efforts to maintain the Allowance at a level adequate to provide for loan losses based on an evaluation of known and inherent risks in the loan portfolio. Among the factors that management considers in establishing the level of the Allowance are overall findings from an analysis of individual 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 adequate at June 30, 2005.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|The following table reflects Merchants' nonperforming asset and coverage ratios as of the dates indicated:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|NPL to total loans                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|Allowance to total loans                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Allowance to NPL                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|Allowance to NPA                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         

<PAGE>  15

|Item 3. Quantitative and Qualitative Disclosures About Market Risk                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|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.                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|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 helps it identify 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. The ALCO is 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, 2005. At that time Merchants' one-year gap position was a $20.21 million liability-sensitive position compared to a $29.22 million liability-sensitive position at the end of 2004.                                                                                                                                                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|Merchants' consultant modeled a 200 basis point rising and falling interest rate scenario at the May 31, 2005 review. The model 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. At the May 31 review the change in net interest income for the next 12 months from Merchants' expected or "most likely" forecast was as follows:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|The analysis shows margin compression in both the rising and falling rate scenarios. In a rising rate environment the short-term liability sensitivity leads to a decrease in net interest income in the first year as funding costs initially increase more rapidly than asset yields. This trend is expected to reverse in year two as the asset base continues to reset at higher rates while funding costs stabilize. The ability to reduce funding costs is limited in the falling rate environment, while the Bank's prime based loans rapidly reset to lower yields. Additionally, assets are expected to shorten, further exacerbating margin compression. The margin compression becomes more pronounced in later years under this static modeling scenario. Merchants is exploring the use of a hedging strategy to protect against falling rates. The use of interest rate hedges, as well as flexibility in positioning the balance sheet, will allow Merchants to manage its net interest income stream should rates start to decrease. The degree to which this exposure materializes will depend, in part, on Merchants' ability to manage deposit rates as interest rates rise or fall.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|The analysis discussed above includes no growth assumptions. The consultant also ran additional simulations, which modeled an upward movement in rates with a flattening 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. The flattening yield curve scenario resulted in additional margin compression. 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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      

<PAGE>  16

|The preceding sensitivity analysis does not represent Merchants' forecast and should not be relied upon as being 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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|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. The Board of Directors has approved hedging policy statements governing the use of these instruments by Merchants. As of June 30, 2005 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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|Credit Risk                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|The 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 interest, 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.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|Item 4. Controls and Procedures                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|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 has 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 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 or in the other factors that could significantly affect those controls during the quarter or six month periods ended June 30, 2005.                                                                                                                                                                                                                                                                                                                                                                                                                                                                    

<PAGE>  17

|MERCHANTS BANCSHARES, INC.                                                                                                                                                                                               
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|PART II - OTHER INFORMATION                                                                                                                                                                                              
|                                                                                                                                                                                                                         
|Item 1. Legal Proceedings                                                                                                                                                                                                
|                                                                                                                                                                                                                         
|Merchants is involved in routine legal proceedings occurring 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.
|                                                                                                                                                                                                                         
|Item 2. Unregistered Sales of Equity Securities and Use of Proceeds                                                                                                                                                      
|                                                                                                                                                                                                                         
|Issuer Purchases of Equity Securities by the Issuer                                                                                                                                                                      
|                                                                                                                                                                                                                         



|                       |  |                  |  |             |  | (c) Total Number of |  | (d) Maximum Number
|---------------------- |  | ---------------- |  | ----------- |  | ------------------- |  | ------------------
|                       |  |                  |  |             |  | Shares Purchased as |  | of Shares that May
|                       |  | (a) Total Number |  | (b) Average |  | Part of Publicly    |  | Yet Be Purchased  
|                       |  | of Shares        |  | Price Paid  |  | Announced Plans     |  | Under the Plans   
|Period                 |  | Purchased        |  | per Share   |  | or Programs         |  | or Programs       
|                      
|April through April 30 |  | 3,300            |  | $26.93      |  | 3,300               |  | 53,919            
|May through May 31     |  | 6,760            |  | $26.75      |  | 6,760               |  | 47,159            
|June through June 30   |  | 22,940           |  | $26.53      |  | 22,940              |  | 24,219            
|                       |  |                  |  |            
|Total                  |  | 33,000           |  | --          |  | 33,000              |  |                   
|                       |  |                  |  |            
|                       |  |                  |  |            

|In January 2001, Merchants' Board of Directors approved a stock repurchase program. In January 2005, the Board of Directors voted to extend the program until January 2006. Under the program, Merchants is authorized to repurchase up to 300,000 shares of its own common stock. Under the plan, Merchants has purchased 275,781 shares of its own common stock on the open market, at an average per share price of $23.29 through June 30, 2005; 97,900 of these shares were purchased during the first two quarters of 2005 at an average price of $26.50.                                       
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|Item 3. Defaults Upon Senior Securities                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|None                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|Item 4. Submission of Matters to a Vote of Security Holders                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|The Company held its Annual Meeting of Shareholders on Tuesday, April 26, 2005, for the purpose of electing four directors, Lorilee A. Lawton, Michael G. Furlong, Robert A. Skiff Jr., Ph.D. and John A. Kane, each to serve for a three-year term expiring on the date of the Annual Meeting of Shareholders in 2008, and until their successors are duly elected and qualified in accordance with Merchants' Bylaws. Shares voted either in person or by proxy totaled 5,930,549, or 93.40% of the shares entitled to vote. The following table sets forth the results of the voting for directors:
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|Item 5. Other Information                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|None                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  

<PAGE>  18

|Item 6. Exhibits
|----------------
|                
|(a)             
|                
|                
|                
|                
|                
|(b)             
|                

<PAGE>  19

|MERCHANTS BANCSHARES, INC.                                                                                                                                                              
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|SIGNATURES                                                                                                                                                                              
|                                                                                                                                                                                        
|Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
|                                                                                                                                                                                        
|                                                                                                                                                                                        
|                                                                                                                                                                                        
|                                                                                                                                                                                        
|                                                                                                                                                                                        
|                                                                                                                                                                                        
|                                                                                                                                                                                        
|                                                                                                                                                                                        
|                                                                                                                                                                                        
|                                                                                                                                                                                        
|                                                                                                                                                                                        
|                                                                                                                                                                                        
|                                                                                                                                                                                        
|                                                                                                                                                                                        
|                                                                                                                                                                                        
|                                                                                                                                                                                        
|                                                                                                                                                                                        

<PAGE>  20