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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-K



|x |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF SECURITIES EXCHANGE ACT OF 1934
|- |  | --------------------------------------------------------------------------------



For the fiscal year ended December 31, 2006



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



For the transition period from              to



Commission file number 0-26016



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PALMETTO BANCSHARES, INC.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|South Carolina                                                 |  | 74-2235055                          
|(State or other jurisdiction of incorporation or organization) |  | (IRS Employer Identification No.)   
|                                                               | 
|301 Hillcrest Drive, Laurens, South Carolina                   |  | 29360                               
|(Address of principal executive offices)                       |  | (Zip Code)                          
|                                                               | 
|(864) 984-4551                                                 |  | palmettobank.com                    
|(Registrants telephone number)                                |  | (Registrants subsidiarys web site)



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Securities registered pursuant to Section 12(b) of the Act:  None



Securities registered pursuant to Section 12(g) of the Act:



Common Stock, par value $5.00 per share

(Title of class)



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



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



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.    Yes  x    No ̈



Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ̈



Indicate by check mark whether the registrant is a large accelerated filer,
an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Act.



Large accelerated filer ̈Accelerated filer  x    Non-accelerated filer ̈



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



The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant (computed by reference to the price at which the stock was most recently sold) was $194,266,440 as of the
last business day of the registrants most recently completed second fiscal quarter. There is no established public trading market for the shares. See Part II, Item 5.



6,379,805 shares of the registrants common stock were outstanding as of March 2, 2007.



DOCUMENTS INCORPORATED BY REFERENCE



The Companys Proxy Statement dated March 16, 2007 with respect to
an Annual Meeting of Shareholders to be held April 17, 2007: Incorporated by reference in Part III of this Form 10-K.



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



2006 ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS



|              |  |                                                                                                                     |  |    
|------------- |  | ------------------------------------------------------------------------------------------------------------------- |  | ---
|PART I       
|              |  |                                                                                                                    
|Item 1.       |  | Business                                                                                                            |  | 3  
|Item 1A.      |  | Risk Factors                                                                                                        |  | 12 
|Item 1B.      |  | Unresolved Staff Comments                                                                                           |  | 19 
|Item 2.       |  | Properties                                                                                                          |  | 20 
|Item 3.       |  | Legal Proceedings                                                                                                   |  | 21 
|Item 4.       |  | Submission of Matters to a Vote of Security Holders                                                                 |  | 21 
|             
|PART II      
|              |  |                                                                                                                    
|Item 5.       |  | Market for the Registrants Common Equity and Related Shareholder Matters and Issuer Purchases of Equity Securities |  | 22 
|Item 6.       |  | Selected Financial Data                                                                                             |  | 24 
|Item 7.       |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                               |  | 25 
|              |  | Forward-Looking Statements                                                                                          |  | 25 
|              |  | Impact of Inflation                                                                                                 |  | 25 
|              |  | Critical Accounting Policies                                                                                        |  | 25 
|              |  | Financial Condition                                                                                                 |  | 28 
|              |  | Disclosures Regarding Market Risk                                                                                   |  | 52 
|              |  | Liquidity                                                                                                           |  | 54 
|              |  | Off-Balance Sheet Arrangements                                                                                      |  | 57 
|              |  | Earnings Review                                                                                                     |  | 60 
|              |  | Accounting and Reporting Matters                                                                                    |  | 67 
|Item 7A.      |  | Quantitative and Qualitative Disclosures about Market Risk                                                          |  | 69 
|Item 8.       |  | Financial Statements and Supplementary Data                                                                         |  | 70 
|Item 9.       |  | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure                                |  | 127
|Item 9a.      |  | Controls and Procedures                                                                                             |  | 127
|Item 9b.      |  | Other Information                                                                                                   |  | 127
|             
|PART III     
|              |  |                                                                                                                    
|Item 10.      |  | Directors, Executive Officers and Corporate Governance                                                              |  | 128
|Item 11.      |  | Executive Compensation                                                                                              |  | 128
|Item 12.      |  | Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters                      |  | 128
|Item 13.      |  | Certain Relationships and Related Transactions, and Director Independence                                           |  | 128
|Item 14.      |  | Principal Accounting Fees and Services                                                                              |  | 128
|             
|PART IV      
|              |  |                                                                                                                    
|Item 15.      |  | Exhibits, Financial Statement Schedules                                                                             |  | 129
|              | 
|SIGNATURES    |  | 131                                                                                                                
|              | 
|EXHIBIT INDEX |  | 133                                                                                                                



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Part I



|Item 1.Business | 
|--------------- | 



Company Overview



General



Palmetto Bancshares, Inc. is a
regional financial services holding company headquartered in Laurens, South Carolina and organized in 1982 under the laws of South Carolina. Through its wholly owned subsidiary, The Palmetto Bank (the Bank), Palmetto Bancshares, Inc.
engages in the general banking business through 32 retail banking offices in the upstate South Carolina markets of Laurens, Greenville, Spartanburg, Greenwood, Anderson, Cherokee, Abbeville, Pickens, and Oconee counties (the Upstate). In
addition to retail offices, at December 31, 2006, the Bank had 38 automatic teller machine (ATM) locations (including seven at nonretail office locations) and five-limited service offices located in retirement centers in the
Upstate. Additionally, as noted in Item 8. Financial Statements and Supplementary Data, Note 5, the Bank opened an additional ATM location during the first quarter of 2007. The Bank was organized and chartered under South Carolina law in 1906.
Throughout this report, the Company shall refer to Palmetto Bancshares, Inc. and its subsidiary, the Bank, which includes its brokerage subsidiary, Palmetto Capital, Inc. (Palmetto Capital), except where the context requires
otherwise.



The Bank derives its income primarily from interest
on loans and investment securities. To a lesser extent, income is earned from fees from the sale of loans, fees received in connection with servicing loans, and service charges on deposit accounts. Income is also earned through Palmetto Capital and
the Banks trust department. The Banks major expenses are salaries and benefits, the interest it pays on deposits and borrowings, and general operating expenses.



The Company conducts its business through the Bank, which is subject to the laws of the state of South Carolina and federal
regulations governing the financial services industry. The Company is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended. Bank holding companies are subject to regulation and supervision by the Board of
Governors of the Federal Reserve System.



The Company provides
banking and other financial services throughout its targeted markets to consumers and to small- and medium-sized businesses, including the owners and employees of those businesses. In addition to traditional banking services, the Company offers
brokerage and trust services. Traditional banking services include the Banks retail and commercial distribution network, telephone banking, and Internet banking. In addition, the Bank provides a variety of depository accounts including, but
not limited to, interest-bearing and noninterest-bearing checking, savings, certificate of deposit, and money market accounts. The Bank also offers a variety of loan products, including, but not limited to, commercial, installment, real estate,
indirect, and home equity loans as well as credit card services. The Banks indirect lending department establishes relationships with Upstate automobile dealers to provide customer financing on qualifying automobile purchases, and the
Banks mortgage-banking operation meets a range of its customers financial service needs by originating, selling, and servicing mortgage both fixed-rate and adjustable-rate mortgage products. The Banks mortgage-banking operations
provide both fixed-rate and adjustable-rate mortgage products and loan servicing. Mortgage lenders are located in the banking offices. The Companys trust department offers trust services for companies and individuals, and Palmetto Capital
offers customers brokerage services relating to stocks, treasury and municipal bonds, mutual funds, and insurance annuities, as well as college and retirement planning through a third party arrangement with Raymond James. Investment advisors are
located in banking office locations. In addition, the Company maintains separate investment locations in Greenville and Laurens Counties. Trust professionals are located in banking offices and the Companys operations center.



The Company is subject to competition from other financial institutions, and
operating results, like those of other financial institutions operating in South Carolina, are significantly influenced by local and state economic



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conditions, including, but not limited to, the strength of the real estate market. In addition, both the fiscal and regulatory policies of the federal and
state government and regulatory authorities that govern financial institutions and market interest rates impact the Companys financial condition and results of operations.



The Companys earnings and growth are subject to the influence of certain economic conditions, including, but not
limited to, inflation, recession, and unemployment. The Companys earnings are impacted not only by general economic conditions but also by the monetary and fiscal policies of the United States and federal agencies, particularly the Federal
Reserve. The Federal Reserve implements national monetary policy, such as seeking to curb inflation and combat recession, by its open market operations in United States Government securities and by its control of the discount rates applicable to
borrowings by banks from the Federal Reserve. The actions of the Federal Reserve in these areas influence the growth of Bank loans, investments, and deposits and impact the interest rates charged on loans and paid on deposits. The Federal
Reserves policies have had a significant impact on the operating results of commercial banks and are expected to continue to do so in the future. The nature and timing of any future changes in monetary policies are not predictable.



The Companys
strategy is to be recognized as the Upstates premier independent community banking organization, and the Company believes that there are opportunities for internal loan and deposit growth because our operations are located in some of the
strongest growth markets in the Upstate. The Company plans to position itself to take full advantage of these markets. To this end, in conjunction with the Companys 100thanniversary celebration on September 21, 2006, the Company announced its plan to relocate its corporate headquarters to downtown Greenville in 2008.
Tentative plans project construction of the new leased facility to begin in 2007 with a projected completion date in 2008. Management is currently in negotiations of a build-to-suit ground and building lease with the property owner. The 42,000
square foot, classical bank design will be located at the corner of East North and Church Streets. Despite being in some of the best growth markets in South Carolina, the Company faces the risk of being particularly sensitive to changes in the state
and local economies. If the economy weakens, it could cause loan demand to decline and also impact the Companys core deposit growth.



The Bank celebrated the grand opening of its Boiling Springs banking office on October 16, 2006. Prior to this grand opening, the Bank was operating
in a temporary location. During 2007, the Bank anticipates that it will construct and relocate two existing banking offices, the Pendleton banking office in Anderson County, and the Greer banking office in Greenville County. The Bank has purchased a
parcel of land with regard to the Pendleton banking office relocation and is currently considering land options with regard to the Greer banking office relocation. Management believes that these new locations will allow the Bank more space to better
serve our customers. Management continually reviews opportunities for Upstate expansion that are believed to be in the best interest of the Company, its customers, and its shareholders.



The Companys primary market area is located within Upstate, South Carolina. Primary business sectors in the region
include banking and finance, manufacturing, health care, retail, telecommunications, government services, and education. The Company believes that it is not dependent on any one or a few types of commerce due to the areas diverse economic
base.



Net interest income is the Companys primary source
of revenue. The Company derives interest income through traditional banking services including interest income earned on loans and investment securities. The Company generates noninterest income through fees charged on deposit accounts and income
generated through the Companys mortgage-banking, brokerage, and trust services. Lowering funding costs is essential to improving the Companys net interest margin. During 2006, the Company continued its focus on growing deposit balances
while remaining cognizant of pricing dilemmas resulting from the recent increasing interest rate environment. In addition to traditional deposit funding sources, the Company utilizes borrowings to support interest-earning asset growth. Although
often obtained at rates higher than those of traditional deposit funding sources, borrowings represent a source of funding diversification that can be used for leverage in deposit pricing. In addition, borrowings help an institution avoid overpaying
for deposits. Among other tools, the Company uses marginal cost analysis when considering funding options. Management believes that marginal cost analysis is the key to incorporating borrowings in deposit pricing. Although alternative funding
sources do not always result in



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lower interest expense, management believes that such funding alternatives can increase the Companys net interest income by employing these funds in
higher yielding interest-earning assets.



Since asset quality
is tied to many key performance indicators including, but not limited to, profitability and capital adequacy, maintaining sound asset quality continues to be a primary focus for the Company. Activities designed to monitor and improve asset quality
typically have a positive impact on operations by reducing the credit risk profile of the Company and reducing future collection costs. Nevertheless, certain risks are inherent within any loan portfolio particularly portfolios containing commercial,
commercial real estate, and installment loans, and these risks must be continually managed. Management monitors asset quality and credit risk on an ongoing basis.



The Company is focused on retaining existing and attracting new customers and feels that it sets itself apart from its
competitors by providing superior customer service. Such service is accomplished through a variety of delivery channels marketing a full range of high quality financial products and services. The Company sets targets for growth in traditional
deposit accounts annually in an effort to cross sell and increase the number of products per banking relationship. The Company uses traditional marketing techniques, such as direct mailings and advertising, to attract new customers as the Company
recognizes that attracting new customers provides both interest opportunities and a new avenue for the generation of fee income. In addition, new deposit customers are key to providing a mix of lower-cost funding sources. To meet the convenience
needs of existing and potential customers, the Company offers extended weekday hours at banking offices, Saturday banking at select banking offices, a call center, and Internet banking options. The Company intends to continue to expand into new
areas within its existing market and continue to explore and offer additional services as both market and economic conditions warrant.



At December 31, 2006, the Company had total assets of $1.2 billion, total traditional deposits of $993.6 million, total retail repurchase
agreements of $14.4 million, total commercial paper of $21.0 million, total other borrowings of $16.0 million, and stockholders equity of $100.4 million. Net income for the years ended December 31, 2006, 2005, and 2004 totaled $15.2,
$13.8, and $12.1 million, respectively. Total assets totaled $1.1 billion and $993.1 million at December 31, 2005 and 2004, respectively. The Company has no long-lived assets outside of the country.



Competition



The Upstate is a highly competitive banking market in which most of the
largest financial institutions in the state are represented. As a result, the Bank faces strong competition when attracting deposits and originating loans. Size gives the larger financial institutions certain advantages in competing for business
from larger corporations. These advantages include, but are not limited to, higher lending limits and the ability to offer more extensive distribution networks covering larger market areas. As a result, the Bank does not generally attempt to compete
for the banking relationships of larger corporations. Instead, the Bank concentrates its efforts on individuals and small and medium-size businesses.



Although the Bank has historically directly competed for deposits with commercial banks and other financial institutions, in recent years, money market,
stock, and fixed income mutual funds have attracted an increasing share of household savings. Consequently, the Company considers these funds to be competitors of the Bank. Competition among various financial institutions is based on interest rates
offered on deposit accounts, interest rates charged on loans, credit and service charges, the quality of service rendered, and the convenience of banking offices. The Bank feels that it sets itself apart from its competitors by providing superior
personal service through a variety of delivery channels and a full range of high quality financial products and services. The Bank believes it competes effectively in its market.



Employees



At December 31, 2006, the Company had 400 full-time equivalent employees, none of whom were subject to collective bargaining agreements, compared
with 387 full-time equivalent employees at December 31, 2005.



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Employees, depending on their level of employment, are offered a comprehensive employment program including, but not limited to, medical, dental, and select
vision benefits, life insurance, long-term disability coverage, a noncontributory defined benefit pension plan, and a 401(k) plan. The Company believes its employee relations are excellent.



Dividends



The holders of the Companys common stock are entitled to receive
dividends, when and if declared by the Board of Directors, out of funds legally available for such dividends. The holding company is a legal entity separate and distinct from the Bank and depends on the payment of dividends from the Bank. Current
federal law would prohibit, except under certain circumstances and with prior regulatory approval, an insured depository institution, such as the Bank, from paying dividends or making any other capital distribution if, after making the payment or
distribution, the institution would be considered undercapitalized as that term is defined in applicable regulations. In addition, as a South Carolina chartered bank, the Bank is subject to legal limitations on the amount of dividends it is
permitted to pay.



See Item 5. Market For
Registrants Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities, Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsLiquidityPalmetto Bancshares,
and Item 8. Financial Statements and Supplementary Data, Note 18 and Note 19 all contained herein for further discussion regarding common stock dividend payment determination and restrictions.



Business Segments



The Company adheres to the provisions of the Statement of Financial
Accounting Standards (SFAS) No. 131, Disclosures About Segments of an Enterprise and Related Information. Operating segments are components of an enterprise about which separate financial information is available that
are evaluated regularly by the chief operating decision maker in deciding how to allocate resources and assess performance. SFAS No. 131 requires that a public enterprise report a measure of segment profit or loss, certain specific revenue and
expense items, segment assets, and information about the way that the operating segments were determined, among other items.



The Company considers business segments by analyzing distinguishable components that are engaged in providing individual products, services or a groups of
related products or services and that are subject to risks and returns that are different from those of other business segments. To this end, when determining whether products and services are related, the Company considers the nature of the
products or services, the nature of the production processes, the type or class of customer for the products or services, and the methods used to distribute the products or provide the services.



Within the general loan portfolio, the Bank offers mortgage-banking services
and indirect lending products. These services have similar production processes and are targeted to similar customers using similar distribution channels as those employed for the entire Bank loan portfolio. Additionally, decisions are not made by
chief decision makers based on the results of these services alone. Instead, decisions with regard to mortgage-banking services indirect lending products are typically made in conjunction with decisions made with regard to the entire loan portfolio.
As such, the Company has concluded that these products are not considered to represent an operating segment separate from the banking segment.



Additionally, the Bank offers trust and investment services to its customers through similar distribution channels utilized by the Bank. Such services are
not routinely evaluated separately from the Bank. Additionally at December 31, 2006, fees for such services represented 3% of the Companys total revenues. As such, are not considered to represent an operating segment separate from the
banking segment.



Management also uses its judgment in
determining the composition of its business segments based on factors such as risk and returns, internal organization and management structure, and the Companys process of internal reporting to chief decision makers.



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At December 31, 2006, the Company determined it had one reportable operating segment, banking. As
such, separate segment information is not presented herein as management believes that the Consolidated Financial Statements contained herein within Item 8 report the information required by SFAS No. 131 with regard to the Companys
banking segment



Securities and Exchange Commission



The public may read and copy any materials filed in hard
copy by the Company with the Securities and Exchange Commission (the SEC) at the SECs Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. The public may obtain information on the operation of the Public
Reference Room by calling the SEC at 1-800-SEC-0330. The Company files reports electronically with the SEC. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file
reports electronically. This site may be accessed at www.sec.gov. Filings filed by the Company electronically with the SEC may be accessed through this website.



Other Information



The Company currently makes reports filed with the Securities and Exchange Commission available, free of charge, through its website
(www.palmettobank.com) through a link to the SECs website as noted above. The Company is currently exploring options to make such reports available through its website without having to navigate from the Banks main website. Such reports
may also be requested through sending written correspondence directed to 301 Hillcrest Drive, Laurens, South Carolina 29360 Attention: Senior Vice President, Finance and Accounting.



Supervision and Regulation



General



As a bank holding company registered under the Bank Holding Company Act of 1956, as amended (the BHCA), the holding company is required by
federal law to report to, and otherwise comply with the rules and regulations of, the Federal Reserve. The Bank is subject to extensive regulation, examination and supervision by the Federal Reserve, as its primary federal regulator, and the Federal
Deposit Insurance Corporation, as the deposit insurer. The Bank is also a member of the Federal Home Loan Bank System. The Bank must file reports with the Federal Reserve and the Federal Deposit Insurance Corporation concerning its activities and
financial condition in addition to obtaining regulatory approvals prior to entering into certain transactions such as mergers with, or acquisitions of, other financial institutions. The Federal Reserve and / or the Federal Deposit Insurance
Corporation conduct periodic examinations to test the Banks safety and soundness and compliance with various regulatory requirements. This regulation and supervision establishes a comprehensive framework of activities in which an institution
can engage and is intended primarily for the protection of the insurance fund and depositors. The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and
examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in such regulatory requirements and policies, whether by the Federal
Reserve, the Federal Deposit Insurance Corporation or Congress, could have a material adverse impact on the Company, the Bank and its operations. Certain regulatory requirements applicable to the Bank and to the Company are referred to below or
elsewhere herein. To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statutory and regulatory provisions. Any change in applicable laws may have a
material impact on the current and potential business of the holding company and the Bank. In addition, the operations of both may be impacted by possible legislative and regulatory changes and by the monetary policies of the United States.



Supervision and Regulation of the Holding Company



Bank Holding Company Act of
1956.As a bank holding company registered under the BHCA, the holding company is subject to regulation and supervision by the Federal Reserve. Under the BHCA, the holding



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companys activities, and those of its subsidiary, are limited to banking, managing or controlling banks, furnishing services to or performing services
for its subsidiary, and / or engaging in any other activity that the Federal Reserve determines to be closely related to banking. The BHCA prohibits the holding company from acquiring direct or indirect control of more than 5% of any class of
outstanding voting stock, or substantially all of the assets of, any bank or merging or consolidating with another bank holding company without prior approval of the Federal Reserve. The BHCA also prohibits the holding company from engaging in or
acquiring ownership or control of more than 5% of the outstanding voting stock of any company engaged in a nonbanking business unless such business is determined by the Federal Reserve to be closely related to banking or managing or controlling
banks.



Until September 29, 1995, the BHCA prohibited the
holding company from acquiring control of any bank operating outside the state of South Carolina unless the statutes of the state where the bank to be acquired was located specifically authorized such action. As of June 1, 1997, a bank
headquartered in one state was authorized to merge with a bank headquartered in another state as long as neither of the states had opted out of such interstate merger authority prior to such date. After a bank has established banking offices in a
state through an interstate merger transaction, the bank may establish and acquire additional banking offices in the state where a bank headquartered in that state could have established or acquired banking offices under applicable federal or state
law.



Responsibilities with Respect to the
Bank.    There are a number of obligations and restrictions imposed on bank holding companies and their depository institution subsidiaries by law and regulatory policy that are designed to minimize potential loss exposure to the
depositors of such depository institutions and to the Federal Deposit Insurance Corporation (the FDIC) insurance funds in the event the depository institution becomes in danger of defaulting under its obligations to repay deposits. Under
a policy of the Federal Reserve, a bank holding company is required to serve as a source of financial strength to its subsidiary depository institutions and to commit resources to support such institutions in circumstances where it might not do so
absent such policy. The Federal Reserve also has the authority under the BHCA to require a bank holding company to terminate any activity or relinquish control of a nonbank subsidiary (other than a nonbank subsidiary of a bank) upon the Federal
Reserves determination that such activity or control constitutes a serious risk to the financial soundness or stability of any subsidiary depository institution of the bank holding company. Further, federal law grants federal bank regulatory
authorities additional discretion to require a bank holding company to divest itself of any bank or nonbank subsidiary if the agency determines that divestiture may aid the depository institutions financial condition.



South Carolina State Board of Financial Institutions (the State
Board).    As a bank holding company registered under the South Carolina BHCA, the holding company is subject to regulation by the State Board. The holding company must file with the State Board periodic reports with
respect to its financial condition and operations, management, and relationships between the holding company and its subsidiary. Additionally, the holding company must obtain approval from the State Board prior to engaging in acquisitions of banking
or nonbanking institutions or assets.



Capital
Requirements.    The Federal Reserve has adopted risk-based capital guidelines for bank holding companies. Under these guidelines, the minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet
activities) is 8%. At least half of the total capital is required to be Tier 1 capital, principally consisting of common shareholders equity, noncumulative preferred stock, a limited amount of cumulative perpetual preferred stock, and minority
interests in the equity accounts of consolidated subsidiaries, less certain goodwill items. The remainder, known as Tier 2 capital, may consist of a limited amount of subordinated debt and intermediate term preferred stock, certain hybrid capital
instruments and other debt securities, perpetual preferred stock, and a limited amount of the general allowance for loan losses. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet items, are multiplied
by a risk-weight ranging from 0% to 100% based on the risk inherent in the type of asset. In addition to the risk-based capital guidelines, the Federal Reserve has adopted a minimum Tier 1 (leverage) capital ratio under which a bank holding
company



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must maintain a minimum level of Tier 1 capital (as determined under applicable rules) to average total consolidated assets of at least 3% in the case of
bank holding companies that have the highest regulatory examination ratios and are not contemplating significant growth or expansion. All other bank holding companies are required to maintain a Tier 1 (leverage) capital ratio of at least 4%.



See Item 8. Financial Statements and Supplementary Data,
Note 19 contained herein for further discussion regarding capital requirements.



Supervision and Regulation of the Bank



The Bank is a FDIC-insured, state-chartered banking corporation and is subject to various statutory requirements and rules and regulations promulgated and enforced primarily by the FDIC and the State Board. These
statutes, rules, and regulations relate to insurance of deposits, required reserves, allowable investments, loans, mergers, consolidations, issuance of securities, payment of dividends, establishment of banking offices, and other aspects of the
business of the Bank. The FDIC is an independent federal agency established originally to insure the deposits, up to prescribed statutory limits, of federally insured banks and to preserve the safety and soundness of the banking industry. In
addition, federal law imposes a number of restrictions on state-chartered, FDIC-insured banks and their subsidiaries. These restrictions range from prohibitions against engaging as a principal in certain activities to the requirement of prior
notification of banking office closings.



Capital
Requirements.    The Bank is subject to capital requirements imposed by the FDIC. The FDIC requires state-chartered, nonmember banks to comply with risk-based capital standards substantially similar to those required by the
Federal Reserve, as described in Supervision and RegulationSupervision and Regulation of the Holding CompanyCapital Requirements. The FDIC also requires state-chartered, nonmember banks to maintain a minimum leverage ratio similar to
that adopted by the Federal Reserve. Under the FDICs leverage capital requirement, the Bank required to maintain an absolute minimum Tier 1 (leverage) capital ratio of not less than 4%.



See Item 8. Financial Statements and Supplementary Data, Note 19
contained herein for further discussion regarding capital requirements.



Prompt Corrective Regulatory Action.    Current law provides federal banking agencies with broad powers to take prompt corrective regulatory action to resolve problems of insured depository institutions. The extent of
these powers depends upon whether the institutions in question are determined to be well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized or critically undercapitalized. Under uniform regulations defining such
capital levels issued by each of the federal banking agencies, a bank is considered well capitalized if it has a total risk-based capital ratio of 10% or greater, a Tier 1 risk-based capital ratio of 6% or greater, a leverage ratio of 5% or greater,
and is not subject to any order or written directive to meet and maintain a specific capital level for any capital measure. An adequately capitalized bank is defined as one that has a total risk-based capital ratio of 8% or greater, a Tier 1
risk-based capital ratio of 4% or greater, and a leverage ratio of 4% or greater (or 3% or greater in the case of a bank with a composite CAMELS rating of 1). A CAMELS rating is a score given to a financial institution by its primary regulator which
represents a composite rating of the various areas examined: capital adequacy, asset quality, management, earnings, liquidity, and sensitivity to market risk. A bank is considered undercapitalized if it has a total risk-based capital ratio of less
than 8%, a Tier 1 risk-based capital ratio of less than 4% or a leverage ratio of less than 4% (or 3% in the case of a bank with a composite CAMELS rating of 1). A bank is considered significantly undercapitalized if the bank has a total
risk-based capital ratio of less than 6%, a Tier 1 risk-based capital ratio of less than 3%, or a leverage ratio of less than 3%. A bank is considered critically undercapitalized if the bank has a ratio of tangible equity to total assets equal to or
less than 2%.



See Item 8. Financial Statements and
Supplementary Data, Note 19 contained herein for further discussion regarding capital requirements.



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Federal Deposit Insurance Corporation.    The Banks deposits are insured up to
applicable limits by the Deposit Insurance Fund of the Federal Deposit Insurance Corporation. The Deposit Insurance Fund is the successor to the Bank Insurance Fund and the Savings Association Insurance Fund, which were merged in 2006. The Federal
Deposit Insurance Corporation recently amended its risk-based assessment system for 2007 to implement authority granted by the Federal Deposit Insurance Reform Act of 2005 (Reform Act). Under the revised system, insured institutions are
assigned to one of four risk categories based on supervisory evaluations, regulatory capital levels and certain other factors. An institutions assessment rate depends upon the category to which it is assigned. Risk Category I, which contains
the least risky depository institutions, is expected to include more than 90% of all institutions. Unlike the other categories, Risk Category I contains further risk differentiation based on the Federal Deposit Insurance Corporations analysis
of financial ratios, examination component ratings and other information. Assessment rates are determined by the Federal Deposit Insurance Corporation and currently range from five to seven basis points for the healthiest institutions (Risk Category
I) to 43 basis points of assessable deposits for the riskiest (Risk Category IV). The Federal Deposit Insurance Corporation may adjust rates uniformly from one quarter to the next, except that no single adjustment can exceed three basis points.



The Reform Act also provided for a one-time credit for
eligible institutions based on their assessment base as of December 31, 1996. Subject to certain limitations with respect to institutions that are exhibiting weaknesses, credits can be used to offset assessments until exhausted. The Banks
one-time credit is expected to approximate $576 thousand. The Reform Act also provided for the possibility that the Federal Deposit Insurance Corporation may pay dividends to insured institutions once the Deposit Insurance fund reserve ratio equals
or exceeds 1.35% of estimated insured deposits.



In addition to
the assessment for deposit insurance, institutions are required to make payments on bonds issued in the late 1980s by the Financing Corporation to recapitalize the predecessor to the Savings Association Insurance Fund. During fiscal 2006, Financing
Corporation payments for Savings Association Insurance Fund members approximated 1.28 basis points of assessable deposits.



The Banks total assessment paid for this period (including the FICO assessment) was approximately $117 thousand. The Federal Deposit Insurance
Corporation has authority to increase insurance assessments. A significant increase in insurance premiums would likely have an adverse effect on the operating expenses and results of operations of the Bank. Management cannot predict what insurance
assessment rates will be in the future.



Insurance of deposits
may be terminated by the Federal Deposit Insurance Corporation upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law,
regulation, rule, order or condition imposed by the Federal Deposit Insurance Corporation or the Federal Reserve. Management of the Bank does not know of any practice, condition or violation that might lead to termination of deposit insurance.



Federal Deposit Insurance Corporation Improvement Act Of 1991
(FDICIA).    To facilitate the early identification of problems, FDICIA required the federal banking agencies to prescribe more stringent reporting requirements. The FDICs final regulations implementing those
provisions require, among other things, that management report on the institutions responsibility for preparing financial statements, establishing and maintaining an internal control structure and procedures for financial reporting, and
compliance with designated laws and regulations concerning safety and soundness. The final regulations also require that independent registered public accounting firms attest to, and report separately on, assertions in managements reports
regarding compliance with such laws and regulations using FDIC approved audit procedures. These regulations apply to financial institutions with greater than $1 billion in assets at the beginning of their fiscal year. Accordingly, the Bank is
subject to these regulations.



Federal Home Loan Bank
(FHLB) System



The Bank is a member of the
Federal Home Loan Bank System,    which consists of 12 regional Federal Home Loan Banks. The Federal Home Loan Bank provides a central credit facility primarily for member



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institutions. The Bank, as a member of the Federal Home Loan Bank, is required to acquire and hold shares of capital stock in that Federal Home Loan Bank. A
members FHLB capital stock requirement is an amount equal to the sum of a membership requirement and an activity-based requirement as described in the FHLBs Capital Plan. The Bank was in compliance with this requirement with an
investment in Federal Home Loan Bank stock at December 31, 2006 of $2.6 million. Dividends on FHLB capital stock have yielded returns of 6.3% and 3.8% for the years ended December 31, 2006 and 2005, respectively. Although it does not
provide borrowing capacity, a members capital stock is pledged to the FHLB as additional collateral to secure the members indebtedness.



The Federal Home Loan Banks are required to provide funds used for the resolution of insolvent thrifts in the late 1980s and to contribute funds for
affordable housing programs. Those requirements could reduce the amount of dividends that the Federal Home Loan Banks pay to their members and could also result in the Federal Home Loan Banks imposing a higher rate of interest on advances to their
members. If dividends were reduced, or interest on future Federal Home Loan Bank advances increased, the Banks net interest income would likely also be reduced.



Congress created the FHLB system pursuant to the Federal Home Loan Bank Act to provide secured advances to the FHLBs
members in an effort to promote liquidity in the housing finance markets. Under the Federal Home Loan Bank Act and implementing regulations of the Federal Housing Finance Board, the FHLB is required to ensure that borrowing members have sufficient
qualifying collateral at all times to secure outstanding advances.



The FHLB generally establishes credit availability for each creditworthy institution. Credit availability is not a formal commitment to extend credit but an indication of the amount of credit the FHLB is willing to extend to a member. The
FHLB monitors each members credit availability on a periodic basis and may make adjustments to the credit availability as needed. The amount of a members credit availability is contingent upon a number of factors, including, but not
limited to, continued financial soundness of the member, and adequacy of the amount of qualifying collateral available to secure new and outstanding advances.



Qualifying collateral may include various types of mortgage loans, securities, and deposits. The member has certain obligations to the FHLB for its
pledged collateral. These obligations include periodic reporting on eligible, pledged collateral and adherence to the FHLBs collateral verification review procedures.



The FHLB has established an overall credit limit for each member. This limit is designed to mitigate the FHLBs credit
exposure to an individual member while encouraging members to diversify their funding sources. Generally, this credit limit is 40 percent of the members total assets. However, a members eligibility to borrow in excess of 30 percent of
assets is subject to its meeting eligibility criteria. Under certain circumstances, a member approved for a 40 percent credit limit may request approval to exceed the credit limit.



Community Reinvestment Act (CRA)



Under the Community Reinvestment Act the Company has a continuing and affirmative obligation consistent with its safe and
sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The Community Reinvestment Act does not establish specific lending requirements or programs for financial institutions nor does
it limit an institutions discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the Community Reinvestment Act. The Community Reinvestment Act requires the FDIC,
in connection with its examination of an institution, to assess the institutions record of meeting the credit needs of its community and to take such record into account in its evaluation of applications by such institution. The Community
Reinvestment Act requires public disclosure of an institutions Community Reinvestment Act rating. The Banks latest Community Reinvestment Act rating, received from the FDIC was Satisfactory.



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|Item 1A.Risk | Factors
|------------ | -------



In addition to the other information contained in this report, the following risks may impact the Company. Any risk factor described in this report could
by itself, or together with one or more other factors, adversely impact the Companys business, financial condition, and / or results of operations. In addition, there are factors that may not be described in this report that could cause
results to differ from expectations.



Changes in economic
conditions particularly in Upstate South Carolina could negatively impact the Companys business.



The Companys business is directly impacted by factors such as economic, political and market conditions, broad trends in industry and finance,
legislative, and regulatory changes, changes in government monetary and fiscal policies and inflation, all of which are beyond the Companys control. The Company is particularly impacted by economic conditions in the Upstate region of the state
of South Carolina because all of its branches are located in this area. Deterioration in economic conditions could result in the following consequences, any of which could have a material adverse impact on the Companys business, financial
condition, results of operations, and cash flows:



| |  |  | Problem assets and foreclosures may increase;
| | - |  | ---------------------------------------------



| |  |  | Demand for the Companys products and services may decline;
| | - |  | -----------------------------------------------------------



| |  |  | Low cost on noninterest-bearing deposits may decrease; and
| | - |  | ----------------------------------------------------------



| |  |  | Collateral for loans made by the Company, especially real estate, may decline in value, in turn reducing customers borrowing power, and reducing the value of
assets and collateral associated with existing loans.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



In view of the geographic concentration of the Companys operations and the collateral securing its loan portfolio in Upstate, South Carolina, the Companys lack of geographic diversification may make it particularly susceptible
to the adverse impacts of any of these consequences, any of which could have a material adverse impact on the Companys business, financial condition, results of operations, and cash flows.



Changes in Federal Reserve policies could negatively impact the
Companys business.



An important function of the
Federal Reserve is the regulation of the money supply. The instruments of monetary policy employed by the Federal Reserve include open market operations in United States Government securities, changes in the discount rate on member bank borrowings,
changes in reserve requirements against member bank deposits, and limitations on interest rates which member banks pay on time and savings deposits. The Federal Reserve uses these methods in varying combinations to influence overall growth and
distribution of bank loans, investments, and deposits. The use of these methods may impact interest rates charged on loans or paid on deposits by the Company. Changes in Federal Reserve policies are beyond the Companys control and are
difficult to predict or anticipate but could, nonetheless, result in a material adverse impact on the Companys business, financial condition, results of operations, and cash flows.



The Companys growth and expansion may strain its ability to manage its operations and financial resources.



The Companys financial performance and
profitability depend on its ability to execute corporate growth strategies. In addition to seeking deposit and loan growth in the Companys existing markets, the Company intends to pursue expansion opportunities primarily through strategically
placed new branches. Although the Company has in the past pursued expansion opportunities through the acquisition of community banks and branch locations in identified strategic markets, such expansion is not currently the Companys primary
growth strategy. Continued growth, however, may present operating and other problems that could adversely impact the Companys business, financial condition, results of operations, and cash flows. Accordingly, there can be no assurance that the
Company will be able to execute its growth strategy or maintain the level of profitability recently experienced.



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Growth may place a strain on administrative, operational, and financial resources and increase demands on
systems and controls. The Company plans to pursue opportunities to expand business through internally generated growth. This business growth may require continued enhancements to and expansion of the Companys operating and financial systems
and controls and may strain or significantly challenge them. In the event that the Company chooses to pursue acquisition options, the process of consolidating the businesses and implementing the strategic integration of any acquired businesses with
the Companys existing business may take a significant amount of time. It may also place additional strain on Company resources thereby subjecting the Company to additional expenses. The Company cannot assure that it will be able to integrate
these businesses successfully or in a timely manner. In addition, existing operating and financial control systems and infrastructure may not be adequate to maintain and effectively monitor future growth.



The Companys continued growth may increase its need for qualified
personnel. The Company cannot assure that it will be successful in attracting, integrating, and retaining such personnel. The following risks, associated with growth, could have a material adverse impact on the Companys business, financial
condition, results of operations, and cash flows:



| |  |  | Inability to continue to upgrade or maintain effective operating and financial control systems,
| | - |  | -----------------------------------------------------------------------------------------------



| |  |  | Inability to recruit and hire necessary personnel or to successfully integrate new personnel into the Companys operations,
| | - |  | ---------------------------------------------------------------------------------------------------------------------------



| |  |  | Inability to successfully integrate the operations of acquired businesses or to manage the Companys growth effectively, and
| | - |  | ----------------------------------------------------------------------------------------------------------------------------



| |  |  | Inability to respond promptly or adequately to the emergence of unexpected expansion difficulties.
| | - |  | --------------------------------------------------------------------------------------------------



The Company is dependent on key personnel and the loss of one or more of
those key personnel may materially and adversely impact the Companys prospects.



Competition for qualified employees and personnel in the banking industry is intense. The process of recruiting personnel with the combination of skills and attributes required to carry out the Companys
strategies is often lengthy. In addition, the Companys success depends, to a significant degree, upon the ability to attract and retain qualified management, loan origination, finance, administrative, marketing, and technical personnel and
upon the continued contributions of management and personnel.



The Companys business is subject to interest rate risk and variations in interest rates may negatively impact its financial performance.



A substantial portion of the Companys income is derived from the differential or spread between interest earned on interest-earning
assets and interest paid on interest-bearing liabilities. At December 31, 2006, the Companys balance sheet was liability sensitive, when analyzing the coming twelve month period, and, as a result, net interest margin tends to expand in a
falling interest rate environment and decrease in a falling interest rate environment. Because of the differences in the maturities and repricing characteristics of the Companys interest-earning assets and interest-bearing liabilities, changes
in interest rates do not produce equivalent changes in interest income earned on interest-earning assets and interest paid on interest-bearing liabilities. Accordingly, fluctuations in interest rates could adversely impact the Companys
interest rate spread and, in turn, profitability. In addition, loan origination volumes are impacted by market interest rates. Rising interest rates, generally, are associated with a lower volume of loan originations while lower interest rates are
typically associated with higher loan originations. Conversely, in rising interest rate environments, loan repayment rates may decline and in falling interest rate environments, loan repayment rates may increase. Falling interest rate environments
may cause additional refinancing of commercial real estate and residential mortgage loans that may depress loan volumes or cause rates on loans to decline. In addition, an increase in the general level of short-term interest rates on adjustable-rate
loans may adversely impact the ability of certain borrowers to pay the interest on and principal of their obligations or reduce the amount they wish to borrow. Additionally, as short-term market rates have risen since the second quarter of 2004, the
Company has not proportionally increased interest rates paid on deposits.



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As short-term rates continue to rise, retention of existing deposit customers and the attraction of new deposit customers may require the Company to increase
rates paid on deposit accounts. Because the Company deferred increasing rates paid on deposit accounts during a period of rising short-term market rates, the Company may need to continue to accelerate the pace of rate increases on deposit accounts
as compared to the pace of future increases in short-term market rates. Accordingly, changes in levels of market interest rates could materially and adversely impact net interest income, asset quality, loan origination volume, business, financial
condition, results of operations, and cash flows.



See
Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsDisclosures Regarding Market Risk contained herein for discussion regarding risk relating to variations in interest rates.



The Companys increased emphasis on commercial and construction
lending may lead to increased lending risks.



At
December 31, 2006, $593.4 million, or 63.3%, of the Banks loan portfolio consisted of commercial real estate loans and $112.3 million, or 12.0%, of commercial business loans. These types of loans generally expose a lender to greater risk
of nonrepayment and loss than one-to-four-family residential mortgage loans because repayment of the loans often depends on the successful operation of the property, the income stream of the borrowers and, for construction loans, the accuracy of the
estimate of the propertys value at completion of construction and the estimated cost of construction. Such loans typically involve larger loan balances to single borrowers or groups of related borrowers compared to one- to four-family
residential mortgage loans. Commercial business loans expose the Company to additional risks since such loans typically are made on the basis of the borrowers ability to make repayments from the cash flow of the borrowers business and
are secured by nonreal estate collateral that may depreciate over time. In addition, since such loans generally entail greater risk than one- to four-family residential mortgage loans, the Company may need to increase its allowance for loan losses
in the future to account for the likely increase in probable incurred credit losses associated with the growth of such loans. Also, many of the Companys commercial and construction borrowers have more than one outstanding loan. Consequently,
an adverse development with respect to one credit relationship can expose the Company to a significantly greater risk of loss compared to an adverse development with respect to a one- to four-family residential mortgage loan.



See Item 7. Managements Discussion and Analysis of Financial
Condition and Results of OperationsFinancial ConditionLoans and Item 8. Financial Statements and Supplementary Data, Note 4 contained herein for further discussion regarding risks associated with the Companys commercial and
construction loan portfolios.



The Companys asset
growth potential may be restricted by minimum capital ratio standards.



Capital performs several very important functions. It absorbs losses, promotes public confidence, helps restricts excessive asset growth, and provides protection to depositors and the FDIC insurance funds. Capital,
along with minimum capital ratio standards, restrains unjustified asset expansion by requiring that asset growth be funded by a commensurate amount of additional capital. Alternatives available for increase the capital level in Banks include, but
are not necessarily limited to, increased earnings retention, sale of additional capital stock, and reduced asset growth. Management may attempt to increase earnings retention through a combination of higher earnings and lower cash dividend rates.
Earnings may be improved, for example, by tighter controls over certain expense outlays; repricing of loans, fees, or service charges; upgrading credit standards and administration to reduce loan or securities losses, or through various other
adjustments. An increase in retained earnings will improve capital ratios assuming the increase exceeds asset growth. Historically, the Companys primary source of capital has been increased earnings retention. In order to ensure adequate
levels of capital, an ongoing assessment is conducted of projected sources and uses of capital in conjunction with projected increases in assets and the level of risk. Management believes it has adequate capital to meet its needs without entering
capital markets. Due to the fact that the Company has not historically sold new equity due to the resulting impact of shareholder dilution, in times where increased earnings retention may not be sufficient to address capital



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requirements, the Bank may be required to reduce asset growth to remain well capitalized as defined by the applicable regulatory framework. Disposing of
short-term, marketable assets and allowing volatile liabilities to run off may accomplish this intentional asset shrinkage. This reduction results in a relatively higher capital-to-assets ratio, but it may leave the Bank with a strained liquidity
posture. Therefore, it is a strategy that can have adverse consequences from a safety and soundness perspective.



A downturn in real estate markets could impact the Companys business through its loan portfolio.



A downturn in the real estate markets could negatively impact the
Companys business as a large portion of its loans are secured by real estate. Real estate values and markets are generally impacted by changes in national, regional, or local economic conditions, fluctuations in interest rates and the
availability of loans to potential purchasers, changes in tax laws and other governmental statutes, regulations, and policies, and acts of nature. If real estate prices decline, the value of real estate collateral securing the Companys loans
could be reduced. Ability to recover on defaulted loans by foreclosing and selling the real estate collateral would then be diminished and the Company would be more likely to suffer losses on defaulted loans. As of December 31, 2006,
approximately 77.3% of the Companys loan portfolio consisted of loans collateralized by various types of real estate. Substantially all of the Companys real estate collateral is located in South Carolina. If there is a significant
decline in real estate values, especially in South Carolina, the collateral for the Companys loans will provide less security. Real estate values could also be negatively impacted by factors particular to South Carolina. Any such downturn
could have a material adverse impact on the Companys business, financial condition, results of operations, and cash flows.



See Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsFinancial ConditionLoans and
Item 8. Financial Statements and Supplementary Data, Note 4 contained herein for further discussion regarding risks associated with the Companys real estate loan portfolios.



An increase in loan prepayments and on prepayment of loans underlying mortgage-backed securities may adversely impact the
Companys profitability.



Prepayment rates are
impacted by consumer behavior, conditions in the housing and financial markets, general economic conditions and the relative interest rates on fixed-rate and adjustable-rate mortgage loans. The Company recognizes deferred loan origination costs and
premiums paid on originating these loans by adjusting interest income over the contractual life of the individual loans. As prepayments occur, the rate at which net deferred loan origination costs and premiums are expensed accelerates. Although
changes in prepayment rates are difficult to predict, prepayment rates tend to increase when market interest rates decline relative to the rates on the prepaid instruments



The Company recognizes premiums paid on mortgage-backed securities as an adjustment to interest income over the life of the
security based on the rate of repayment of the securities. Acceleration of prepayment on the loans underlying a mortgage-backed security shortens the life of the security, increases the rate at which premiums are expensed and further reduces
interest income.



The Company may not be able to reinvest loan
and security prepayments at rates comparable to the prepaid instruments particularly in periods of declining interest rates.



See Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsEarnings ReviewNoninterest Income
and Item 8. Financial Statements and Supplementary Data, Note 1 and Note 6 all contained herein for further discussion regarding the Companys accounting policies related to, factors impacting, and methodology for analyzing the
Companys mortgage-servicing rights portfolio.



If the
Company cannot attract deposits, its growth may be inhibited.



The Company plans to increase significantly the level of assets, including its loan portfolio. The Companys ability to increase assets depends in large part on the Companys ability to attract additional deposits at favorable



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rates. The Company intends to seek additional deposits by offering deposit products that are competitive with those offered by other financial institutions
in its markets and by establishing personal relationships with customers. The Company cannot assure that these efforts will be successful. The Companys inability to attract additional deposits at competitive rates could have an adverse impact
on its business, financial condition, results of operations, and cash flows.



The allowance for loan and lease losses may not be adequate to cover actual losses.



Risk arises from the possibility that losses could be sustained because borrowers, guarantors, and related parties may fail to perform in accordance with
the terms of their loans. The underwriting and credit monitoring policies and procedures that the Company has adopted to address such risks may not prevent unexpected losses that could have a material adverse impact on the Companys business,
financial condition, results of operations, and cash flows. Unexpected losses may arise from a wide variety of specific or systemic factors, many of which are beyond the Companys ability to predict, influence, or control. Like all financial
institutions, the Company maintains an allowance for loan losses to provide for loan defaults and nonperformance. The Companys allowance for loan losses may not be adequate to cover actual loan losses, and future provisions for loan losses
could materially and adversely impact the Companys business, financial condition, results of operations, and cash flows. The allowance for loan losses reflects the Companys estimate of the probable losses in its loan portfolio at the
relevant balance sheet date. The allowance for loan losses is based on prior experience as well as an evaluation of the known risks in the current portfolio, composition and growth of the loan portfolio, and economic factors. The determination of an
appropriate level of allowance for loan loss is an inherently difficult process and is based on numerous assumptions. The amount of future losses is susceptible to changes in economic, operating, and other conditions, including changes in interest
rates, that may be beyond the Companys control. As a result, losses may exceed current estimates. Federal and state regulatory agencies, as an integral part of their examination process, review the Companys loans and the related
allowance for loan losses. While the Company believes that its allowance for loan losses is adequate to cover current losses, it cannot provide absolute assurance that it will not increase the allowance for loan losses further or that regulators
will not require an increase in this allowance for loan losses. Either of these occurrences could have a material adverse impact on the Companys business, financial condition, results of operations, and cash flows.



See Item 7. Managements Discussion and Analysis of Financial
Condition and Results of OperationsFinancial ConditionLoans and Allowance for Loan Losses and Item 8. Financial Statements and Supplementary Data, Note 1 and Note 4 all contained herein for further discussion regarding the
Companys accounting policies related to, factors impacting, and methodology for analyzing the adequacy of the Companys allowance for loan losses.



The Company relies on communications, information, operating, and financial control systems technology from third party service providers, and an
interruption in those systems may result in lost business if the Company is not be able to obtain substitute providers on terms that are as favorable if relationships with existing service providers are interrupted.



The Company relies heavily on third party service providers for much of its
communications, information, operating, and financial control systems technology. Any failure or interruption or breach in security of these systems could result in failures or interruptions to customer relationship management, general ledger,
deposit, servicing, and / or loan origination systems. The Company cannot give absolute assurance that such failures or interruptions will not occur or, if they do occur, that they will be adequately addressed by the Company or the third parties on
which it relies. The occurrence of any failures or interruptions could have a material adverse impact on the Companys business, financial condition, results of operations, and cash flows. If any of the Companys third party service
providers experience financial, operational, or technological difficulties, or if there is any other disruption in the Companys relationships with them, the Company may be required to locate alternative sources of such services, and absolute
assurance cannot be provided that it could negotiate terms that are as favorable, or could obtain services with similar functionality as found in existing systems, without the need



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to expend substantial resources, if at all. Any of these circumstances could have a material adverse impact on the Companys business, financial
condition, results of operations, and cash flows.



The
Companys accounting policies and methods are fundamental to how the Company records and reports its financial condition and results of operations. Incorrect application of such policies and methods may result in inaccurate financial results
and / or reporting.



Management must exercise judgment in
selecting and applying many of these accounting policies and methods in order for the Company to comply with generally accepted accounting principles. Such methods must also reflect managements judgment as to the most appropriate manner in
which to record and report the Companys financial condition and results of operations. See Item 8. Financial Statements and Supplementary Data, Note 1 contained herein for further discussion regarding the Companys significant
accounting policies. Of these policies, several have been deemed to be critical to the presentation of the Companys financial condition and results of operations because they require management to make particularly subjective and / or complex
judgments about matters that are inherently uncertain and because of the likelihood that materially different amounts would be reported under different conditions or using different assumptions. See Item 7. Managements Discussion and
Analysis of Financial Condition and Results of OperationsCritical Accounting Policies contained herein for further discussion regarding the accounting policies that management has determined are critical under this definition. The presentation
of financial information no prepared in accordance with generally accepted accounting principles could have a material adverse impact on the Companys business, financial condition, results of operations, and cash flows.



The Company relies on information furnished by or on behalf of customers
and counterparties when making decisions to extend credit that could prove to be unrealizable and, therefore, negatively impact the Companys business.



In deciding whether or not to extend credit or enter into transactions with customers and counterparties, the Company and
its management may rely on information furnished by or on behalf of customers and counterparties. The Company may also rely on representations of customers and counterparties as to the accuracy and completeness of such information and on reports of
independent registered public accounting firms typically covering its customers financial statements. If the Company relies on financial statements that do not comply with generally accepted accounting principles or that are materially
misleading, such reliance could have a material adverse impact on the Companys business, financial condition, results of operations, and cash flows.



The Company faces strong competition from financial service companies and other companies that offer banking services that could negatively impact the
Companys business.



The Company conducts its banking
operations primarily in Upstate, South Carolina. Increased competition in the Companys markets may result in reduced loans and deposits, and, ultimately, it may not be able to compete successfully against current and future competitors. Many
competitors offer the banking services that the Company offers in its service areas. These competitors include national banks, regional banks, and other community banks. The Company also faces competition from many other types of financial
institutions, including savings and loan associations, finance companies, brokerage firms, insurance companies, credit unions, mortgage banks, and other financial intermediaries. In particular, competitors include several major financial companies
whose greater resources may afford them a marketplace advantage by enabling them to maintain numerous locations and mount extensive promotional and advertising campaigns. Additionally, banks and other financial institutions with larger
capitalization and financial intermediaries not subject to bank regulatory restrictions may have larger lending limits that would allow them to serve the credit needs of larger customers. Areas of competition include interest rates for loans and
deposits, efforts to obtain loan and deposit customers and a range in quality of products and services provided, including, but not limited to, new technology-driven products and services. Technological innovation continues to contribute to greater
competition in financial services markets as technological advances enable more companies to provide financial services. The Company



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also faces competition from out-of-state financial intermediaries that have opened loan production offices or that solicit deposits in the market areas
served by the Company. If the Company is unable to attract and retain banking customers, it may be unable to continue its loan and deposit growth and the Companys business, financial condition, results of operations, and cash flows may be
adversely impacted.



The Companys future ability to
pay dividends is subject to restrictions.



The holding
company is a separate and distinct legal entity from the Bank and receives its revenue from dividends of the Bank. These dividends are the principal source of funds to pay dividends on the Companys common stock. Various federal and / or state
laws and regulations limit the amount of dividends that the Bank may pay to its holding company. The Companys ability to pay dividends will continue to depend upon receipt of dividends or other capital distributions from the Bank.
Additionally, the ability to continue to pay dividends is also subject to the regulations noted above. See Item 5. Market For Registrants Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities, Item 7.
Managements Discussion and Analysis of Financial Condition and Results of OperationsLiquidityPalmetto Bancshares, and Item 8. Financial Statements and Supplementary Data, Note 18 and Note 19 all contained herein for further
discussion regarding common stock dividend payment determination and restrictions.



If the Company fails to maintain effective systems of internal and disclosure control, it may not be able to accurately report financial results or prevent fraud. As a result ,investors could lose confidence in the
Companys financial reporting, which could negatively impact the Companys business.



Effective internal and disclosure controls are necessary for the Company to provide reliable financial reports and effectively prevent fraud and operate
successfully as a public company. If the Company cannot provide reliable financial reports or prevent fraud, its reputation and operating results would be harmed. As part of the Companys ongoing monitoring of internal control, material
weaknesses or significant deficiencies may be discovered in internal control as defined under standards adopted by the Public Company Accounting Oversight Board (PCAOB) that require remediation. Under the PCAOB standards, a material
weakness is a significant deficiency or combination of significant deficiencies that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. A significant
deficiency is a control deficiency or combination of control deficiencies that adversely impacts a companys ability to initiate, authorize, record, process, or report external financial data reliably in accordance with generally accepted
accounting principles such that there is a more than remote likelihood that a misstatement of a companys annual or interim financial statements, that is more than inconsequential, will not be prevented or detected.



As a result of weaknesses that may be identified in internal controls, the
Company may also identify certain deficiencies in some of its disclosure controls and procedures that are believed to require remediation. If weaknesses are discovered, efforts will be made to improve internal and disclosure controls. However, there
is no assurance that such efforts will be successful. Any failure to maintain effective controls or make necessary improvement to internal and disclosure controls could harm operating results or cause the Company to fail to meet its reporting
obligations. Ineffective internal and disclosure controls could also cause investors to lose confidence in the Companys reported financial information, which would likely have a negative impact on the trading of the Companys common
stock.



The holding company and the Bank are subject to
extensive government regulation. These regulations may restrict the ability to increase assets and earnings.



The Companys operations and those of the Bank are subject to extensive regulation by federal, state, and local governmental authorities and are
subject to various laws and judicial and administrative decisions imposing requirements and restrictions on part or all of the Companys operations. Such regulations are intended to protect depositors, federal deposit insurance funds, and the
banking system as a whole, not security holders. The banking industry is highly regulated, and Congress and state legislatures and federal and state regulatory agencies



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continually review banking laws, regulations, and policies for possible changes which could impact the Company in substantial and unpredictable ways. There
are currently proposed various laws, rules, and regulations that, if adopted, would impact the Companys operations. The Companys failure to comply with laws, regulations, or policies could result in sanctions by regulatory agencies and
damage to the Companys reputation. Absolute assurance cannot be provided that these proposed laws, rules and regulations, or any other laws, rules, or regulations will not be adopted in the future, which could make compliance much more
difficult or expensive, limit permissible activities, impact the competitive balance among banks, savings associations, credit unions, and other financial institutions, further limit or restrict the amount of commissions, interest, or other charges
earned on loans originated or sold by the Company, or otherwise adversely impact the Companys business, financial condition, results of operations, or cash flows. See Item 1. BusinessSupervision and Regulation contained herein for
further discussion regarding the regulation and supervision of the holding company and the Bank.



A breach of information security could negatively impact the Companys earnings.



Increasingly, the Company depends upon data processing, communication, and
information exchange on a variety of computing platforms and networks and over the Internet and cannot be certain that all systems are entirely free from vulnerability to attack, despite safeguards that have been instituted. In addition, the Company
relies on the services of a variety of vendors to meet data processing and communication needs. If information security is breached, information can be lost or misappropriated, resulting in financial loss or costs to the Company or damages to
others. These costs or losses could materially exceed the amount of insurance coverage, if any, which would adversely impact our earnings.



The Company is subject to heightened regulatory scrutiny with respect to Bank secrecy and anti-money laundering statutes and regulations.



Recently, regulators have intensified their focus on the
USA PATRIOT Acts anti-money laundering and Bank Secrecy Act compliance requirements. In order to comply with regulations, guidelines, and examination procedures in this area, the Company has been required to adopt new policies and procedures
and to install new systems. However, the Company cannot be certain that the policies, procedures, and systems in place are flawless. Therefore, there is no assurance that in every instance full compliance with these requirements is met.



Other risk factors



The following risk factors could also potentially adversely impact the
Companys business, financial condition, results of operations, or cash flows, although management considers the risks to be of a lesser degree than other risk factors discussed herein:



| |  |  | Fluctuations in consumer spending patterns;
| | - |  | -------------------------------------------



| |  |  | Ability of the Company to increase its market share;
| | - |  | ----------------------------------------------------



| |  |  | Accuracy of future expense projections;
| | - |  | ---------------------------------------



| |  |  | Potential for adverse adjustments with regard to income taxes;
| | - |  | --------------------------------------------------------------



| |  |  | Costs and impact of litigation; and
| | - |  | -----------------------------------



| |  |  | Geopolitical conditions such as acts or threats of terrorism, actions taken against the United States or other governments in response to acts or threats of
terrorism, and / or military conflicts with regard to such events.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|Item 1B.Unresolved | Staff Comments
|------------------ | --------------



Not applicable.



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##### Table of Contents

|Item 2.Properties | 
|----------------- | 



The Companys corporate and operations center is currently located at 301 Hillcrest Drive,
Laurens, South Carolina. The Company owns these premises. In conjunction with the Companys 100thanniversary
celebration on September 21, 2006, the Company announced its plan to relocate its corporate headquarters to downtown Greenville, South Carolina in 2008.



At December 31, 2006, the Bank had thirty-two full-service banking offices in the Upstate region of South Carolina in the following counties: Laurens
County (4), Greenville County (10), Spartanburg County (6), Greenwood County (5), Anderson County (3), Cherokee County (2), Pickens County (1), and Oconee County (1) in addition to two Palmetto Capital offices independent of banking office
locations, 38 automatic teller machine (ATM) locations (including eight in nonbanking office locations), and five limited service banking offices located in retirement centers in the Upstate.



During 2006, the Company added two new banking office ATM locations, one in
conjunction with the opening of the Boiling Springs banking office in Spartanburg County and one at its existing North Harper banking office in Laurens County, and four new nonbanking office ATM locations at Northside Village Shopping Center in
Anderson County, Heritage Pointe Shopping Center in Pickens County, and Roebuck Village Shopping and Crossroads Commons Shopping Centers in Spartanburg County. One principal banking office is located in each of the following counties: Laurens,
Greenville, Spartanburg, Greenwood, and Anderson.



Banking
offices range in size from approximately 1,000 to 15,000 square feet. The current corporate and operations location is approximately 55,000 square feet. Facilities are protected by alarm and security systems that meet or exceed regulatory standards.
Ten of the Banks current full service banking offices are leased, and the Bank owns the remaining banking offices. Additionally, during the first quarter of 2006, the Bank completed negotiations with a third party with regard to the sublease
of its previous Blackstock Road banking office location. The Bank owns this banking structure that is located on land that the Bank leases pursuant to a ground lease. Additionally, the Bank owns a banking structure on Haywood Road constructed on
land that the Bank leases pursuant to a ground lease. Further, Palmetto Capital leases its Fountain Inn office. The Bank has seven ground leases with regard to ATMs at nonbanking office locations and four ground leases with regard to real property
most often used for parking at existing branch offices.



The
Bank entered into a building lease, not included in those noted above for banking office locations, with regard to the temporary Boiling Springs banking office that was used while the permanent banking office was constructed during 2006. This lease
had expired by December 31, 2006.



During 2006, the Bank
began an expansion of its Greenwood county Montague banking office. Construction on this office is anticipated to be completed during the first quarter of 2007.



The Bank owns two parcels of property to be used in conjunction with the construction of its new corporate headquarters in Greenville County.
Additionally, during February 2007, the Bank purchased real estate in Anderson County and plans to relocate its existing Pendleton banking office to that site. The Company and is currently considering land options with regard to its anticipated
Greer banking office relocation.



During January 2007, the Bank
entered into a ground lease agreements for leased property at which the Company will house a new ATM. This lease is not included in those summarized above. This ground lease is located in a market area that the Company currently serves.



At December 31, 2006 and 2005, the total net book value of the
premises and equipment owned was $24.5 million and $22.7 million, respectively. None of the Companys properties are mortgaged or subject to liens in favor of any regulatory authorities.



Management evaluates, on an ongoing basis, the suitability and adequacy of
all of its facilities, including banking offices and service facilities, and has active programs of relocating, remodeling, or closing any as



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necessary to maintain efficient and attractive facilities. Management believes all of the Banks banking office and service facility locations are
suitable and adequate for their intended purposes.



See
Item 8. Financial Statements and Supplementary Data, Note 1 contained herein for further discussion regarding the Companys significant accounting policies with regard to premises and equipment. See Item 8. Financial Statements and
Supplementary Data, Note 5 also contained herein for further discussion regarding the Companys premises and equipment, and Note 8 for further discussion regarding minimum rental commitments under leases for banking office and service facility
locations.



|Item 3.Legal | Proceedings
|------------ | -----------



The Company is currently subject to various legal proceedings and claims that have arisen in the ordinary course of its business. In the opinion of
management, based on consultation with the applicable external legal counsel, any reasonably foreseeable outcome of such current litigation would not materially impact the Companys financial condition or results of operations.



|Item 4.Submission | of Matters to a Vote of Security Holders
|----------------- | ----------------------------------------



No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended December 31, 2006.



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Part II



Item 5.Market For Registrants Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities



The Internal Revenue Service often defines fair market value as the price at
which property would change hands between a willing buyer and a willing seller neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. However, this market oriented definition of the value of
stock is less useful when the stock trades infrequently. Unlike the value of publicly traded stock, the fair market value of closely held stock is often difficult to ascertain because no active trading market for the stock exists.



There is no established public trading market for the Companys stock.
The Companys Secretary facilitates stock trades of the Companys common stock by matching willing buyers and sellers that contact her. However, trades can be and are made that are not facilitated through the Secretary between willing
buyers and sellers of which the Company may have no transaction details. Additionally, the Company believes that many of these transactions do not constitute arms length transactions as many of the transactions are between buyers and sellers
with relationships that may lead to a sale at a price other than fair market value. The Company believes that many trades are between buyers and sellers that are family members, that are family members of Company employees, or that are members of
the community who may be willing to pay a premium for the stock of a company headquartered in their community. Because of these factors, the Company does not believe that the prices at which the trades recorded by its Secretary occur can be
considered fair market value, and, as a result, annually, a third party fair market valuation is performed by an external third party on a minority block of the outstanding common shares of Palmetto Bancshares, Inc. for use in conjunction with stock
options. The evaluation performed and effective with respect to fiscal year 2006 stock option grants concluded that the fair market value of the outstanding common shares of Palmetto Bancshares, Inc. for use in conjunction with stock options was
$27.30 per share.



The last known trading price of the
Companys common stock, based on information available to its management through the Companys Corporate Secretary, was $38.00 per common share on December 31, 2006. Management is aware of a number of transactions in which the
Companys common stock traded at this price. However, management has not ascertained that these transactions were a result of arms length negotiations between the parties and, because of the limited number of shares involved, these prices
may not be indicative of the fair market value of the common stock. At December 31, 2006, the Company had 1,475 shareholders representing 6,367,450 shares outstanding. The following table summarizes high and low trading prices of the
Companys common stock by quarter for the periods presented and dividend information for the same periods, based on information available to its management.



|               |  |      |       |     |       |               |     
|-------------- |  | ---- | ----- | --- | ----- | ------------- | ----
|               |  | High |       | Low |       | Cash dividend
|2006           |  |      |       |     |       |               |     
|First quarter  |  | $    | 35.00 |     | 35.00 |               | 0.18
|Second quarter |  |      | 36.00 |     | 35.00 |               | 0.18
|Third quarter  |  |      | 37.00 |     | 36.00 |               | 0.18
|Fourth quarter |  |      | 38.00 |     | 37.00 |               | 0.19
|               |  |      |      
|2005           |  |      |       |     |       |               |     
|First quarter  |  | $    | 33.00 |     | 32.00 |               | 0.16
|Second quarter |  |      | 33.00 |     | 33.00 |               | 0.16
|Third quarter  |  |      | 34.00 |     | 33.00 |               | 0.16
|Fourth quarter |  |      | 35.00 |     | 34.00 |               | 0.18



The Company or its
predecessor, the Bank, has paid regular dividends on common stock since 1909. The amount of the dividend is determined by the Board of Directors and is dependent upon the Companys earnings,



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financial condition, capital position, and such other factors as the Board of Directors may deem relevant. For the years ended December 31, 2006, 2005,
and 2004, cash dividends were paid of $4.6 million or $0.73 per common share, $4.2 million or $0.66 per common share, and $3.6 million or $0.58 per common share, respectively. The Company has historically paid dividends on a quarterly basis. These
dividends equate to dividend payout ratios of 30.45%, 30.27%, and 30.07% in 2006, 2005, and 2004, respectively. Although there can be no guarantee that additional dividends will be paid in future periods, the Company plans to continue its quarterly
dividend payments.



See Item 1. BusinessDividends,
and Item 8. Financial Statements and Supplementary Data, Note 18 and Note 19 all contained herein for further discussion regarding common stock dividend payment restrictions.



The following table summarizes compensation plans under which equity securities of the Company are authorized for issuance
as of December 31, 2006. Security holders previously approved all equity compensation plans of the Company in existence at December 31, 2006.



|                                                           |  |                                                                          |  |                                                          |       |                                                                                                                                            |    
|---------------------------------------------------------- |  | ------------------------------------------------------------------------ |  | -------------------------------------------------------- | ----- | ------------------------------------------------------------------------------------------------------------------------------------------ | ---
|                                                           |  | (a) Number of securitiesto be issued upon exerciseof outstanding options |  | (b) Weighted averageexercise price ofoutstanding options |       | (c) Number of securitiesremaining availablefor future issuancesunder equitycompensation plans(excluding securitiesreflected in column (a))
|Equity compensation plans approved by security holders     |  | 251,670                                                                  |  | $                                                        | 18.67 |                                                                                                                                            | 800
|Equity compensation plans not approved by security holders |  |                                                                         |  |                                                          |      |                                                                                                                                            |   
|                                                           |  |                                                                          |  |                                                          |       |                                                                                                                                            |    
|Total equity compensation plans                            |  | 251,670                                                                  |  | $                                                        | 18.67 |                                                                                                                                            | 800
|                                                           |  |                                                                          |  |                                                          |       |                                                                                                                                            |    



See Item 8.
Financial Statements and Supplementary Data, Note 1 contained herein for further discussion regarding the Companys significant accounting policies with regard to its equity compensation plans and Item 8. Financial Statements and
Supplementary Data, Note 13 also contained herein for further discussion regarding the Companys equity compensation plans.



23



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|Item 6.Selected | Financial Data
|--------------- | --------------



|                                                               |  |                                                          |           |   |      |           |      |           |      |           |      |          
|-------------------------------------------------------------- |  | -------------------------------------------------------- | --------- | - | ---- | --------- | ---- | --------- | ---- | --------- | ---- | ---------
|                                                               |  | At and for the years ended December 31,                 
|                                                               |  | 2006                                                     |           |   | 2005 |           | 2004 |           | 2003 |           | 2002
|                                                               |  | (dollars in thousands, except common and per share data)
|SUMMARY OF OPERATIONS                                          |  |                                                          |           |   |      |           |      |           |      |           |      |          
|Interest income                                                |  | $                                                        | 76,446    |   |      | 62,783    |      | 51,029    |      | 49,663    |      | 49,657   
|Interest expense                                               |  |                                                          | 27,297    |   |      | 17,279    |      | 11,177    |      | 10,923    |      | 12,533   
|                                                               |  |                                                          |           |   |      |           |      |           |      |           |      |          
|Net interest income                                            |  |                                                          | 49,149    |   |      | 45,504    |      | 39,852    |      | 38,740    |      | 37,124   
|Provision for loan losses                                      |  |                                                          | 1,625     |   |      | 2,400     |      | 2,150     |      | 3,600     |      | 4,288    
|                                                               |  |                                                          |           |   |      |           |      |           |      |           |      |          
|Net interest income after provision for loan losses            |  |                                                          | 47,524    |   |      | 43,104    |      | 37,702    |      | 35,140    |      | 32,836   
|Noninterest income                                             |  |                                                          | 16,514    |   |      | 15,402    |      | 14,857    |      | 15,017    |      | 13,637   
|Noninterest expense                                            |  |                                                          | 40,835    |   |      | 37,784    |      | 34,879    |      | 34,259    |      | 32,156   
|                                                               |  |                                                          |           |   |      |           |      |           |      |           |      |          
|Income before provision for income taxes                       |  |                                                          | 23,203    |   |      | 20,722    |      | 17,680    |      | 15,898    |      | 14,317   
|Provision for income taxes                                     |  |                                                          | 7,962     |   |      | 6,942     |      | 5,569     |      | 5,005     |      | 4,696    
|                                                               |  |                                                          |           |   |      |           |      |           |      |           |      |          
|Net income                                                     |  | $                                                        | 15,241    |   |      | 13,780    |      | 12,111    |      | 10,893    |      | 9,621    
|                                                               |  |                                                          |           |   |      |           |      |           |      |           |      |          
|COMMON AND PER SHARE DATA                                      |  |                                                          |           |   |      |           |      |           |      |           |      |          
|Net income per common share:                                   |  |                                                          |           |   |      |           |      |           |      |           |      |          
|Basic                                                          |  | $                                                        | 2.40      |   |      | 2.18      |      | 1.93      |      | 1.73      |      | 1.53     
|Diluted                                                        |  |                                                          | 2.37      |   |      | 2.15      |      | 1.90      |      | 1.70      |      | 1.49     
|Cash dividends per common share                                |  |                                                          | 0.73      |   |      | 0.66      |      | 0.58      |      | 0.51      |      | 0.45     
|Book value per common share                                    |  |                                                          | 15.76     |   |      | 14.05     |      | 12.82     |      | 11.49     |      | 10.68    
|Outstanding common shares                                      |  |                                                          | 6,367,450 |   |      | 6,331,335 |      | 6,297,285 |      | 6,263,210 |      | 6,324,659
|Weighted average common shares outstandingbasic               |  |                                                          | 6,353,752 |   |      | 6,317,110 |      | 6,272,594 |      | 6,301,024 |      | 6,296,956
|Weighted average common shares outstandingdiluted             |  |                                                          | 6,421,742 |   |      | 6,417,358 |      | 6,378,787 |      | 6,395,170 |      | 6,470,996
|Dividend payout ratio                                          |  |                                                          | 30.45     | % |      | 30.27     |      | 30.07     |      | 29.49     |      | 29.46    
|                                                               |  |                                                          |           |   |     
|YEAR-END BALANCES                                              |  |                                                          |           |   |      |           |      |           |      |           |      |          
|Assets                                                         |  | $                                                        | 1,153,136 |   |      | 1,075,015 |      | 993,102   |      | 895,377   |      | 822,644  
|Investment securities available for sale, at fair market value |  |                                                          | 116,567   |   |      | 125,988   |      | 143,733   |      | 128,930   |      | 115,108  
|Loans (1)                                                      |  |                                                          | 947,588   |   |      | 871,002   |      | 779,108   |      | 699,612   |      | 637,393  
|Deposits and other borrowings                                  |  |                                                          | 1,044,996 |   |      | 978,926   |      | 906,895   |      | 819,443   |      | 749,661  
|Shareholders equity                                           |  |                                                          | 100,376   |   |      | 88,941    |      | 80,762    |      | 71,989    |      | 67,521   
|                                                               |  |                                                          |           |   |     
|AVERAGE BALANCES                                               |  |                                                          |           |   |      |           |      |           |      |           |      |          
|Assets                                                         |  | $                                                        | 1,114,553 |   |      | 1,043,897 |      | 932,672   |      | 855,813   |      | 774,022  
|Interest-earning assets                                        |  |                                                          | 1,042,289 |   |      | 977,679   |      | 872,253   |      | 799,462   |      | 715,623  
|Investment securities available for sale, at fair market value |  |                                                          | 120,395   |   |      | 132,709   |      | 134,854   |      | 113,648   |      | 100,367  
|Loans (1)                                                      |  |                                                          | 898,028   |   |      | 833,353   |      | 730,430   |      | 670,707   |      | 585,885  
|Deposits and other borrowings                                  |  |                                                          | 1,012,741 |   |      | 952,623   |      | 851,680   |      | 780,742   |      | 705,834  
|Shareholders equity                                           |  |                                                          | 95,077    |   |      | 85,790    |      | 76,566    |      | 70,745    |      | 64,060   
|                                                               |  |                                                          |           |   |     
|SIGNIFICANT OPERATING RATIOS BASED ON EARNINGS                 |  |                                                          |           |   |      |           |      |           |      |           |      |          
|Return on average assets                                       |  |                                                          | 1.37      | % |      | 1.32      |      | 1.30      |      | 1.27      |      | 1.24     
|Return on average shareholders equity                         |  |                                                          | 16.03     |   |      | 16.06     |      | 15.82     |      | 15.40     |      | 15.02    
|Net interest margin                                            |  |                                                          | 4.72      |   |      | 4.65      |      | 4.57      |      | 4.85      |      | 5.19     
|                                                               |  |                                                          |           |   |     
|SIGNIFICANT CAPITAL RATIOS                                     |  |                                                          |           |   |      |           |      |           |      |           |      |          
|Average shareholders equity to average assets                 |  |                                                          | 8.53      | % |      | 8.22      |      | 8.21      |      | 8.27      |      | 8.28     
|Equity to assets at year-end                                   |  |                                                          | 8.70      |   |      | 8.27      |      | 8.13      |      | 8.04      |      | 8.21     
|Tier 1 risk-based capital                                      |  |                                                          | 9.37      |   |      | 9.36      |      | 9.43      |      | 9.22      |      | 9.72     
|Total risk-based capital                                       |  |                                                          | 10.19     |   |      | 10.28     |      | 10.38     |      | 10.25     |      | 10.73    
|Tier 1 leverage ratio                                          |  |                                                          | 8.59      |   |      | 8.08      |      | 7.76      |      | 7.58      |      | 7.59     
|                                                               |  |                                                          |           |   |     
|SIGNIFICANT CREDIT QUALITY RATIOS                              |  |                                                          |           |   |      |           |      |           |      |           |      |          
|Nonaccrual loans to total assets                               |  |                                                          | 0.61      | % |      | 0.92      |      | 0.23      |      | 0.43      |      | 0.30     
|Net loans charged-offs to average loans (2)                    |  |                                                          | 0.17      |   |      | 0.19      |      | 0.27      |      | 0.38      |      | 0.61     

---

|(1) |  | Calculated using loans including mortgage loans held for sale, net of unearned, excluding the allowance for loan losses
|--- |  | -----------------------------------------------------------------------------------------------------------------------

|(2) |  | Calculated using loans excluding mortgage loans held for sale, net of unearned, excluding the allowance for loan losses
|--- |  | -----------------------------------------------------------------------------------------------------------------------



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|Item 7. | Managements Discussion and Analysis of Financial Condition and Results Of Operations
|------- | -------------------------------------------------------------------------------------



The following discussion and analysis is presented to assist the reader with
understanding the financial condition and results of operations of the Company. The information presented in the following discussion of financial condition and results of operations of the Company results from the activities of, the Bank, which
comprises the majority of the consolidated net income, revenues, and assets of the Company. This discussion should be read in conjunction with the audited Consolidated Financial Statements and related notes and other financial data presented in
Item 8 herein and the supplemental financial data presented throughout this report. Percentage calculations contained herein have been calculated based on rounded results presented herein.



Forward-Looking Statements



The Company makes forward-looking statements in this report and in other reports and proxy statements filed with the SEC. In addition, certain statements in future filings by the Company with the SEC, in press releases, and in oral and
written statements made by or with the approval of the Company, which are not statements of historical fact, constitute forward-looking statements. Broadly speaking, forward-looking statements include, but are not limited to, projections of the
Companys revenues, income, earnings per common share, capital expenditures, dividends, capital structure, or other financial items, descriptions of plans or objectives of management for future operations, products or services, forecasts of the
Companys future economic performance, and descriptions of assumptions underlying or relating to any of the foregoing. In this report, for example, management makes forward-looking statements discussing expectations about future credit losses
and nonperforming assets, the future value of the mortgage-servicing rights portfolio, the future value of equity securities, the impact of new accounting standards, future short-term and long-term interest rate levels and their impact on the
Companys net interest margin, net income, liquidity, capital, and future capital expenditures.



Forward-looking statements discuss matters that are not historical facts. Because such statements discuss future events or conditions, forward-looking
statements often include words such as anticipate, believe, estimate, expect, intend, plan, project, target, can, could,
may, should, will, would, or similar expressions. Do not unduly rely on forward-looking statements. Such statements give expectations about the Companys future and are not guarantees.
Forward-looking statements speak only as of the date for which they are made, and the Company might not update them to reflect changes that occur after the date they are made.



Impact of Inflation



The
Consolidated Financial Statements and related financial data presented herein have been prepared in accordance with generally accepted accounting principles. These principles require the measurement of financial condition and results of operations
in terms of historical dollars without considering changes in relative purchasing power over time due to inflation.



Unlike many companies that manufacture goods or provide services, virtually all of the assets and liabilities of the Company are monetary in nature and,
as a result, its operations could be significantly impacted by interest rate fluctuations. Interest rates do not necessarily move in the same direction or in the same magnitude as the price of goods and services since such changes in interest rates
are impacted by inflation. The Company intends to continue to actively manage the gap between its interest-sensitive assets and liabilities. See Item 7. Managements Discussion and Analysis of Financial Condition and Results of
OperationsDisclosures Regarding Market Risk contained herein for discussion regarding the relationship of the Companys interest-sensitive assets and liabilities.



Critical Accounting Policies



The Companys accounting and financial reporting policies are in conformity with generally accepted accounting principles (GAAP). The preparation of financial statements in conformity with such principles requires
management to make estimates and assumptions that impact the reported amounts of assets and



25



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##### Table of Contents

liabilities, the disclosure of contingent assets and liabilities during the reporting period, and the reported amounts of revenue and expense during the
reporting period. Management, in conjunction with the Companys independent registered public accounting firm, has discussed the development and selection of the critical accounting estimates discussed herein with the Audit Committee of the
Companys Board of Directors.



The Companys
significant accounting policies are discussed in Item 8. Financial Statements and Supplementary Data, Note 1 contained herein. Of these significant accounting policies, the Company considers its policies regarding the accounting for its
Allowance, pension plan, mortgage-servicing rights portfolio, past acquisitions, and income taxes to be its most critical accounting policies due to the valuation techniques used and the sensitivity of these financial statement amounts to the
methods, assumptions, and estimates underlying these balances. Accounting for these critical areas requires a significant degree of judgment that could be subject to revision as newer information becomes available. In order to determine the
Companys critical accounting policies, management considers if the accounting estimate requires assumptions about matters that were highly uncertain at the time the accounting estimate was made and if different estimates that reasonably could
have been used in the current period or changes in the accounting estimate that are reasonably likely to occur from period to period would have a material impact on the presentation of financial condition, changes in financial condition, or results
of operations.



The Allowance represents managements
estimate of probable losses inherent in the lending portfolio. See Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsFinancial ConditionLoans and Allowance for Loan Losses and
Item 8. Financial Statements and Supplementary Data, Note 1 and Note 4 all contained herein for further discussion regarding the Companys accounting policies related to, factors impacting, and methodology for analyzing the adequacy of the
Companys Allowance. This methodology relies upon managements judgments. Managements judgments are based on an assessment of various issues, including, but not limited to, the pace of loan growth, emerging portfolio concentrations,
the risk management system relating to lending activities, recently entered markets, recently added product offerings, loan portfolio quality trends, and uncertainty in current economic and business conditions. Management considers the year-end
Allowance appropriate and adequate to cover probable losses in the loan portfolio. However, managements judgment is based upon a number of assumptions about current events that are believed to be reasonable but which may or may not prove
valid. Thus, there can be no assurance that loan losses in future periods will not exceed the current Allowance amount or that future increases in the Allowance will not be required. No assurance can be given that managements ongoing
evaluation of the loan portfolio, in light of changing economic conditions and other relevant factors, will not require significant future additions to the Allowance, thus adversely impacting the results of operations of the Company.



As explained in Item 8. Financial Statements and Supplementary Data,
Note 1 contained herein, for the year ended December 31, 2006, the Company accounted for its postretirement benefit plan in accordance with SFAS No. 87, Employers Accounting for Pensions and followed the disclosure
requirements of SFAS No. 132, as revised, Employers Disclosures about Pensions and Other Postretirement Benefitsan amendment of FASB Statements No. 87, 88, and 106, which revises employers disclosures about
pension plans and other postretirement benefit plans. SFAS No. 132(R) did not change the measurement or recognition of the plans required by SFAS No. 87, SFAS No. 88, Employers Accounting for Settlements and Curtailments
of Defined Benefit Pension Plans and for Termination Benefits, and SFAS No. 106, Employers Accounting for Postretirement Benefits Other Than Pensions. In order to account for pension plans, costs and related liabilities
are developed using actuarial valuations. These valuations include key assumptions determined by management, including, among other things, discount rates, projected compensation increases, as well as retirement and benefit payment projections. In
addition, in order to properly account for the Companys postretirement benefit plan, assumptions must be made regarding plan assets. The expected long-term rate of return assumption considers the asset mix and past performance of plan assets,
as well as other factors. See Item 8. Financial Statements and Supplementary Data, Note 13 contained herein for further discussion regarding the Companys estimates and assumptions related to the Companys pension assets, obligations,
and related periodic cost. Assessing the adequacy of the Companys pension assets, obligations, and related periodic cost is a process that requires



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considerable judgment. Management considers the year-end net pension obligation to be an appropriate and adequate measure of future postretirement benefit
plan payments. However, managements judgment is based upon a number of assumptions that are believed to be reasonable but which may or may not prove valid. Thus, there can be no assurance that future increases in the pension obligation will
not be required related to obligations at December 31, 2006, thus adversely impacting the results of operations of the Company.



In addition to the discussion of risk factors impacting the Companys mortgage-servicing rights portfolio included in Item 1a. Risk Factors
contained herein, see Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsEarnings ReviewNoninterest Income and Item 8. Financial Statements and Supplementary Data, Note 1 and Note
6 all contained herein for further discussion regarding the Companys accounting policies related to, factors impacting, and methodology for analyzing the Companys mortgage-servicing rights portfolio. The Companys accounting for its
mortgage-servicing rights portfolio represents another accounting estimate heavily dependent on current economic conditions, especially the interest rate environment, and managements judgments. The Company utilizes the expertise of a third
party consultant to assess the portfolios value including, but not limited to, capitalization, impairment, and amortization rates. The consultant utilizes estimates for the amount and timing of estimated prepayment rates, credit loss
experience, costs to service loans, and discount rates to determine an estimate of the fair market value of the Companys mortgage-servicing rights portfolio. Management believes that the modeling techniques and assumptions used by the
consultant are reasonable. Future annual amounts could be impacted by changes in factors noted above as well as those noted within Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsForward
Looking Statements which discusses mortgage-banking income.



Although growth through acquisition is not currently a strategic growth initiative of the Company, historically, the Company has increased its market share through Bank acquisitions (the last of these acquisitions occurred in 1999). These
acquisitions resulted in goodwill or other intangible assets that are subject to periodic impairment testing in accordance with SFAS No. 142, Goodwill and Other Intangible Assets. Such impairment testing calculations, performed by
the Company annually as of June 30, include estimates. Furthermore, the determination of which intangible assets have finite lives is subjective as is the determination of the amortization period for such intangible assets. The Company tests
for goodwill impairment by determining the fair market value for each reporting unit and comparing the fair market value to the carrying amount of the applicable reporting unit. If the carrying amount exceeds fair market value, the potential for
impairment exists, and a second step of impairment testing is performed. In the second step, the fair market value of the reporting units goodwill is determined by allocating the reporting units fair market value to all of its assets
(recognized and unrecognized) and liabilities as if the reporting unit had been acquired in a business combination at the date of the impairment test. If the implied fair market value of reporting unit goodwill is less than its carrying amount,
goodwill is impaired and is written-down to its fair market value. The Companys impairment testing as of June 30, 2006 indicated that no impairment charge was required as of that date, however, there can be no assurance that future events
and circumstances will not change these determination and adversely impact the results of operations of the Company. No such events or circumstances have come to managements attention since its June 30, 2006 testing. See Item 8.
Financial Statements and Supplementary Data, Note 1 contained herein for further discussion regarding the Companys accounting policies related to its intangible assets.



Management uses assumptions and estimates in determining income taxes payable or refundable for the current year, deferred
income tax liabilities and assets for events recognized differently for book and tax purposes, and income tax expense. Determining these amounts requires analysis of certain transactions and interpretation of tax laws and regulations. Management
exercises judgment in evaluating the amount and timing of recognition of the resulting tax liabilities and assets. These judgments and estimates are reevaluated on a continual basis as regulatory and business factors change. No assurance can be
given that either the tax returns submitted by the Company or the income tax reported on the Consolidated Financial Statements will not be adjusted by adverse rulings by the United States Tax Court, changes in the tax code, or assessments made
by the Internal Revenue Service. The Company is subject to potential adverse adjustments, including, but not limited to, an increase in the statutory federal or state income tax rates, the permanent nondeductibility of amounts currently



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considered deductible either now or in future periods, and the dependency on the generation of future taxable income, including capital gains, in order to
ultimately realize deferred income tax assets. See Item 8. Financial Statements and Supplementary Data, Note 1 and Note 12 all contained herein for further discussion regarding the Companys significant accounting policies impacting the
Companys income taxes as well as discussion regarding the Companys current period income tax expense and future tax liabilities associated with differences in the timing of expense and income recognition for book and tax accounting
purposes.



Financial Condition



The
following information is intended to supplement any information relating to the Consolidated Balance Sheets contained within Item 8 of this Annual Report on Form 10-K.



Overview



PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Consolidated Balance Sheets

(dollars
in thousands, except common and per share data)



|                                                               |  |                  |           |   |                  |           |   |                |         |   |                 |        |  
|-------------------------------------------------------------- |  | ---------------- | --------- | - | ---------------- | --------- | - | -------------- | ------- | - | --------------- | ------ | -
|                                                               |  | December 31,2006 |           |   | December 31,2005 |           |   | Dollarvariance |         |   | Percentvariance |       
|ASSETS                                                         |  |                  |           |   |                  |           |   |                |         |   |                 |        |  
|Cash and cash equivalents                                      |  |                  |           |   |                  |           |   |                |         |   |                 |        |  
|Cash and due from banks                                        |  | $                | 43,084    |   |                  | 36,978    |   |                | 6,106   |   |                 | 16.5   | %
|Federal funds sold                                             |  |                  | 3,582     |   |                  | 998       |   |                | 2,584   |   |                 | 258.9  |  
|                                                               |  |                  |           |   |                  |           |   |                |         |   |                 |        |  
|Total cash and cash equivalents                                |  |                  | 46,666    |   |                  | 37,976    |   |                | 8,690   |   |                 | 22.9   |  
|                                                               |  |                  |           |  
|Federal Home Loan Bank (FHLB) stock, at cost                 |  |                  | 2,599     |   |                  | 3,786     |   |                | (1,187  | ) |                 | (31.4  | )
|Investment securities available for sale, at fair market value |  |                  | 116,567   |   |                  | 125,988   |   |                | (9,421  | ) |                 | (7.5   | )
|Mortgage loans held for sale                                   |  |                  | 1,675     |   |                  | 4,821     |   |                | (3,146  | ) |                 | (65.3  | )
|                                                               |  |                  |           |  
|Loans                                                          |  |                  | 945,913   |   |                  | 866,181   |   |                | 79,732  |   |                 | 9.2    |  
|Less: allowance for loan losses                                |  |                  | (8,527    | ) |                  | (8,431    | ) |                | (96     | ) |                 | 1.1    |  
|                                                               |  |                  |           |   |                  |           |   |                |         |   |                 |        |  
|Loans, net                                                     |  |                  | 937,386   |   |                  | 857,750   |   |                | 79,636  |   |                 | 9.3    |  
|                                                               |  |                  |           |  
|Premises and equipment, net                                    |  |                  | 24,494    |   |                  | 22,676    |   |                | 1,818   |   |                 | 8.0    |  
|Goodwill                                                       |  |                  | 3,691     |   |                  | 3,691     |   |                |        |   |                 |       |  
|Other intangible assets                                        |  |                  | 127       |   |                  | 175       |   |                | (48     | ) |                 | (27.4  | )
|Accrued interest receivable                                    |  |                  | 6,421     |   |                  | 5,226     |   |                | 1,195   |   |                 | 22.9   |  
|Other                                                          |  |                  | 13,510    |   |                  | 12,926    |   |                | 584     |   |                 | 4.5    |  
|                                                               |  |                  |           |   |                  |           |   |                |         |   |                 |        |  
|Total assets                                                   |  | $                | 1,153,136 |   |                  | 1,075,015 |   |                | 78,121  |   |                 | 7.3    | %
|                                                               |  |                  |           |   |                  |           |   |                |         |   |                 |        |  
|LIABILITIES AND SHAREHOLDERS EQUITY                           |  |                  |           |   |                  |           |   |                |         |   |                 |        |  
|Liabilities                                                    |  |                  |           |   |                  |           |   |                |         |   |                 |        |  
|Deposits                                                       |  |                  |           |   |                  |           |   |                |         |   |                 |        |  
|Noninterest-bearing                                            |  | $                | 133,623   |   |                  | 131,157   |   |                | 2,466   |   |                 | 1.9    | %
|Interest-bearing                                               |  |                  | 859,958   |   |                  | 772,226   |   |                | 87,732  |   |                 | 11.4   |  
|                                                               |  |                  |           |   |                  |           |   |                |         |   |                 |        |  
|Total deposits                                                 |  |                  | 993,581   |   |                  | 903,383   |   |                | 90,198  |   |                 | 10.0   |  
|                                                               |  |                  |           |  
|Retail repurchase agreements                                   |  |                  | 14,427    |   |                  | 16,728    |   |                | (2,301  | ) |                 | (13.8  | )
|Commercial paper (Master notes)                                |  |                  | 20,988    |   |                  | 17,915    |   |                | 3,073   |   |                 | 17.2   |  
|Federal funds purchased                                        |  |                  | 6,000     |   |                  | 1,000     |   |                | 5,000   |   |                 | 500.0  |  
|FHLB borrowingsshort-term                                     |  |                  |          |   |                  | 16,900    |   |                | (16,900 | ) |                 | (100.0 | )
|FHLB borrowingslong-term                                      |  |                  | 10,000    |   |                  | 23,000    |   |                | (13,000 | ) |                 | (56.5  | )
|Accrued interest payable                                       |  |                  | 1,584     |   |                  | 1,275     |   |                | 309     |   |                 | 24.2   |  
|Other                                                          |  |                  | 6,180     |   |                  | 5,873     |   |                | 307     |   |                 | 5.2    |  
|                                                               |  |                  |           |   |                  |           |   |                |         |   |                 |        |  
|Total liabilities                                              |  |                  | 1,052,760 |   |                  | 986,074   |   |                | 66,686  |   |                 | 6.8    |  
|                                                               |  |                  |           |   |                  |           |   |                |         |   |                 |        |  
|Shareholders Equity                                           |  |                  |           |   |                  |           |   |                |         |   |                 |        |  
|Common stock                                                   |  |                  | 31,837    |   |                  | 31,656    |   |                | 181     |   |                 | 0.6    |  
|Capital surplus                                                |  |                  | 1,102     |   |                  | 659       |   |                | 443     |   |                 | 67.2   |  
|Retained earnings                                              |  |                  | 68,132    |   |                  | 57,532    |   |                | 10,600  |   |                 | 18.4   |  
|Accumulated other comprehensive loss, net of tax               |  |                  | (695      | ) |                  | (906      | ) |                | 211     |   |                 | (23.3  | )
|                                                               |  |                  |           |   |                  |           |   |                |         |   |                 |        |  
|Total shareholders equity                                     |  |                  | 100,376   |   |                  | 88,941    |   |                | 11,435  |   |                 | 12.9   |  
|                                                               |  |                  |           |   |                  |           |   |                |         |   |                 |        |  
|Total liabilities and shareholders equity                     |  | $                | 1,153,136 |   |                  | 1,075,015 |   |                | 78,121  |   |                 | 7.3    | %
|                                                               |  |                  |           |   |                  |           |   |                |         |   |                 |        |  



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At December 31, 2006, the Companys assets totaled $1.153 billion, an increase of $78.1 million
or 7.3% over December 31, 2005. The increase in assets during fiscal year 2006 resulted primarily from an increase in total loans of $76.6 million partially offset by a decline in investment securities available for sale of $9.4 million, or
7.5%. Average assets increased 6.8% during the year, and average interest-earning assets increased 6.6%. Total liabilities increased $66.7 million, or 6.8%, at December 31, 2006 over December 31, 2005, to a balance of $1.053 billion. This
increase resulted from an increase in traditional deposits of $90.2 million, or 10.0%, an increase in commercial paper of $3.1 million, or 17.2%, and an increase in federal funds purchased over the same periods totaling $5.0 million. Offsetting
these increases were declines in retail repurchase agreements totaling $2.3 million, or 13.8%, and FHLB advances totaling $29.9 million, or 74.9%. Total deposits and other borrowings totaled $1.045 billion at December 31, 2006, up from $978.9
million at December 31, 2005. Total shareholders equity at December 31, 2006 totaled $100.4 million, an increase of $11.4 million, or 12.9%, over December 31, 2005.



At December 31, 2005, the Companys assets totaled $1.075 billion, an increase of $81.9 million or 8.3% over
December 31, 2004. The increase in assets during fiscal year 2005 resulted primarily from an increase in total loans of $91.9 million partially offset by a decline in investment securities available for sale of $17.7 million, or 12.3%.
Average assets increased 11.9% during the year, and average interest-earning assets increased 12.1%. Total liabilities increased $73.7 million, or 8.1%, at December 31, 2005 over December 31, 2004, to a balance of $986.1 million. This
increase resulted primarily from an increase in traditional deposits of $75.9 million, or 9.2%. Offsetting these increases was a decline federal funds purchased and FHLB borrowings of $5.1 million over the same periods. Total deposits and
other borrowings totaled $978.9 million at December 31, 2005, up from $906.9 million at December 31, 2004. Total shareholders equity at December 31, 2005 totaled $88.9 million, an increase of $8.2 million, or 10.1%,
over December 31, 2004.



Investment Securities
Available for Sale



The investment securities portfolio,
all of which was classified as available for sale at December 31, 2006, is a component of the Companys asset-liability management strategy. Investment securities available for sale are accounted for at fair market value, with unrealized
gains and losses recorded net of tax as a component of Accumulated Other Comprehensive Income (Loss) in Shareholders Equity. The Company employs a third party to determine the fair market value of the securities portfolio. Fair market value is
determined as of the date of the end of the reporting period based on available quoted market prices or quoted market prices for similar securities if a quoted market price is not available.



The primary objective of the Companys management of the investment
portfolio is to maintain a portfolio of high quality, highly liquid investments yielding competitive returns. The Company achieves these objectives by executing decisions made by authorized officers of the Company within policies established by the
Companys Board of Directors. The Company is required under federal regulations to maintain adequate liquidity to ensure safe and sound operations. The Company maintains investment balances based on a continuing assessment of cash flows, the
level of loan production, current interest rate risk strategies, and the assessment of the potential future direction of market interest rate changes. Investment securities differ in terms of default risk, interest rate risk, liquidity risk, and
expected rate of return. Default risk is the risk that an issuer will be unable to make interest payments or to repay the principal amount on schedule.



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Investment securities available for sale totaled $116.6 million at December 31, 2006, a decrease of
$9.4 million, or 7.5%, when compared with December 31, 2005. Average balances of available for sale investment securities decreased to $120.4 million during fiscal year 2006 from $132.7 million during fiscal year 2005. The following table
summarizes the composition of the Companys investment securities available for sale portfolio at the dates indicated (dollars in thousands).



|                                               |  |                   |         |            |                   |   |       |         |            |      
|---------------------------------------------- |  | ----------------- | ------- | ---------- | ----------------- | - | ----- | ------- | ---------- | -----
|                                               |  | December 31, 2006 |         |            | December 31, 2005
|                                               |  | Total             |         | % of Total |                   |   | Total |         | % of Total
|Government-sponsored enterprises               |  | $                 | 42,383  |            | 36.4              | % |       | 49,960  |            | 39.7 
|State and municipal                            |  |                   | 48,014  |            | 41.2              |   |       | 56,006  |            | 44.4 
|Mortgage-backed                                |  |                   | 26,170  |            | 22.4              |   |       | 20,022  |            | 15.9 
|                                               |  |                   |         |            |                   |   |       |         |            |      
|Total investment securities available for sale |  | $                 | 116,567 |            | 100.0             | % |       | 125,988 |            | 100.0
|                                               |  |                   |         |            |                   |   |       |         |            |      



The shift in
composition within the investment securities available for sale portfolio during 2006 resulted from the sale of long-term municipals and reinvestment into mortgage-backed securities (MBSs) that management believes have better total
return characteristics over various rate scenarios.



At
December 31, 2006, the investment security portfolio represented 10.1% of total assets, a decline from 11.7% at December 31, 2005. The decline in the total investment securities portfolio of approximately 7.5% from December 31, 2005
to December 31, 2006 resulted primarily from short-term taxable securities issued by government-sponsored enterprises (GSEs) not being reinvested but instead being used to fund loan growth and repay borrowings during the year ended
December 31, 2006.



See Item 8. Financial Statements
and Supplementary Data, Consolidated Statements of Cash Flows contained herein for further discussion regarding how purchases of and proceeds from the sale, maturities, and / or calls of investment securities as well as principal paydowns of
mortgage-backed securities impacted the investment securities available for sale portfolio during the three year period ended December 31, 2006.



The following tables summarize the amortized costs, fair market values, maturities, and average amortized yields with regard to the Companys
investment securities portfolio at the dates indicated (in thousands).



|                                               |  |                   |         |                   |         |                   |         |                 |         |               |         |                 |        
|---------------------------------------------- |  | ----------------- | ------- | ----------------- | ------- | ----------------- | ------- | --------------- | ------- | ------------- | ------- | --------------- | -------
|                                               |  | December 31, 2006 |         | December 31, 2005 |         | December 31, 2004
|                                               |  | Amortizedcost     |         | Fairmarketvalue   |         | Amortizedcost     |         | Fairmarketvalue |         | Amortizedcost |         | Fairmarketvalue
|Government-sponsored enterprises               |  | $                 | 42,554  |                   | 42,383  |                   | 50,257  |                 | 49,960  |               | 10,053  |                 | 10,021 
|State and municipal                            |  |                   | 48,780  |                   | 48,014  |                   | 56,766  |                 | 56,006  |               | 68,198  |                 | 69,496 
|Mortgage-backed                                |  |                   | 26,362  |                   | 26,170  |                   | 20,438  |                 | 20,022  |               | 64,010  |                 | 64,216 
|                                               |  |                   |         |                   |         |                   |         |                 |         |               |         |                 |        
|Total investment securities available for sale |  | $                 | 117,696 |                   | 116,567 |                   | 127,461 |                 | 125,988 |               | 142,261 |                 | 143,733
|                                               |  |                   |         |                   |         |                   |         |                 |         |               |         |                 |        



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|                                               |  |                   |         |           |      |  
|---------------------------------------------- |  | ----------------- | ------- | --------- | ---- | -
|                                               |  | December 31, 2006 |        
|                                               |  | Amortizedcost     |         | Bookyield |     
|Government-sponsored enterprises               |  |                   |         |           |      |  
|In one year or less                            |  | $                 | 38,118  |           | 4.37 | %
|After 1 through 5 years                        |  |                   | 4,436   |           | 4.18 |  
|After 5 through 10 years                       |  |                   |        |           |     |  
|After 10 years                                 |  |                   |        |           |     |  
|                                               |  |                   |         |           |      |  
|                                               |  |                   | 42,554  |           | 4.35 |  
|State and municipal                            |  |                   |         |           |      |  
|In one year or less                            |  |                   | 1,383   |           | 4.43 |  
|After 1 through 5 years                        |  |                   | 15,994  |           | 3.32 |  
|After 5 through 10 years                       |  |                   | 29,816  |           | 3.52 |  
|After 10 years                                 |  |                   | 1,587   |           | 3.82 |  
|                                               |  |                   |         |           |      |  
|                                               |  |                   | 48,780  |           | 3.49 |  
|Mortgage-backed                                |  |                   |         |           |      |  
|In one year or less                            |  |                   | 1,788   |           | 4.05 |  
|After 1 through 5 years                        |  |                   | 9,437   |           | 4.13 |  
|After 5 through 10 years                       |  |                   | 8,329   |           | 5.20 |  
|After 10 years                                 |  |                   | 6,808   |           | 5.37 |  
|                                               |  |                   |         |           |      |  
|                                               |  |                   | 26,362  |           | 4.78 |  
|                                               |  |                   |         |           |      |  
|Total investment securities available for sale |  | $                 | 117,696 |           | 4.09 | %
|                                               |  |                   |         |           |      |  



See Item 8.
Financial Statements and Supplementary Data, Note 1 contained herein for further discussion regarding the Companys significant accounting policies with regard to its investment securities portfolio, and see Item 8. Financial Statements
and Supplementary Data, Note 3 also contained herein for further discussion regarding the Companys investment securities portfolio.



Concentrations of Credit Risk. Financial instruments, which potentially subject the Company to concentrations of credit risk, consist principally of
loans, investment securities, federal funds sold and due from bank balances.



The Companys investment portfolio consists principally of securities issued by government-sponsored enterprises, and securities issued by states and municipalities within the United States. The following table
summarizes the amortized cost and fair market value of the securities of issuers that, in the aggregate, exceed ten percent of shareholders equity at December 31, 2006 (dollars in thousands).



|                                 |  |               |        |           |       |   |                 |        |           |      
|-------------------------------- |  | ------------- | ------ | --------- | ----- | - | --------------- | ------ | --------- | -----
|                                 |  | AmortizedCost |        | % of GSEs |       |   | Fairmarketvalue |        | % of GSEs
|Government-sponsored enterprises |  |               |        |           |       |   |                 |        |           |      
|FHLB                             |  | $             | 18,432 |           | 43.3  | % |                 | 18,353 |           | 43.3 
|FHLMC                            |  |               | 15,972 |           | 37.5  |   |                 | 15,922 |           | 37.6 
|FNMA                             |  |               | 8,150  |           | 19.2  |   |                 | 8,108  |           | 19.1 
|                                 |  |               |        |           |       |   |                 |        |           |      
|                                 |  | $             | 42,554 |           | 100.0 | % |                 | 42,383 |           | 100.0
|                                 |  |               |        |           |       |   |                 |        |           |      



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|                    |  |               |        |                             |       |   |                 |        |                                |      
|------------------- |  | ------------- | ------ | --------------------------- | ----- | - | --------------- | ------ | ------------------------------ | -----
|                    |  | AmortizedCost |        | % of MBSs                   |       |   | Fairmarketvalue |        | % of MBSs                     
|Mortgage-backed     |  |               |        |                             |       |   |                 |        |                                |      
|FHLMC               |  | $             | 9,099  |                             | 34.5  | % |                 | 8,953  |                                | 34.2 
|FNMA                |  |               | 17,263 |                             | 65.5  |   |                 | 17,217 |                                | 65.8 
|                    |  |               |        |                             |       |   |                 |        |                                |      
|                    |  | $             | 26,362 |                             | 100.0 | % |                 | 26,170 |                                | 100.0
|                    |  |               |        |                             |       |   |                 |        |                                |      
|                    |  |               |        |                            
|                    |  | AmortizedCost |        | % of portfolioamortizedcost |       |   | Fairmarketvalue |        | % of portfoliofair marketvalue
|Total GSEs and MBSs |  |               |        |                             |       |   |                 |        |                                |      
|FHLB                |  | $             | 18,432 |                             | 15.7  | % |                 | 18,353 |                                | 15.7 
|FHLMC               |  |               | 25,071 |                             | 21.3  |   |                 | 24,875 |                                | 21.3 
|FNMA                |  |               | 25,413 |                             | 21.6  |   |                 | 25,325 |                                | 21.7 
|                    |  |               |        |                             |       |   |                 |        |                                |      
|                    |  | $             | 68,916 |                             | 58.6  | % |                 | 68,553 |                                | 58.7 
|                    |  |               |        |                             |       |   |                 |        |                                |      



The Company places its
deposits and correspondent accounts with, and sells its federal funds to, high quality institutions. Management believes credit risk associated with correspondent accounts is not significant.



Loans



General. Loans represent the most significant component of the Companys interest-earning assets with average loans
accounting for 86.2% and 85.2% of average interest-earning assets in fiscal years 2006 and 2005, respectively. The Company strives to maintain a diversified loan portfolio in an effort to spread risk and reduce exposure to economic downturns that
may occur. Although the Company may originate loans outside of its market area, the Company originates the majority of its loans in its primary market area of Upstate, South Carolina.



The following table summarizes the Companys loan portfolio, by collateral type, at the dates indicated (dollars in
thousands).



|                                   |  |                   |         |            |                   |   |       |         |            |      
|---------------------------------- |  | ----------------- | ------- | ---------- | ----------------- | - | ----- | ------- | ---------- | -----
|                                   |  | December 31, 2006 |         |            | December 31, 2005
|                                   |  | Total             |         | % of Total |                   |   | Total |         | % of Total
|Commercial and industrial          |  | $                 | 126,742 |            | 13.4              | % |       | 143,334 |            | 16.5 
|                                   |  |                   |         |           
|Real estate1 - 4 family           |  |                   | 171,828 |            | 18.1              |   |       | 167,693 |            | 19.3 
|Real estateconstruction           |  |                   | 19,959  |            | 2.1               |   |       | 29,731  |            | 3.4  
|Real estateother                  |  |                   | 540,869 |            | 57.1              |   |       | 458,154 |            | 52.6 
|                                   |  |                   |         |            |                   |   |       |         |            |      
|Total loans secured by real estate |  |                   | 732,656 |            | 77.3              |   |       | 655,578 |            | 75.3 
|                                   |  |                   |         |           
|General consumer                   |  |                   | 70,502  |            | 7.4               |   |       | 55,008  |            | 6.3  
|Credit line                        |  |                   | 4,868   |            | 0.5               |   |       | 4,465   |            | 0.5  
|Bankcards                          |  |                   | 11,813  |            | 1.3               |   |       | 11,744  |            | 1.3  
|Others                             |  |                   | 1,007   |            | 0.1               |   |       | 873     |            | 0.1  
|                                   |  |                   |         |            |                   |   |       |         |            |      
|Total loans                        |  | $                 | 947,588 |            | 100.0             | % |       | 871,002 |            | 100.0
|                                   |  |                   |         |            |                   |   |       |         |            |      



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The Company emphasizes growth in loans secured by real estate as such loans are typically less risky than
loans secured by collateral other than real estate or unsecured loans. The loan portfolio secured by real estate comprised 77.3% of the Companys loan portfolio at December 31, 2006 compared with 75.3% of the Companys loan portfolio
at December 31, 2005. The majority of the growth in loans secured by real estate was offset by a decline in loans, as a percentage of the loan portfolio, secured by commercial and industrial security other than real estate.



The following table summarizes net loans, by loan purpose, excluding those
mortgage loans held for sale, at the dates indicated (dollars in thousands).



|                              |  |                   |         |   |                   |       |   |                   |         |   |                   |       |   |                   |         |   |            |       |   |       |         |   |            |       |   |       |         |   |            |       |  
|----------------------------- |  | ----------------- | ------- | - | ----------------- | ----- | - | ----------------- | ------- | - | ----------------- | ----- | - | ----------------- | ------- | - | ---------- | ----- | - | ----- | ------- | - | ---------- | ----- | - | ----- | ------- | - | ---------- | ----- | -
|                              |  | December 31, 2006 |         |   | December 31, 2005 |       |   | December 31, 2004 |         |   | December 31, 2003 |       |   | December 31, 2002 |        
|                              |  | Total             |         |   | % of Total        |       |   | Total             |         |   | % of Total        |       |   | Total             |         |   | % of Total |       |   | Total |         |   | % of Total |       |   | Total |         |   | % of Total |      
|Commercial business           |  | $                 | 112,264 |   |                   | 12.0  | % |                   | 90,345  |   |                   | 10.5  |   |                   | 90,708  |   |            | 11.8  |   |       | 87,950  |   |            | 12.8  |   |       | 102,884 |   |            | 16.6  |  
|Commercial real estate        |  |                   | 593,377 |   |                   | 63.3  |   |                   | 561,574 |   |                   | 65.5  |   |                   | 478,943 |   |            | 62.6  |   |       | 420,470 |   |            | 61.4  |   |       | 352,352 |   |            | 56.9  |  
|Installment                   |  |                   | 22,139  |   |                   | 2.4   |   |                   | 18,677  |   |                   | 2.2   |   |                   | 19,910  |   |            | 2.6   |   |       | 22,169  |   |            | 3.2   |   |       | 24,801  |   |            | 4.0   |  
|Installment real estate       |  |                   | 66,161  |   |                   | 7.0   |   |                   | 55,682  |   |                   | 6.5   |   |                   | 51,846  |   |            | 6.8   |   |       | 47,560  |   |            | 6.9   |   |       | 51,098  |   |            | 8.3   |  
|Indirect                      |  |                   | 43,634  |   |                   | 4.7   |   |                   | 30,481  |   |                   | 3.6   |   |                   | 16,383  |   |            | 2.1   |   |       | 15,644  |   |            | 2.3   |   |       | 14,499  |   |            | 2.4   |  
|Credit line                   |  |                   | 1,982   |   |                   | 0.2   |   |                   | 2,022   |   |                   | 0.2   |   |                   | 2,012   |   |            | 0.3   |   |       | 2,071   |   |            | 0.3   |   |       | 2,110   |   |            | 0.3   |  
|Prime access                  |  |                   | 53,883  |   |                   | 5.7   |   |                   | 54,296  |   |                   | 6.3   |   |                   | 45,655  |   |            | 5.9   |   |       | 33,014  |   |            | 4.8   |   |       | 18,034  |   |            | 2.9   |  
|Residential mortgage          |  |                   | 35,252  |   |                   | 3.8   |   |                   | 34,453  |   |                   | 4.0   |   |                   | 52,669  |   |            | 6.9   |   |       | 46,155  |   |            | 6.7   |   |       | 41,089  |   |            | 6.6   |  
|Bankcards                     |  |                   | 11,813  |   |                   | 1.2   |   |                   | 11,744  |   |                   | 1.4   |   |                   | 10,930  |   |            | 1.4   |   |       | 9,996   |   |            | 1.5   |   |       | 10,038  |   |            | 1.6   |  
|Business manager              |  |                   | 370     |   |                   |      |   |                   | 230     |   |                   |      |   |                   | 552     |   |            | 0.1   |   |       | 2,200   |   |            | 0.3   |   |       | 2,609   |   |            | 0.4   |  
|Other                         |  |                   | 1,793   |   |                   | 0.2   |   |                   | 2,059   |   |                   | 0.2   |   |                   | 1,473   |   |            | 0.2   |   |       | 1,092   |   |            | 0.2   |   |       | 2,247   |   |            | 0.4   |  
|                              |  |                   |         |   |                   |       |   |                   |         |   |                   |       |   |                   |         |   |            |       |   |       |         |   |            |       |   |       |         |   |            |       |  
|Total loans, gross            |  | $                 | 942,668 |   |                   | 100.5 | % |                   | 861,563 |   |                   | 100.4 |   |                   | 771,081 |   |            | 100.7 |   |       | 688,321 |   |            | 100.4 |   |       | 621,761 |   |            | 100.4 |  
|Allowance for loan losses     |  |                   | (8,527  | ) |                   | (0.9  | ) |                   | (8,431  | ) |                   | (1.0  | ) |                   | (7,619  | ) |            | (1.0  | ) |       | (7,463  | ) |            | (1.1  | ) |       | (6,402  | ) |            | (1.0  | )
|Loans in process              |  |                   | 2,587   |   |                   | 0.3   |   |                   | 3,857   |   |                   | 0.5   |   |                   | 1,470   |   |            | 0.2   |   |       | 4,086   |   |            | 0.6   |   |       | 2,676   |   |            | 0.4   |  
|Deferred loans fees and costs |  |                   | 658     |   |                   | 0.1   |   |                   | 761     |   |                   | 0.1   |   |                   | 703     |   |            | 0.1   |   |       | 806     |   |            | 0.1   |   |       | 1,104   |   |            | 0.2   |  
|                              |  |                   |         |   |                   |       |   |                   |         |   |                   |       |   |                   |         |   |            |       |   |       |         |   |            |       |   |       |         |   |            |       |  
|Total loans, net              |  | $                 | 937,386 |   |                   | 100.0 | % |                   | 857,750 |   |                   | 100.0 |   |                   | 765,635 |   |            | 100.0 |   |       | 685,750 |   |            | 100.0 |   |       | 619,139 |   |            | 100.0 |  
|                              |  |                   |         |   |                   |       |   |                   |         |   |                   |       |   |                   |         |   |            |       |   |       |         |   |            |       |   |       |         |   |            |       |  



Certain risks are
inherent within any loan portfolio particularly portfolios containing commercial, commercial real estate, and installment loans. While these types of loans provide benefits to the Companys assetliability management program and reduce
exposure to interest rate changes, such loans may entail additional credit risks when compared with residential mortgage loans. Risk factors inherent in the Companys loan portfolio are described below and could have an impact on future
delinquency and charge-off levels. Since lending activities comprise a significant source of the Companys revenues and because of the risks inherent in its loan portfolio, the Companys main objective with regard to its lending activities
is to adhere to sound lending practices.



Commercial business
lending generally involves greater risk than real estate lending and involves risks that are different from those associated with real estate lending. The Companys commercial business loans are generally made on a secured basis with terms that
do not exceed five years. Such loans typically have interest rates that change at periods ranging from one day to one year based on the prime lending rate as the interest rate index or to a fixed-rate at the time of commitment for a period not
usually exceeding five years. The Company generally obtains personal guarantees when arranging business financing. The Company makes commercial business loans to businesses within most industry sectors with no particular industry concentrations.
Although commercial loans are often collateralized by equipment, inventory, accounts receivable, or other business assets, the liquidation of collateral in some cases may not be a sufficient source of repayment because accounts receivable may be
uncollectible and inventories and equipment may be obsolete or of limited use. Accordingly, the repayment of a commercial business loan depends primarily on the creditworthiness of the borrower (and any guarantors) while liquidation of collateral is
a secondary and often insufficient source of repayment.



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Real estate acquisition and development lending is generally considered to be collateral-based lending
with loan amounts based on predetermined loan-to-collateral values. For loans secured by real estate, liquidation of the underlying collateral is viewed as the primary source of repayment in the event of borrower default. Commercial and installment
real estate lending generally involves greater risk than single-family lending since commercial and installment real estate lending typically involves larger loan balances to single borrowers or groups of related borrowers than does single-family
lending. Furthermore, the repayment of loans secured by income-producing properties is typically dependent upon the successful operation of the related real estate project. If the cash flow from the property is reduced, the borrowers ability
to repay the Companys loans may be impaired. These risks can be impacted significantly by supply and demand in the market for the type of property securing the loan and by general economic conditions. Thus, commercial and installment real
estate loans may be subject to adverse conditions in the economy to a greater extent than single-family real estate loans. The Company makes commercial and installment real estate loans to businesses within most industry sectors with no particular
industry concentrations. Interest rates charged on such real estate loans are determined by market conditions existing at the time of the loan commitment. Generally, loans have adjustable-rates, and the rate may be fixed for three to five years
determined by market conditions, collateral, and the Companys relationship with the borrower. Amortization of commercial and installment real estate loans varies but typically does not exceed 20 years.



Installment loans entail greater risk than do residential mortgage loans
particularly in the case of loans that are unsecured or secured by rapidly depreciating assets. In such cases, any repossessed collateral for a defaulted installment loan may not provide an adequate source of repayment of the outstanding loan
balance. In addition, installment loan collections are dependent on the borrowers continuing financial stability and are more likely to be adversely impacted by job loss, divorce, illness, or personal bankruptcy. The application of various
federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount that the Company can recover on such loans.



The Companys indirect lending department establishes relationships with Upstate automobile dealers to provide customer financing on qualifying
automobile purchases. Through these relationships, the Company purchases loans originated by unaffiliated automobile dealers in South Carolina. Loans purchased by this department are subject to the same underwriting standards as those used by the
Company in its other lending portfolios, and such loans are only purchased after approval by the Companys underwriters.



The Company makes both fixed-rate and adjustable-rate residential mortgage loans with terms generally ranging from 10 to 30 years. Adjustable-rate
mortgage loans currently offered by the Company have up to 30 year terms with interest rates that adjust annually or adjust annually after being fixed for a period of several years in accordance with a designated index. The Company could offer loans
that have up to 30 year terms and interest rates that adjust annually or adjust annually after being fixed for a period of three or seven years in accordance with a designated index. Adjustable-rate mortgage loans may be originated with a limit on
any increase or decrease in the interest rate per year further limited by the amount by which the interest rate can increase or decrease over the life of the loan.



In order to encourage the origination of adjustable-rate mortgage loans with interest rates that adjust annually, the
Company, like many of its competitors, may offer a more attractive rate of interest on such loans than on fixed-rate mortgage loans. Generally, on mortgage loans exceeding an 80% loan-to-value ratio, the Company requires private mortgage insurance
that protects the Company against losses of at least 20% of the mortgage loan amount. It is the Companys policy to have collateral securing real estate loans appraised.



A large percentage of single-family loans are made pursuant to guidelines that permit the sale of these loans in the
secondary market to government or private agencies. The Company participates in secondary market activities by selling whole loans and participations in loans primarily to the FHLB under its Mortgage Partnership Program and the Federal Home Loan
Mortgage Corporation. This practice enables the Company to satisfy the demand for these loans in its local communities, to meet asset and liability objectives of management, and to develop a source of fee income through the servicing of loans. The
Company may sell fixed-



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##### Table of Contents

rate, adjustable-rate, and balloon-term loans. Based on current interest rates, as well as other factors, the Company presently intends to sell selected
originations of conforming 30 year and 15 year fixed-rate mortgage loans.



The Company originates residential construction loans to finance the construction of individual, owner-occupied houses. Such loans involve additional risks because loan funds are advanced upon the security of the
project under construction. Residential construction loans are generally originated with up to 80% loan-to-value ratios. The Company typically structures these construction loans to be converted to pre-approved permanent loans at the completion of
the construction phase. Loan proceeds are disbursed in increments as construction progresses and as inspections warrant.



As part of its residential lending program, the Company also offers construction loans with 80% loan-to-value ratios to qualified builders although 90%
loan-to-value ratios may be utilized at the discretion of the Company. These construction loans are generally at a competitive fixed or adjustable-rate of interest for one or two year terms. The Company also offers lot loans intended for residential
use that may be on a fixed or adjustable-rate basis.



During
2006, the Company introduced business credit scoring and began placing an emphasis on small commercial loans. Management believes that these changes resulted in an increase in commercial business loans as a percentage of the total portfolio.



Management believes that the aggressive commercial real estate
building in recent years may indicate an upcoming period of oversupply. In order to avoid an excess supply of commercial limited-service properties, during 2006, the Company began to further tighten underwriting standards with regard to such loans
resulting in a decline in commercial real estate loans as a percentage of the total portfolio.



During 2006, the Companys indirect lending portfolio increased by $13.2 million, or 43.2%. Management attributes this indirect loan growth to a new program offered by the Company that targets high credit scoring
consumers at competitive rates. The goal of this program is to introduce the Company and its products to reputable automobile dealers. Once introduced, the Companys goal is to continue to build and maintain relationships with these dealers and
their customers.



The following table summarizes the
Companys loan portfolio outstanding, by collateral type, at December 31, 2006 that, based on contractual terms, are due during the periods noted. Loans having no stated maturity and no stated schedule of repayments are reported as due in
one year or less. The table also summaries loans outstanding at December 31, 2006 with regard to fixed-rate maturity and variable-rate repricing terms due in periods after one year (in thousands).



|                          |  |                        |         |                                                                        |         |                     |         |       |         |            |         |               |       
|------------------------- |  | ---------------------- | ------- | ---------------------------------------------------------------------- | ------- | ------------------- | ------- | ----- | ------- | ---------- | ------- | ------------- | ------
|                          |  | Maturity               |         | Rate structure for loanswith maturities orrepricing terms over oneyear
|                          |  | Due in oneyear or less |         | Due after one yearthrough five years                                   |         | Due after fiveyears |         | Total |         | Fixed-rate |         | Variable-rate
|Commercial and industrial |  | $                      | 69,054  |                                                                        | 43,660  |                     | 14,027  |       | 126,741 |            | 57,687  |               |      
|Real estate1 - 4 family  |  |                        | 59,307  |                                                                        | 21,581  |                     | 89,265  |       | 170,153 |            | 98,259  |               | 12,587
|Real estateconstruction  |  |                        | 17,342  |                                                                        | 1,734   |                     | 883     |       | 19,959  |            | 2,617   |               |      
|Real estateother         |  |                        | 260,756 |                                                                        | 242,976 |                     | 37,137  |       | 540,869 |            | 280,113 |               |      
|General consumer          |  |                        | 9,863   |                                                                        | 44,220  |                     | 16,420  |       | 70,503  |            | 60,640  |               |      
|Credit line               |  |                        | 2,869   |                                                                        | 1,999   |                     |        |       | 4,868   |            | 1,999   |               |      
|Bankcards                 |  |                        | 11,813  |                                                                        |        |                     |        |       | 11,813  |            |        |               |      
|Others                    |  |                        | 93      |                                                                        | 369     |                     | 545     |       | 1,007   |            | 914     |               |      
|                          |  |                        |         |                                                                        |         |                     |         |       |         |            |         |               |       
|Total loans               |  | $                      | 431,097 |                                                                        | 356,539 |                     | 158,277 |       | 945,913 |            | 502,229 |               | 12,587
|                          |  |                        |         |                                                                        |         |                     |         |       |         |            |         |               |       



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See Item 8. Financial Statements and Supplementary Data, Note 1 contained herein for further
discussion regarding the Companys significant accounting policies with regard to its general loan portfolio as well as loan securitization transactions and Item 8. Financial Statements and Supplementary Data, Note 4 also contained herein
for further discussion regarding the Companys loan portfolio.



Credit Quality.    A willingness to take credit risk is inherent in the decision to grant credit. Prudent risk taking requires a management system based on sound policies and control processes that ensure compliance with
those policies. The Company believes that it maintains a conservative philosophy regarding its lending mix and adherence to underwriting standards is managed through a multi-layered credit approval process including, but not limited to, the review
of loans approved by lenders. The Company monitors its compliance with lending policies through loan approval and documentation review, exception report reviews, and ongoing analysis of asset quality trends.



The Company regularly reviews its problem assets including, but not limited
to, delinquent loans, nonperforming loans, and troubled debt restructurings to determine whether any such loans require classification adjustments in accordance with applicable regulations.



The following table summarizes the loan classification system used by the
Company with regard to its loan portfolio. The Company considers classified assets to be those classified as special mention, substandard, doubtful, or loss.



|      |  |                 
|----- |  | ----------------
|Grade |  | Classification  
|1     |  | Superior quality
|2     |  | High quality    
|3     |  | Satisfactory    
|4     |  | Marginal        
|5     |  | Special Mention 
|6     |  | Substandard     
|7     |  | Doubtful        
|8     |  | Loss            



Special
mention assets are defined by the Company as assets that do not currently expose the Company to a sufficient degree of risk to warrant classification as either substandard, doubtful, or loss. Such assets do,
however, possess credit deficiencies or potential weaknesses deserving managements close attention that, if not corrected, could weaken the asset and increase future risk. An asset is considered substandard if inadequately
protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Substandard assets include those assets characterized by the distinct possibility that the institution will sustain some loss if
the deficiencies are not corrected. Assets classified as doubtful have all of the weaknesses inherent in those classified as substandard with the added characteristic that the weaknesses make collection or liquidation in
full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Assets classified as loss are those considered uncollectible and of such little value that continuance as assets without the
establishment of a specific loss reserve is not warranted.



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The following table summarizes trends in problem assets and other asset quality indicators at the dates
indicated (dollars in thousands). The composition of nonaccrual loans is based on loan collateral type.



|                                                     |  |              |         |   |      |         |      |         |      |         |      |        
|---------------------------------------------------- |  | ------------ | ------- | - | ---- | ------- | ---- | ------- | ---- | ------- | ---- | -------
|                                                     |  | December 31,
|                                                     |  | 2006         |         |   | 2005 |         | 2004 |         | 2003 |         | 2002
|Real estate                                          |  | $            | 6,271   |   |      | 9,165   |      | 1,705   |      | 2,719   |      | 1,528  
|Commercial and industrial                            |  |              | 549     |   |      | 631     |      | 353     |      | 677     |      | 748    
|Credit cards                                         |  |              |        |   |      |        |      | 10      |      | 73      |      | 26     
|Other consumer                                       |  |              | 179     |   |      | 117     |      | 255     |      | 359     |      | 198    
|                                                     |  |              |         |   |      |         |      |         |      |         |      |        
|Total nonaccrual loans                               |  |              | 6,999   |   |      | 9,913   |      | 2,323   |      | 3,828   |      | 2,500  
|                                                     |  |              |         |   |     
|Real estate acquired in settlement of loans          |  |              | 600     |   |      | 1,954   |      | 2,413   |      | 2,170   |      | 2,468  
|Repossessed automobiles                              |  |              | 319     |   |      | 167     |      | 282     |      | 243     |      | 181    
|                                                     |  |              |         |   |      |         |      |         |      |         |      |        
|Total nonperforming assets                           |  | $            | 7,918   |   |      | 12,034  |      | 5,018   |      | 6,241   |      | 5,149  
|                                                     |  |              |         |   |      |         |      |         |      |         |      |        
|Loans past due 90 days and still accruing (1)        |  | $            | 260     |   |      | 207     |      | 147     |      | 212     |      | 233    
|                                                     |  |              |         |   |      |         |      |         |      |         |      |        
|Ending loans (2)                                     |  | $            | 945,913 |   |      | 866,181 |      | 773,254 |      | 693,213 |      | 625,542
|Nonaccrual loans as a percentage of loans (2)        |  |              | 0.74    | % |      | 1.14    |      | 0.30    |      | 0.55    |      | 0.40   
|Nonperforming assets as a percentage of total assets |  |              | 0.69    | % |      | 1.12    |      | 0.51    |      | 0.70    |      | 0.63   
|Allowance for loan losses to nonaccrual loans        |  |              | 1.22    | x |      | 0.85    |      | 3.28    |      | 1.95    |      | 2.56   

---

|(1) |  | Substantially all of these loans are bankcard loans
|--- |  | ---------------------------------------------------

|(2) |  | Calculated using loans excluding mortgage loans held for sale, net of unearned, excluding the Allowance
|--- |  | -------------------------------------------------------------------------------------------------------



Delinquent and problem loans are a normal part of any lending function. The Company determines past due and delinquency
status based on contractual terms. When a borrower fails to make a scheduled loan payment, the Company attempts to cure the default through several methods including, but not limited to, collection contact and assessment of late fees. If these
methods do not result in the borrower submitting the past due payment, further action may be taken. Interest on loans deemed past due continues to accrue until such time that the loan is placed in nonaccrual status (the Company places loans in
nonaccrual status prior to any amount being charged-off). Nonaccrual loans are those loans that management, through a continuing evaluation of loans, has determined offer a more than normal risk of future collectibility. In most cases, loans are
automatically placed in nonaccrual status by the loan system when the loan payment becomes 90 days delinquent and no acceptable arrangement has been made between the Company and the borrower. Loans may be manually placed in nonaccrual status on the
loan system if management determines that some factor other than delinquency (such as bankruptcy proceedings) cause the Company to believe that more than a normal amount of risk exists with regard to collectibility. When the loan is placed in
nonaccrual status, accrued interest income is reversed based on the effective date of nonaccrual status. Thereafter, interest income on the nonaccrual loans is recognized only as received. The Company classifies nonperforming loans as substandard or
lower. When the probability of future collectibility on a nonaccrual loan declines from probable to possible, the Company may proceed with measures to remedy the default, including commencing foreclosure action, if necessary. Mortgage instruments
generally secure loans within the Companys mortgage loan portfolio and specific steps must be taken when commencing foreclosure action on such loans. Notice of default in conjunction with these loans is required to be recorded and mailed. If
the default is not cured within a specified time period, a notice of sale is posted, mailed, and advertised, and a sale is then conducted.



The Company typically excludes bankcard balances from the nonaccrual process noted above. Due to the nature of the portfolio, the Company does not believe
that it is necessarily probable that collectibility of these loans is remote when delinquencies exceed 90 days. For this reason, these balances often continue to accrue income after they have become greater than 90 days delinquent.



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The decrease in nonaccrual loans of $2.9 million from December 31, 2005 to December 31, 2006
was primarily the result of the removal from nonaccrual status during 2006 of the special circumstance loan in nonaccrual status at December 31, 2005 that totaled approximately $3.3 million. In its consideration of collectibility of nonaccrual
loans, management takes into consideration, among other factors, that 89.6% of nonaccrual loans at December 31, 2006 were secured by real estate. In the event of foreclosure, management believes losses would be offset by funds received through
the liquidation of the underlying real estate collateral.



See
Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsLoans, and Item 8. Financial Statements and Supplementary Data, Note 4 all contained herein for further discussion regarding loans in
nonaccrual status and Note 1 contained herein for further discussion regarding the Companys significant accounting policies with regard to loans in nonaccrual status.



SFAS No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings, establishes standards of
financial accounting and reporting by the debtor and by the creditor for a troubled debt restructuring. Additionally, it requires that adjustments in payment terms from a troubled debt restructuring generally be considered adjustments of the yield
(effective interest rate) of the loan. So long as the aggregate payments (both principal and interest) to be received by the creditor are not less than the creditors carrying amount of the loan, the creditor recognizes no loss, but instead
recognizes a lower yield over the term of the restructured debt. Similarly, the debtor recognizes no gain unless the aggregate future payments (including amounts contingently payable) are less than the debtors recorded liability. Troubled debt
restructurings include loans with respect to which the Company has agreed to modifications of the terms of the loan such as changes in the interest rate charged and / or other concessions. Troubled debt restructurings entered into by the Company for
the years ended December 31, 2006 and December 31, 2005 were reviewed by the Company to ensure loan classifications were in accordance with applicable regulations. Any specific allocations identified during the review based on probable
losses have been included in the Companys Allowance for the applicable period.



As of December 31, 2006, management was aware of information about possible credit problems with regard to one of the Companys loan relationships. The loans within the relationship were purchased
participations. Although management does have doubt as to the ability of the borrower to comply with the present loan repayment terms, management believes the collateral securing these loans is sufficient to cover the Banks exposure. As of
December 31, 2006, management was aware of no other potential problem loans that were not already categorized as nonaccrual, past due, or restructured, that had borrower credit problems causing management to have serious doubt as to the ability
of the borrower to comply with the present loan repayment terms.



Through the Companys regularly reviews of these facets of its loan portfolio, management determines whether any loans require classification in accordance with applicable regulations. As such, the Companys believes that loans
are appropriately classified.



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The following table summarizes the composition of the Companys classified assets by collateral type
at the dates indicated (in thousands).



|                          |  |                   |       |             |        |          |       |      |   |       |       
|------------------------- |  | ----------------- | ----- | ----------- | ------ | -------- | ----- | ---- | - | ----- | ------
|                          |  | December 31, 2006
|                          |  | Specialmention    |       | Substandard |        | Doubtful |       | Loss |   | Total
|Commercial and industrial |  | $                 | 301   |             | 1,098  |          | 839   |      |  |       | 2,238 
|Real estate1 - 4 family  |  |                   | 198   |             | 4,499  |          | 273   |      |  |       | 4,970 
|Real estateother         |  |                   | 865   |             | 7,899  |          | 669   |      |  |       | 9,433 
|General consumer          |  |                   | 2     |             | 321    |          | 36    |      |  |       | 359   
|Credit line               |  |                   | 6     |             | 47     |          | 1     |      |  |       | 54    
|                          |  |                   |       |             |        |          |       |      |   |       |       
|Total classified assets   |  | $                 | 1,372 |             | 13,864 |          | 1,818 |      |  |       | 17,054
|                          |  |                   |       |             |        |          |       |      |   |       |       
|                          | 
|                          |  | December 31, 2005
|                          |  | Specialmention    |       | Substandard |        | Doubtful |       | Loss |   | Total
|Commercial and industrial |  | $                 | 230   |             | 2,925  |          | 851   |      |  |       | 4,006 
|Real estate1 - 4 family  |  |                   | 1,147 |             | 4,023  |          | 239   |      |  |       | 5,409 
|Real estateother         |  |                   | 82    |             | 11,400 |          | 58    |      |  |       | 11,540
|General consumer          |  |                   | 25    |             | 287    |          | 68    |      |  |       | 380   
|Credit line               |  |                   | 6     |             | 54     |          | 1     |      | 1 |       | 62    
|                          |  |                   |       |             |        |          |       |      |   |       |       
|Total classified assets   |  | $                 | 1,490 |             | 18,689 |          | 1,217 |      | 1 |       | 21,397
|                          |  |                   |       |             |        |          |       |      |   |       |       



During the fourth
quarter of 2005, two loans, both of which were secured by other real estate, were placed in nonaccrual status. In accordance with the Banks Lending Policy, the loans were downgraded to substandard. At December 31, 2005, the
principal balance of these loans totaled $7.2 million. Management believes the collateral securing these loans is sufficient to cover the Banks exposure. Payment was received in January 2006 on one of these loans (balance of $3.3 million at
December 31, 2005) that warranted the removal of nonaccrual status at that time. The second loan remained in nonaccrual status, thus rated substandard, at December 31, 2006. $878 thousand of the loan balance was specifically
reserved at December 31, 2006.



Excluding the impact of
this loan, overall, classified assets decreased $1.1 million from December 31, 2005 to December 31, 2006. From a portfolio perspective, classified asset decreases were experienced in loans of all collateral types with the exception of
those securitized by other real estate. From a classification perspective, decreases were experienced in all collateral types summarized above. Management believes that the general overall improvement of classified assets resulted from
managements conservative approach to, and management of, loan quality.



The Company reviews impaired loans in accordance with SFAS No. 114, Accounting by Creditors for Impairment of a Loan, as amended by SFAS No. 118, Accounting by Creditors for
Impairment of a Loan-Income Recognition and Disclosuresan amendment of FASB Statement No. 114. The Company considers a loan impaired when, based on current information and events, it is probable that it will be unable to collect all
amounts due according to the contractual terms of the loan. Impairment for loans considered individually significant and that exhibit probable or observed credit weaknesses are measured based on the present value of expected future cash flows
discounted at the loans effective interest rate, or the fair value of the collateral if the loan is collateral dependent. If the determined fair value of an impaired loan is less than the carrying value of the loan and a loss has deemed to
have occurred, reserves are established for the excess of the principal amount of the loan over the fair or net realizable value. For loans that are not individually significant, loans $250 thousand or less, or represent a homogeneous population,
the Company evaluates impairment collectively based on factors including, but not limited to, historical loss experience for these types of loans. These homogeneous loans are excluded from the impaired loan disclosures. At December 31, 2006 and
2005, the Company had $8.2 million



39



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and $12.8 million of impaired loans for which $1.8 million and $1.9 million, respectively was specifically reserved in the Allowance. The average balance of
impaired loans for 2006 and 2005 was $10.5 million and $8.4 million, respectively. At December 31, 2006 impaired loans included $323 thousand in restructured loans. Impaired loans included no restructured loans at December 31, 2005.
Because impaired loans are generally classified as nonaccrual, no interest income is recognized on such loans subsequent to being placed in nonaccrual status.



See Item 8. Financial Statements and Supplementary Data, Note 1 contained herein for further discussion regarding the Companys significant
accounting policies with regard to impaired loans and Note 4 also contained herein for further discussion regarding the Companys impaired loans.



As discussed previously, for loans secured by real estate, liquidation of the underlying collateral is viewed as the primary source of repayment in the
event of borrower default. Additionally, commercial and installment real estate lending generally involves greater risk than single-family lending since commercial real estate lending typically involves larger loan balances to single borrowers or
groups of related borrowers than does single-family lending. Furthermore, the repayment of loans secured by income-producing properties is typically dependent upon the successful operation of the related real estate project. If the cash flow from
the property is reduced, the borrowers ability to repay the Companys loans may be impaired. Due to these increased risks, the Company pays close attention to the quality of such loans. Real estate loans secured by collateral other than
one to four family real estate, increased 15.0% from December 31, 2005 to December 31, 2006 and comprised 59.2% of the loan portfolio at December 31, 2006. See Item 1A. Risk Factors contained herein for discussion regarding the
potential for increased lending risks to which the Company may be subjected due to its increased emphasis on commercial and construction lending or any downturn in the real estate market. In the event of default, management believes that losses
would be offset by funds received through the liquidation of the underlying real estate collateral.



Real estate and personal property acquired by the Company in settlement of loans is classified within Other Assets on the Consolidated Balance Sheets
until such time that it is sold. When property is acquired, it is recorded at the lower of cost or estimated fair market value less cost to sell at the date of acquisition with any resulting writedowns being taken through the Allowance. Fair market
values of such property are reviewed regularly, and writedowns are recorded when it is determined that the carrying value of the property exceeds the fair market value less estimated costs to sell. Gains and losses on the sale of property acquired
in settlement of loans and writedowns resulting from periodic reevaluation are charged to the Consolidated Statements of Income. Costs relating to the development and improvement of such property are capitalized within Other Assets on the
Consolidated Balance Sheets. Costs relating to holding the property are charged to expense within Other Noninterest Expense on the Consolidated Statements of Income. Generally, any interest accrual on such loans would have ceased when the loan
became 90 days delinquent.



Real estate acquired in settlement
of loans decreased to $600 thousand at December 31, 2006 from $2.0 million at December 31, 2005. The following table summarizes the changes in the allowances, including the balance at the beginning and end of each period, provision
charged to expense, and losses charged to the Allowance related to the Companys real estate acquired in settlement of loans for the periods indicated (in thousands).



|                                                                        |  |                                       |        |   |      |        |  
|----------------------------------------------------------------------- |  | ------------------------------------- | ------ | - | ---- | ------ | -
|                                                                        |  | At and for the year endedDecember 31, |       
|                                                                        |  | 2006                                  |        |   | 2005 |       
|Real estate acquired in settlement of loans, beginning of period        |  | $                                     | 1,954  |   |      | 2,413  |  
|Add: New real estate acquired in settlement of loans                    |  |                                       | 294    |   |      | 1,096  |  
|Less: Sales / recoveries of real estate acquired in settlement of loans |  |                                       | (1,451 | ) |      | (1,283 | )
|Less: Provision charged to expense                                      |  |                                       | (197   | ) |      | (272   | )
|                                                                        |  |                                       |        |   |      |        |  
|Real estate acquired in settlement of loans, end of period              |  | $                                     | 600    |   |      | 1,954  |  
|                                                                        |  |                                       |        |   |      |        |  



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Management believes that the decrease in property added to the portfolio during 2006 was a direct
reflection of economic conditions that directly impact the borrowers ability to service their debt. Relationships within the portfolio declined from 22 at December 31, 2005 to 13 at December 31, 2006. Based on the Companys
policies and procedures regarding the regular review of fair market values of real estate acquired in settlement of loans and writedowns taken accordingly, management believes that the properties within the portfolio were properly valued at
December 31, 2006. Additionally, management believes that the excess of sales from the portfolio during fiscal year 2006 over additions during the same timeframe indicate that the properties within the portfolio are marketable.



See Item 8. Financial Statements and Supplementary Data, Note 1
contained herein for further discussion regarding the Companys significant accounting policies with regard to real estate acquired in settlement of loans and Note 8 also contained herein for further discussion regarding the Companys real
estate acquired in settlement of loans portfolio.



Management
believes that because the Companys loan portfolio is closely monitored. Additionally, management believes that there will always remain a core level of delinquent loans and real estate and personal property acquired in settlement of loans from
normal lending operations.



Concentrations of Credit Risk.
Financial instruments, which potentially subject the Company to concentrations of credit risk, consist principally of loans, investment securities, federal funds sold and due from bank balances.



The Company makes loans to individuals and small to medium-sized businesses
for various personal and commercial purposes primarily in Upstate, South Carolina. The Companys loan portfolio is not concentrated in loans to any single borrower or a relatively small number of borrowers. Additionally, management is not aware
of any concentrations of loans to classes of borrowers or industries that would be similarly impacted by economic conditions. Management has identified, and the following table summarizes at the dates indicated, concentrations of types of lending
that it monitors (dollars in thousands).



|                                                  |  |                    |         |                              |     |   |                             |    |  
|------------------------------------------------- |  | ------------------ | ------- | ---------------------------- | --- | - | --------------------------- | -- | -
|                                                  |  | December 31, 2006  |        
|                                                  |  | Outstandingbalance |         | As apercentageof totalequity |     |   | As apercentageof totalloans |   
|Loans secured by:                                 |  |                    |         |                              |     |   |                             |    |  
|Commercial and industrial nonmortgage instruments |  | $                  | 126,742 |                              | 126 | % |                             | 13 | %
|Residential mortgage instruments                  |  |                    | 171,828 |                              | 171 |   |                             | 18 |  
|Nonresidential mortgage instruments               |  |                    | 540,869 |                              | 539 |   |                             | 57 |  
|                                                  | 
|                                                  |  | December 31, 2005  |        
|                                                  |  | Outstandingbalance |         | As apercentageof totalequity |     |   | As apercentageof totalloans |   
|Loans secured by:                                 |  |                    |         |                              |     |   |                             |    |  
|Commercial and industrial nonmortgage instruments |  | $                  | 143,334 |                              | 161 | % |                             | 17 | %
|Residential mortgage instruments                  |  |                    | 167,693 |                              | 189 |   |                             | 19 |  
|Nonresidential mortgage instruments               |  |                    | 458,154 |                              | 515 |   |                             | 53 |  



Loans secured by
commercial and industrial nonmortgage instruments are typically of higher risk and are made on the basis of the borrowers ability to make repayment from the cash flow of the borrowers business. Such loans are generally secured by a
variety of collateral types, including, but not limited to, accounts receivable, inventory and equipment.



41



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##### Table of Contents

In addition to monitoring potential concentrations of loans to particular borrowers or groups of
borrowers, industries, geographic regions, and loan types, management monitors whether or not the Company has exposure to credit risk from other lending practices such as loans that subject borrowers to substantial payment increases (e.g. principal
deferral periods, loans with initial interest-only periods, etc.) and loans with high loan-to-value ratios. Management has determined that, at December 31, 2006, the Company has no concentrations in such loans, as the Company does not typically
engage in such lending practices.



Additionally, there are
industry practices that could subject the Company to increased credit risk should economic conditions change over the course of a loans life. For example, the Company makes adjustable-rate loans and fixed-rate principal-amortizing loans with
maturities prior to the loan being fully paid (i.e. balloon-term loans). These loans are underwritten and monitored to manage the associated risks. Therefore, management believes that these particular practices do not subject the Company to unusual
credit risk.



Allowance for Loan Losses



In evaluating the adequacy of the allowance for loan losses and determining
the related provision for loan losses, if any, management may consider, though not intended to be an all-inclusive list, historical loss experience and change in the size and mix of the overall portfolio composition, specific allocations based on
probable losses identified during the review of the portfolio, delinquency trends in the portfolio and the composition of nonperforming loans, including the percent of nonperforming loans with supplemental mortgage insurance or secured by real
estate, and subjective factors, including local and general economic business factors and trends, industry and interest rate trends, new lending products, changes in underwriting criteria, and portfolio concentrations. Management is currently using
a five year lookback period when computing historical loss rates to determine the allocated component of the Allowance.



In addition to the Companys portfolio review process as noted in Item 7.    Managements Discussion and Analysis of
Financial Condition and Results of OperationsLoans, various regulatory agencies, as an integral part of their examination process, periodically review the Companys allowance for loan losses. Such agencies may require the Company to
recognize additions to the allowance based on their judgments about information available to them at the time of their examination. While the Company uses available information to recognize inherent losses on loans, future adjustments to the
allowance for loan losses may be necessary based on changes in economic conditions and other factors and the impact of such changes on the Banks borrowers.



The adequacy of the Allowance is analyzed on a monthly basis using an internal analysis model. On a quarterly basis, the
Companys Allowance model and conclusions are reviewed and approved by senior management. The Companys analysis of Allowance adequacy includes consideration for loan impairment.



See Item 8. Financial Statements and Supplementary Data, Note 1
contained herein for further discussion regarding the Companys significant accounting policies with regard to the Allowance.



The Allowance totaled $8.5 million and $8.4 million, at December 31, 2006 and 2005, respectively representing 0.90% and 0.97% of loans, calculated
using loans excluding mortgage loans held for sale, net of unearned income, excluding allowance for loan losses.



Loans held for sale are carried at the lower of cost or fair market value. The fair market value of mortgage loans held for sale is based on prices for
outstanding commitments to sell these loans. Typically, the carrying amount approximates fair market value due to the Companys practice of selling these loans within 60 days of origination. Likewise, such instruments are not included in the
assumptions related to the Allowance model.



42



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##### Table of Contents

The following table summarizes the allocation of the Allowance and the percentage of loans to total
loans, excluding net of unearned balances, both by collateral type, at the dates indicated (dollars in thousands). Management believes that the Allowance can be allocated by category only on an approximate basis. The allocation of the Allowance to
each category is not necessarily indicative of future losses and does not restrict the use of the Allowance to absorb losses in other categories.



|                          |  |                |       |                         |       |   |                |       |                         |       |                |       |                         |       |                |       |                         |       |                |       |                         |      
|------------------------- |  | -------------- | ----- | ----------------------- | ----- | - | -------------- | ----- | ----------------------- | ----- | -------------- | ----- | ----------------------- | ----- | -------------- | ----- | ----------------------- | ----- | -------------- | ----- | ----------------------- | -----
|                          |  | December 31,  
|                          |  | 2006           |       |                         | 2005  |   | 2004           |       | 2003                    |       | 2002          
|                          |  | Totalallowance |       | % of loansto totalloans |       |   | Totalallowance |       | % of loansto totalloans |       | Totalallowance |       | % of loansto totalloans |       | Totalallowance |       | % of loansto totalloans |       | Totalallowance |       | % of loansto totalloans
|Commercial and industrial |  | $              | 1,167 |                         | 13.4  | % |                | 1,897 |                         | 16.5  |                | 2,861 |                         | 20.4  |                | 2,737 |                         | 27.9  |                | 2,341 |                         | 31.5 
|Real estate1 - 4 family  |  |                | 1,344 |                         | 18.1  |   |                | 1,267 |                         | 19.3  |                | 1,243 |                         | 22.9  |                | 865   |                         | 22.6  |                | 965   |                         | 23.8 
|Real estate construction |  |                | 20    |                         | 2.1   |   |                | 26    |                         | 3.4   |                | 26    |                         | 3.1   |                | 72    |                         | 3.0   |                | 125   |                         | 3.9  
|Real estateother         |  |                | 2,745 |                         | 57.1  |   |                | 2,044 |                         | 52.6  |                | 1,139 |                         | 46.5  |                | 1,308 |                         | 38.2  |                | 872   |                         | 31.4 
|General consumer          |  |                | 1,860 |                         | 7.4   |   |                | 2,153 |                         | 6.3   |                | 1,300 |                         | 5.1   |                | 1,683 |                         | 6.3   |                | 1,464 |                         | 7.0  
|Credit line               |  |                | 162   |                         | 0.5   |   |                | 130   |                         | 0.5   |                | 125   |                         | 0.5   |                | 167   |                         | 0.6   |                | 99    |                         | 0.6  
|Bankcards                 |  |                | 382   |                         | 1.3   |   |                | 310   |                         | 1.3   |                | 316   |                         | 1.4   |                | 211   |                         | 1.4   |                | 217   |                         | 1.6  
|Others                    |  |                | 847   |                         | 0.1   |   |                | 604   |                         | 0.1   |                | 609   |                         | 0.1   |                | 420   |                         |      |                | 319   |                         | 0.2  
|                          |  |                |       |                         |       |   |                |       |                         |       |                |       |                         |       |                |       |                         |       |                |       |                         |      
|Total                     |  | $              | 8,527 |                         | 100.0 | % |                | 8,431 |                         | 100.0 |                | 7,619 |                         | 100.0 |                | 7,463 |                         | 100.0 |                | 6,402 |                         | 100.0
|                          |  |                |       |                         |       |   |                |       |                         |       |                |       |                         |       |                |       |                         |       |                |       |                         |      



The fluctuations
within the allocation of the Allowance from December 31, 2005 to December 31, 2006 are primarily the result of historical loss experience and change in the size and mix of the overall portfolio composition. See Item 7.
Managements Discussion and Analysis of Financial Condition and Results of OperationsFinancial ConditionLoans contained herein for discussion regarding the composition of the loan portfolio as well as the fluctuations within the
portfolio from fiscal year 2005 to fiscal year 2006.



The
primary increases with regard to the allocation of the Allowance to specific loan portfolios at December 31, 2005 were within the portfolios secured by other real estate and general consumer collateral. The increase in allocation of the
Allowance to the portfolio secured by other real estate was due, in large part, to two impaired loans at December 31, 2005, as discussed in Item 7. Managements Discussion and Analysis of Financial Condition and Results of
OperationsLoans, both of which were secured by other real estate. As such, the loans were classified as substandard in accordance with the Banks Lending Policy. The loans impaired statuses increased the related Allowance coverage.
At December 31, 2005, the principal balance of these loans totaled $7.2 million. The increase in allocation of the Allowance to the loan portfolio secured by general consumer collateral was due, in part, to the increase in the indirect lending
portfolio at December 31, 2005 over December 31, 2004 as well as an increase in the potential historical loss percentage with regard to this category.



43



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##### Table of Contents

The following table summarizes activity within the Allowance at the dates and for the years indicated
(dollars in thousands). Losses and recoveries are charged or credited to the Allowance at the time realized.



|                                              |  |                                         |         |   |      |         |      |         |      |         |      |        
|--------------------------------------------- |  | --------------------------------------- | ------- | - | ---- | ------- | ---- | ------- | ---- | ------- | ---- | -------
|                                              |  | At and for the years ended December 31,
|                                              |  | 2006                                    |         |   | 2005 |         | 2004 |         | 2003 |         | 2002
|Allowance balance, beginning of year          |  | $                                       | 8,431   |   |      | 7,619   |      | 7,463   |      | 6,402   |      | 5,658  
|Provision for loan losses                     |  |                                         | 1,625   |   |      | 2,400   |      | 2,150   |      | 3,600   |      | 4,288  
|Loans charged-off                             |  |                                         |         |   |      |         |      |         |      |         |      |        
|Commercial and industrial                     |  |                                         | 453     |   |      | 244     |      | 549     |      | 786     |      | 1,074  
|Real estate1 - 4 family                      |  |                                         | 247     |   |      | 415     |      | 232     |      | 561     |      | 398    
|Real estateconstruction                      |  |                                         |        |   |      |        |      |        |      |        |      |       
|Real estateother                             |  |                                         | 191     |   |      | 242     |      | 256     |      | 219     |      |       
|Consumer                                      |  |                                         | 791     |   |      | 891     |      | 1,113   |      | 1,181   |      | 2,298  
|                                              |  |                                         |         |   |      |         |      |         |      |         |      |        
|Total loans charged-off                       |  |                                         | 1,682   |   |      | 1,792   |      | 2,150   |      | 2,747   |      | 3,770  
|Recoveries                                    |  |                                         |         |   |      |         |      |         |      |         |      |        
|Commercial and industrial                     |  |                                         | 37      |   |      | 35      |      | 49      |      | 32      |      | 105    
|Real estate1 - 4 family                      |  |                                         | 15      |   |      |        |      |        |      |        |      | 9      
|Real estateconstruction                      |  |                                         |        |   |      |        |      |        |      |        |      |       
|Real estateother                             |  |                                         | 6       |   |      | 35      |      | 4       |      | 46      |      |       
|Consumer                                      |  |                                         | 95      |   |      | 134     |      | 103     |      | 130     |      | 112    
|                                              |  |                                         |         |   |      |         |      |         |      |         |      |        
|Total recoveries                              |  |                                         | 153     |   |      | 204     |      | 156     |      | 208     |      | 226    
|                                              |  |                                         |         |   |      |         |      |         |      |         |      |        
|Net loans charged-off                         |  |                                         | 1,529   |   |      | 1,588   |      | 1,994   |      | 2,539   |      | 3,544  
|                                              |  |                                         |         |   |      |         |      |         |      |         |      |        
|Allowance balance, end of year                |  | $                                       | 8,527   |   |      | 8,431   |      | 7,619   |      | 7,463   |      | 6,402  
|                                              |  |                                         |         |   |      |         |      |         |      |         |      |        
|Average loans (1)                             |  | $                                       | 895,062 |   |      | 828,545 |      | 725,555 |      | 659,683 |      | 577,949
|Ending loans (1)                              |  |                                         | 945,913 |   |      | 866,181 |      | 773,254 |      | 693,213 |      | 625,542
|Net loans charged-offs to average loans (1)   |  |                                         | 0.17    | % |      | 0.19    |      | 0.27    |      | 0.38    |      | 0.61   
|Allowance for loan losses to ending loans (1) |  |                                         | 0.90    |   |      | 0.97    |      | 0.99    |      | 1.08    |      | 1.02   

---

|(1) |  | Calculated using loans excluding mortgage loans held for sale, net of unearned income, excluding allowance for loan losses
|--- |  | --------------------------------------------------------------------------------------------------------------------------



See Item 7. Managements Discussion and Analysis of Financial
Condition and Results of OperationsEarnings ReviewProvision for Loan Losses contained herein for discussion regarding the decrease in the provision for loan losses from fiscal year 2005 to fiscal year 2006.



Total net loans charged-off totaled $1.5 million in fiscal year 2006 down
from $1.6 million in fiscal year 2005. When comparing net loans charged-off during fiscal year 2005 and fiscal year 2006, declines were experienced in all portfolios with the exception of the portfolio secured by commercial and industrial
collateral. Although management attributes the decline in net loans charged-off to the careful management of the Companys loan portfolio, management believes that the increase in net loans charged-off within the portfolio secured by commercial
and industrial collateral was caused by risk factors as explained in See Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsLoans.



The level of the Allowance during fiscal year 2006 was also impacted by
growth within the loan portfolio during the period.



Management
believes that the declining trend of the Allowance to ending loans results from several factors including, but not limited to, managements conservative philosophy regarding its lending mix which impacts risk grades assigned at loan
origination, the ongoing management of asset quality, and growth within the portfolio being primarily loans secured by real estate which generally involve less risk that other types of lending, all of which impact Allowance allocations.



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Based on the current economic environment and other factors that impact the assessment of the
Companys Allowance as discussed above, management believes that the Allowance at December 31, 2006 was maintained at a level adequate to provide for estimated probable losses in the loan portfolio. See Item 7. Managements
Discussion and Analysis of Financial Condition and Results of OperationsLoans contained herein for discussion regarding factors inherent in the loan portfolio impacting managements December 31, 2006 assessment of the Allowance.
However, assessing the adequacy of the Allowance is a process that requires considerable judgment. Managements judgments are based on numerous assumptions about current events believed to be reasonable but which may or may not be valid. Thus,
there can be no assurance that loan losses in future periods will not exceed the current Allowance or that future increases in the Allowance will not be required. No assurance can be given that managements ongoing evaluation of the loan
portfolio, in light of changing economic conditions and other relevant circumstances, will not require future additions to the Allowance, thus adversely impacting the results of operations of the Company.



Deposits



Retail deposit accounts have traditionally been the primary source of funds
for the Company and also provide a customer base for the sale of additional financial products and services. The Company sets targets for growth in traditional deposit accounts annually in an effort to cross sell and increase the number of products
per banking relationship. During the year ended December 31, 2006, the Company emphasized the growth of traditional deposit accounts through internal and external referral programs and targeted promotions.



The Company offers a number of traditional deposit accounts including
noninterest-bearing checking, interest-bearing checking, savings, money market, individual retirement accounts (IRAs) and certificate of deposit accounts. The Companys deposits are obtained primarily from residents within its
market area.



The Company experiences fluctuations in deposit
flows because of the influence of general interest rates, market conditions, and competitive factors. The AssetLiability Committee meets weekly and makes changes to the mix, maturity, and pricing of assets and liabilities in an effort to
minimize the impact on operations from such external conditions. Deposits are attractive sources of funding because of their stability and generally low cost, as compared to other funding sources, and their ability to provide fee income through
service charges and cross sales of other services.



The Company
provides customers with access to their funds using the convenience of an ATM network that incorporates regional and national ATM networks. At December 31, 2006, the Bank had 38 ATM locations (including eight at nonbanking offices) and five
limited service banking offices located in various Upstate retirement centers. The Company also provides account access through its Internet and telephone banking products and attracts deposit customers by offering a variety of services and
accounts, competitive interest rates, and conveniences such as extended banking office hours, both early and late, all-day deposit credit, and Saturday banking hours. In addition, the Company uses traditional marketing techniques, such as direct
mailings and advertising, to attract new customers. Management believes the Company enjoys an excellent reputation for providing products and services that meet the needs of all of the Companys market segments. For example, Seniority Club
members benefit from a number of advantageous programs.



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##### Table of Contents

The following table summarizes the Companys deposit composition at the dates indicated (dollars in
thousands).



|                                                 |  |                   |         |            |                   |   |                   |         |                   |       |                   |         |            |       |       |         |            |       |       |         |            |      
|------------------------------------------------ |  | ----------------- | ------- | ---------- | ----------------- | - | ----------------- | ------- | ----------------- | ----- | ----------------- | ------- | ---------- | ----- | ----- | ------- | ---------- | ----- | ----- | ------- | ---------- | -----
|                                                 |  | December 31, 2006 |         |            | December 31, 2005 |   | December 31, 2004 |         | December 31, 2003 |       | December 31, 2002
|                                                 |  | Total             |         | % of Total |                   |   | Total             |         | % of Total        |       | Total             |         | % of Total |       | Total |         | % of Total |       | Total |         | % of Total
|Noninterest-bearing transaction deposit accounts |  | $                 | 133,623 |            | 13.4              | % |                   | 131,157 |                   | 14.5  |                   | 124,489 |            | 15.0  |       | 115,982 |            | 15.0  |       | 114,573 |            | 15.9 
|Interest-bearing transaction deposit accounts    |  |                   | 313,613 |            | 31.6              |   |                   | 220,472 |                   | 24.4  |                   | 185,072 |            | 22.4  |       | 172,766 |            | 22.4  |       | 156,665 |            | 21.7 
|                                                 |  |                   |         |            |                   |   |                   |         |                   |       |                   |         |            |       |       |         |            |       |       |         |            |      
|Transaction deposit accounts                     |  |                   | 447,236 |            | 45.0              |   |                   | 351,629 |                   | 38.9  |                   | 309,561 |            | 37.4  |       | 288,748 |            | 37.4  |       | 271,238 |            | 37.6 
|                                                 |  |                   |         |            |                   |   |                   |         |                   |      
|Money market deposit accounts                    |  |                   | 124,874 |            | 12.6              |   |                   | 111,380 |                   | 12.3  |                   | 95,608  |            | 11.6  |       | 85,077  |            | 11.0  |       | 79,553  |            | 11.0 
|Savings deposit accounts                         |  |                   | 41,887  |            | 4.2               |   |                   | 45,360  |                   | 5.0   |                   | 44,972  |            | 5.4   |       | 41,974  |            | 5.5   |       | 37,807  |            | 5.2  
|Time deposit accounts                            |  |                   | 379,584 |            | 38.2              |   |                   | 395,014 |                   | 43.8  |                   | 377,306 |            | 45.6  |       | 355,949 |            | 46.1  |       | 333,393 |            | 46.2 
|                                                 |  |                   |         |            |                   |   |                   |         |                   |       |                   |         |            |       |       |         |            |       |       |         |            |      
|Total traditional deposit accounts               |  | $                 | 993,581 |            | 100.0             | % |                   | 903,383 |                   | 100.0 |                   | 827,447 |            | 100.0 |       | 771,748 |            | 100.0 |       | 721,991 |            | 100.0
|                                                 |  |                   |         |            |                   |   |                   |         |                   |       |                   |         |            |       |       |         |            |       |       |         |            |      



Total traditional
deposit accounts increased $90.2 million from December 31, 2005 to December 31, 2006, up from growth of $75.9 million from December 31, 2004 to December 31, 2005.



Core traditional deposit accounts, which include checking, money market, and savings accounts, grew by $105.6 million during
fiscal year 2006, or 20.8%. Such accounts grew by $58.2 million, or 12.9%, during fiscal year 2005. The increase in core traditional deposit accounts during both of these periods was primarily a result of the Companys continued ability to
attract deposits through pricing adjustments, expansion of its geographic market area, level of quality customer service, and through the Companys reputation in the communities served. Additionally, the Company has made efforts to enhance its
deposit mix by working to attract lower cost deposit accounts. The Company believes that the growth in core traditional deposit accounts from fiscal year 2005 to fiscal year 2006 was enhanced by the introduction, continuation, and enhancement of
programs and promotions, such as the Seniority Club checking product, a health savings account product, and new business investment money market account, as well as by branch opening promotions and the Banks new customer referral program.



In addition, the Company believes that some of the growth
within core traditional deposit accounts resulted from additional marketing efforts geared toward the Banks existing Palmetto Index Account which has become more attractive to customers as rates have risen since 2004 as well as growth in
health savings accounts which was introduced during the fourth quarter of 2005 to help individuals save for future qualified medical and retiree health expenses on a tax-free basis in an effort to address the underlying problem of the affordability
of health care coverage.



The Company introduced its Health
Savings transaction deposit account during the fourth quarter of 2005. This product was designed to assist customers and their families with the payment or reimbursement of qualified medical expenses. Contributions, although limited, and
distributions to and from this account are tax-free provided they such are used for qualified medical expenses.



Contributing to the growth in money market deposit accounts during 2006 was a deposit of approximately $14 million from one entity and an increase in
money market funds by the Banks trust department of approximately $6 million during the period, offset somewhat by cash outflows during 2006.



Time deposit accounts decreased by $15.4 million, or 3.9% during fiscal year 2006 compared with growth of $17.7 million, or 4.7% during fiscal year 2005.
36-month Step Up certificate of deposit promotions were



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##### Table of Contents

offered during the fiscal years ending December 31, 2002, 2003, and 2004. Promotional certificate of deposit accounts offered during 2003 matured during
2006. The Bank offered several specifically targeted programs, as described below, in an effort to retain maturing funds and successfully retained a large portion of these maturing funds. The decline in time deposit accounts during this period is
due in large part to the funds that the Bank was unable to retain and the maturing funds that were reinvested by customers into difference Bank deposit products.



| |  |  | 36-month Step Up certificate of deposit promotions were offered during the fiscal years ending December 31, 2002, 2003, and 2004. Certificate of deposit
accounts generated through the 2004 promotion are scheduled to mature during 2007.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | 15 month certificate of deposit accounts offered by the Bank during December 2005 are scheduled to mature during 2007.
| | - |  | ----------------------------------------------------------------------------------------------------------------------



| |  |  | 15 month certificate of deposit accounts offered by the Bank in conjunction with the opening of the new Boiling Springs banking office during the second half of
2006 are scheduled to mature during 2007.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | 13 month certificate of deposit accounts offered by the Bank during June and July 2006 in an effort to retain maturing funds at the Easley banking office opened in
2005 are scheduled to mature during 2007.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | 13 month certificate of deposit accounts offered by the Bank during July, August, and September 2006 in an effort to retain maturing funds at the Travelers Rest
banking office are scheduled to mature during 2007. Additionally, 12 month certificate of deposit accounts offered by the Bank during June 2006 at this banking office in an effort to stimulate new deposit account growth are scheduled to mature
during 2007.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | 12 month certificate of deposit accounts offered by the Bank during July, August, and September 2006 in an effort to retain maturing funds at the Easley and
Travelers Rest banking offices are scheduled to mature during 2007.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The table set forth below summarizes the Companys weighted average deposit costs for the periods indicated.



|                                                   |  |                                     |   |  |                                    
|-------------------------------------------------- |  | ----------------------------------- | - |  | -----------------------------------
|                                                   |  | For the year endedDecember 31, 2006 |   |  | For the year endedDecember 31, 2005
|Average cost of core deposit accounts              |  | 2.20                                | % |  | 0.94                               
|Average cost of time deposit accounts              |  | 3.98                                |   |  | 2.99                               
|Average cost of total traditional deposit accounts |  | 3.04                                |   |  | 1.98                               



The table set forth
below summarizes the Companys interest expense on deposit accounts costs for the periods indicated (in thousands).



|                                           |  |                                |        |      |        |      |       
|------------------------------------------ |  | ------------------------------ | ------ | ---- | ------ | ---- | ------
|                                           |  | For the year endedDecember 31,
|                                           |  | 2006                           |        | 2005 |        | 2004
|Transaction deposit accounts               |  | $                              | 5,424  |      | 1,430  |      | 426   
|Money market deposit accounts              |  |                                | 3,979  |      | 1,809  |      | 559   
|Savings deposit accounts                   |  |                                | 147    |      | 143    |      | 133   
|Time deposit accounts                      |  |                                | 15,430 |      | 11,010 |      | 9,071 
|                                           |  |                                |        |      |        |      |       
|Total interest expense on deposit accounts |  | $                              | 24,980 |      | 14,392 |      | 10,189
|                                           |  |                                |        |      |        |      |       



Management does not
believe that its dependence on traditional deposit account funding changed materially from December 31, 2005 to December 31, 2006. At December 31, 2006, traditional deposit accounts as a percentage of liabilities were 94.4% compared
with 91.6% at December 31, 2005. The percentage of funding provided by traditional deposit accounts increased during 2006, and accordingly, the Company has not had to rely as heavily on alternative funding sources from which to fund a portion
of loan demand.



47



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##### Table of Contents

Jumbo Certificates of Deposits.The Company does not rely significantly on large denomination
certificate of deposit accounts. Such accounts totaled 12.3% and 12.5% of total liabilities at December 31, 2006 and December 31, 2005, respectively. The following table summarizes the Companys jumbo certificate of deposit accounts
by time remaining until contractual maturity at December 31, 2006 (in thousands). Jumbo certificate of deposit accounts include those accounts with year-end balances totaling $100,000 or greater.



|                                            |  |   |        
|------------------------------------------- |  | - | -------
|Three months or less                        |  | $ | 32,122 
|Over three months through six months        |  |   | 33,788 
|Over six months through twelve months       |  |   | 35,987 
|                                            |  |   |        
|Twelve months or less                       |  |   | 101,897
|Over twelve months                          |  |   | 27,285 
|                                            |  |   |        
|Total jumbo certificate of deposit accounts |  | $ | 129,182
|                                            |  |   |        



Total jumbo
certificate of deposit accounts totaled $123.0 million at December 31, 2005. Although total jumbo certificate of deposit accounts experienced little change from December 31, 2005 to December 31,2006, a shift was experienced with
regard to the maturity of such certificate of deposit accounts. At December 31, 2005, 53.0% of jumbo certificate of deposit accounts were to mature within twelve months. At December 31, 2006, 78.9% of jumbo certificate of deposit accounts
were to mature within twelve months. Specifically targeted programs offered by the Bank to stimulate new deposit account growth and to retain existing but maturing funds, as previously discussed, contributed to the increase in the twelve
months or less category. Although all of the deposits generated by these promotions are not jumbo in size, the deposits that do fall into the jumbo category impact the maturities noted above.



See Item 8. Financial Statements and Supplementary Data, Note 9
contained herein for further discussion regarding the Companys deposit accounts.



Borrowings



In addition
to traditional deposit accounts, the Company utilizes both short-term and long-term borrowing to supplement its supply of lendable funds, to assist in meeting deposit withdrawal requirements, and to fund growth of interest-earning assets in excess
of traditional deposit growth. Retail repurchase agreements, commercial paper, federal funds purchased, and FHLB borrowings serve as the Companys primary sources of such funds.



Borrowings decreased $24.1 million at the end of 2006 when compared with the end of 2005. Borrowings as a percentage of
total liabilities were approximately 4.9% and 7.7% at the end of fiscal year 2006 and fiscal year 2005, respectively. The following table summarizes the Companys borrowings composition at the dates indicated (dollars in thousands).



|                             |  |                   |        |            |                   |   |       |        |            |      
|---------------------------- |  | ----------------- | ------ | ---------- | ----------------- | - | ----- | ------ | ---------- | -----
|                             |  | December 31, 2006 |        |            | December 31, 2005
|                             |  | Total             |        | % of Total |                   |   | Total |        | % of Total
|Retail repurchase agreements |  | $                 | 14,427 |            | 28.1              | % |       | 16,728 |            | 22.1 
|Commercial paper             |  |                   | 20,988 |            | 40.8              |   |       | 17,915 |            | 23.7 
|Federal funds purchased      |  |                   | 6,000  |            | 11.7              |   |       | 1,000  |            | 1.3  
|FHLB borrowingsshortterm   |  |                   |       |            |                  |   |       | 16,900 |            | 22.4 
|FHLB borrowingslongterm    |  |                   | 10,000 |            | 19.4              |   |       | 23,000 |            | 30.5 
|                             |  |                   |        |            |                   |   |       |        |            |      
|Total borrowings             |  | $                 | 51,415 |            | 100.0             | % |       | 75,543 |            | 100.0
|                             |  |                   |        |            |                   |   |       |        |            |      



Short-term and
long-term borrowings are a source of funding that the Company utilizes depending on the current level of deposits, the desirability of raising deposits through market promotions, the Companys unused FHLB borrowing capacity, and the
availability of collateral to secure FHLB borrowings. Long-term borrowings have maturities greater than one year when made.



48



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The Company offers commercial paper as an alternative investment tool for its commercial customers.
Through a master note arrangement between the holding company and the Bank, Palmetto Master Notes are issued as an alternative investment for commercial sweep accounts. These master notes are unsecured but are backed by the full faith and credit of
the holding company. The commercial paper is issued only in conjunction with the automated sweep account customer agreement on deposits at the Bank level.



Federal funds purchased represent unsecured overnight borrowings from other financial institutions. These borrowings are an important source of funding to
the Company. Access to such short-term funding sources allows the Company to meet funding needs without relying on increasing deposits on a short-term basis. Interest rates on such borrowings vary from time to time in response to general economic
conditions.



FHLB borrowings are an alternative to other
funding sources with similar maturities. The FHLB has established an overall credit limit for each member. This limit is designed to mitigate the FHLBs credit exposure to an individual member while encouraging members to diversify their
funding sources. Generally, this credit limit is 40 percent of the members total assets. However, a members eligibility to borrow in excess of 30 percent of assets is subject to its meeting eligibility criteria. Under certain
circumstances, a member approved for a 40 percent credit limit may request approval to exceed the credit limit. A member may exceed the 40 percent limit for a period not to exceed 12 months. This policy serves to define an upper limit for FHLB
advances based on its current approved limit.



Qualifying
collateral to be pledged to secure advances from the FHLB may include qualifying securities, loans, deposits, and stock of the FHLB owned by the Company. The member has certain obligations to the FHLB for its pledged collateral. These obligations
include periodic reporting on eligible, pledged collateral and adherence to the FHLBs collateral verification review procedures. At December 31, 2006, of its approximately $103 million available credit based on qualifying loans to serve
as collateral against short-term or long-term borrowings from the FHLB, the Company employed $10.0 million in borrowings, all of which was determined to be long-term when employed and employed $79.0 million in a letter of credit. FHLB letters of
credit provide an attractive alternative to using traditional collateral for various transactions. Advantages of FHLB letters of credit include enhancing member liquidity (substituting letter of credit for securities as collateralization of public
unit deposits) and utilization of residential mortgage loans as collateral for the letters of credit. However, the utilization of FHLB letters of credit reduces the Companys available credit based on qualifying loans to serve as collateral.
The Company uses the FHLB letter of credit for collateralization of public deposits.



The FHLB may assess fees and charges to cover costs relating to the receipt, holding, redelivery, and reassignment of the Companys collateral. The FHLB publishes a schedule of such fees and charges on its
website. In addition, the FHLB may assess fees to cover collateral verification reviews performed by, or on behalf of, the FHLB. The Company has not yet been charged any such fees and does not anticipate such fees, if assessed, will be significant.



Any FHLB advance with a fixed interest rate is subject to a
prepayment fee in the event of full or partial repayment prior to maturity or the expiration of any interim interest rate period. Management was not aware of any circumstances at December 31, 2006 that would require prepayment of any of the
Companys FHLB advances.



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##### Table of Contents

The following table summarizes short-term borrowing information at and for the years indicated (dollars
in thousands).



|                                               |  |                                       |        |   |      |        |      |       
|---------------------------------------------- |  | ------------------------------------- | ------ | - | ---- | ------ | ---- | ------
|                                               |  | At and for the year endedDecember 31,
|                                               |  | 2006                                  |        |   | 2005 |        | 2004
|Retail repurchase agreements                   |  |                                       |        |   |      |        |      |       
|Amount outstanding at year-end                 |  | $                                     | 14,427 |   |      | 16,728 |      | 16,397
|Average amount outstanding during year         |  |                                       | 17,639 |   |      | 20,690 |      | 20,215
|Maximum amount outstanding at any month-end    |  |                                       | 23,344 |   |      | 20,981 |      | 22,308
|Rate paid at year-end*                         |  |                                       | 3.63   | % |      | 2.63   |      | 0.73  
|Weighted average rate paid during the year     |  |                                       | 4.14   |   |      | 2.38   |      | 0.61  
|                                               |  |                                       |       
|Securities sold under agreements to repurchase |  |                                       |        |   |      |        |      |       
|Amount outstanding at year-end                 |  | $                                     |       |   |      |       |      |      
|Average amount outstanding during year         |  |                                       |       |   |      |       |      | 2,508 
|Maximum amount outstanding at any month-end    |  |                                       |       |   |      |       |      | 38,220
|Rate paid at year-end                          |  |                                       |       | % |      |       |      |      
|Weighted average rate paid during the year     |  |                                       |       |   |      |       |      | 1.28  
|                                               |  |                                       |       
|Commercial paper                               |  |                                       |        |   |      |        |      |       
|Amount outstanding at year-end                 |  | $                                     | 20,988 |   |      | 17,915 |      | 17,051
|Average amount outstanding during year         |  |                                       | 21,009 |   |      | 18,833 |      | 16,447
|Maximum amount outstanding at any month-end    |  |                                       | 25,720 |   |      | 21,877 |      | 18,310
|Rate paid at year-end*                         |  |                                       | 3.81   | % |      | 2.81   |      | 0.85  
|Weighted average rate paid during the year     |  |                                       | 4.13   |   |      | 2.33   |      | 0.75  
|                                               |  |                                       |       
|Federal funds purchased                        |  |                                       |        |   |      |        |      |       
|Amount outstanding at year-end                 |  | $                                     | 6,000  |   |      | 1,000  |      |      
|Average amount outstanding during year         |  |                                       | 847    |   |      | 4,098  |      | 4,643 
|Maximum amount outstanding at any month-end    |  |                                       | 6,000  |   |      | 13,320 |      | 17,850
|Rate paid at year-end                          |  |                                       | 5.50   | % |      | 4.37   |      |      
|Weighted average rate paid during the year     |  |                                       | 5.19   |   |      | 2.71   |      | 1.51  

---

|* |  | Rates paid are tiered based on level of deposit. Rate presented represents the average rate for all tiers offered at year-end.
|- |  | ------------------------------------------------------------------------------------------------------------------------------



The following table summarizes the Companys borrowings from the FHLB at
December 31, 2006 (dollars in thousands). The Companys long-term FHLB advance does not have embedded call options.



|                              |  |           |          
|----------------------------- |  | --------- | ---------
|                              |  | Long-term
|Borrowing balance outstanding |  | $         | 10,000   
|Interest rate                 |  |           | 3.85     
|Maturity date                 |  |           | 6/14/2007



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The following table summarizes short-term borrowing information at and for the years indicated (dollars
in thousands).



|                                            |  |                                       |        |   |      |        |      |       
|------------------------------------------- |  | ------------------------------------- | ------ | - | ---- | ------ | ---- | ------
|                                            |  | At and for the year endedDecember 31,
|                                            |  | 2006                                  |        |   | 2005 |        | 2004
|Short-term FHLB borrowings                  |  |                                       |        |   |      |        |      |       
|Amount outstanding at year-end              |  | $                                     |       |   |      | 16,900 |      | 16,000
|Average amount outstanding during year      |  |                                       | 2,140  |   |      | 26,745 |      | 4,990 
|Maximum amount outstanding at any month-end |  |                                       | 10,900 |   |      | 51,400 |      | 24,500
|Rate paid at year-end                       |  |                                       |       | % |      | 4.44   |      | 2.44  
|Weighted average rate paid during the year  |  |                                       | 4.63   |   |      | 3.59   |      | 2.08  
|                                            |  |                                       |       
|Long-term FHLB borrowings                   |  |                                       |        |   |      |        |      |       
|Amount outstanding at year-end              |  | $                                     | 10,000 |   |      | 23,000 |      | 30,000
|Average amount outstanding during year      |  |                                       | 15,841 |   |      | 26,145 |      | 16,475
|Maximum amount outstanding at any month-end |  |                                       | 23,000 |   |      | 30,000 |      | 30,000
|Rate paid at year-end                       |  |                                       | 3.85   | % |      | 3.52   |      | 3.24  
|Weighted average rate paid during the year  |  |                                       | 3.64   |   |      | 3.38   |      | 3.25  



Rates paid for the
year ended December 31, 2006 increased from those paid for the year ended December 31, 2005. The primary reason for the changes in the yields paid on interest-bearing liabilities has been the action of the Federal Reserve Open Market
Committee. Since the second quarter of 2004, the federal funds rate has increased from 1.0% to 5.25% in a series of seventeen moves. The increases in the Companys borrowings costs from the year ended December 31, 2005 to the year ended
December 31, 2006 is attributed to these increasing rate trends.



See Item 8.    Financial Statements and Supplementary Data, Note 1 contained herein for further discussion regarding the Companys significant accounting policies with regard to FHLB borrowings and Item 8.
Financial Statements and Supplementary Data, Note 10 and Note 11 also contained herein for further discussion regarding the Companys borrowings.



Capital Resources



Average shareholders equity was $95.1 million for the year ended December 31, 2006, or 8.5% of average assets. Average shareholders
equity was $85.8 million for the year ended December 31, 2005, or 8.2% of average assets.



Total shareholders equity increased from $88.9 million at December 31, 2005 to $100.4 million at December 31, 2006. The Companys capital ratio of total shareholders equity to total assets
was 8.7% at December 31, 2005 compared with 8.3% at December 31, 2005. During 2006, shareholders equity was increased through the retention of net income, stock option activity, compensation expense related to stock options granted
and a slight increase in accumulated other comprehensive income. These increases were offset by an increase in cash dividends when comparing the year ended December 31, 2006 with the year ended December 31, 2005. See
Item 8.    Financial Statements and Supplementary Data, Consolidated Statements of Changes in Shareholders Equity and Comprehensive Income contained herein for further discussion regarding the changes in
stockholders equity during the years presented.



The
Company and the Bank are required to meet regulatory capital requirements that currently include several measures of capital. At December 31, 2006 and 2005, the Company and the Bank were each categorized as well capitalized under the regulatory
framework for prompt corrective regulatory action.



See
Item 1.    BusinessSupervision and Regulation and Item 8. Financial Statements and Supplementary Data, Note 19 all contained herein for further discussion regarding the Banks and the Companys capital



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##### Table of Contents

regulatory requirements. At December 31, 2006, there were no conditions or events of which management was aware that would materially change the
Companys or the Banks status.



During fiscal year
2006, the Companys cash dividend payout ratio was 30.45% compared with a payout ratio of 30.27% in 2005. Cash dividends per common share in 2006 totaled $0.73, an increase of 10.6% over dividends per common share in 2005 of $0.66. The amount
of the dividends declared is dependent upon the Companys earnings, financial condition, capital position, and such other factors the Board deems relevant. South Carolina regulations restrict the amount of dividends that the Bank can pay to the
holding company and may require prior approval before declaration and payment of any excess dividend.



See Item 5. Market For Registrants Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities, Item 7.
Managements Discussion and Analysis of Financial Condition and Results of OperationsLiquidityPalmetto Bancshares, and Item 8. Financial Statements and Supplementary Data, Note 18 and Note 19 all contained herein for further
discussion regarding common stock dividend payment determination and restrictions.



Management continually reviews opportunities for Upstate expansion that are believed to be in the best interest of the Company, its customers, and its shareholders. During 2006, the Bank began an expansion of its
Greenwood county Montague banking office. Construction on this office is anticipated to be completed during the first quarter of 2007. Additionally, during February 2007, the Bank purchased real estate in Anderson County and plans to relocate its
existing Pendleton banking office to that site. The Company is currently considering land options with regard to its anticipated Greer banking office relocation.



In conjunction with the Companys 100thanniversary celebration on September 21st, the Company announced its plan to relocate its corporate headquarters to downtown Greenville in 2008. Tentative plans project construction of the new leased
facility to begin in 2007 with a projected completion date in 2008. Management is currently in negotiations of a build-to-suit ground and building lease with the property owner. The 42,000 square foot, classical bank design will be located at the
corner of East North and Church Streets. Additionally, the Company anticipates that furniture and equipment for the new corporate headquarters facility will cost the Company an estimated $2.0 million.



During the construction of its new corporate headquarters, the Company will
temporarily move its East North Street banking office to a building owned by the Company located directly next to the permanent building site at 105 North Church Street. The Company anticipates that it will incur costs of approximately $350 thousand
to upfit the building, and lease various banking office equipment, additional office spaces, and employee parking.



Disclosures Regarding Market Risk



Market risk is the risk of loss in a financial instrument arising from adverse changes in market prices and rates, foreign currency exchange rates, commodity prices, and equity prices. The Companys market risk arises primarily from
interest rate risk inherent in its lending and deposit taking activities. To that end, management actively monitors and manages interest rate risk exposure. The Company does not have any market risk sensitive instruments entered into for trading
purposes. Interest rate sensitivity is managed by matching the repricing opportunities on interest-earning assets to those on interest-bearing liabilities. Management uses various assetliability strategies to manage the repricing
characteristics of assets and liabilities designed to ensure that exposure to interest rate fluctuations is limited within the Companys guidelines of acceptable levels of risk taking.



Interest rate risk is addressed by the Companys AssetLiability
Committee, which is comprised of certain members of senior management and a holding company board member. This committee monitors interest rate risk by analyzing the potential impact on net interest income from potential changes in interest rates
and considers the impact of alternative strategies or changes in balance sheet structure. The committee also manages the Companys balance sheet, in part, to maintain the potential impact on net interest income within acceptable ranges despite
changes in interest rate.



52



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The Companys exposure to interest rate risk is reviewed on at least a quarterly basis by the
Companys AssetLiability Committee and Board of Directors. Interest rate risk exposure is measured using interest rate sensitivity analysis to determine the change in net interest income in the event of hypothetical changes in interest
rates. If potential changes to net interest income resulting from hypothetical interest rate changes are not within the Companys guidelines, the Board may direct management to adjust the asset and liability mix to bring interest rate risk
within such guidelines. Current guidelines of the Companys AssetLiability Committee include maintaining the projected negative impact on the Companys net interest income for the coming twelve month period at an amount not to exceed
20%. Management adjusts the Companys interest rate risk exposure position primarily through decisions on the pricing, maturity, and marketing of particular deposit and loan products and through decisions regarding the structure and maturities
of FHLB advances and other borrowings.



Market risk sensitive
instruments are generally defined as derivatives and other financial instruments. At December 31, 2006, 2005 and 2004, the Company had not used any derivatives to alter its interest rate risk profile. The Companys financial instruments
include loans, federal funds sold, FHLB stock, investment securities, deposits, and borrowings. At December 31, 2006, the Companys interest-sensitive assets totaled approximately $1.0 billion while interest-sensitive liabilities totaled
approximately $879.5 million. At December 31, 2005, the Companys interest-sensitive assets totaled approximately $977.7 million while interest-sensitive liabilities totaled approximately $822.5 million.



The yield on interest-sensitive assets and the cost of interest-sensitive
liabilities for the year ended December 31, 2006 was 7.33% and 3.10%, respectively, compared to 6.42% and 2.10%, respectively, for the year ended December 31, 2005. The increase in the yield on interest-sensitive assets and the cost of
interest-sensitive liabilities resulted from the rising interest rate environment.



The Company evaluated the results of its net interest income simulation prepared as of December 31, 2006 for interest rate risk management purposes. Overall, the model results indicate that the Companys
interest rate risk sensitivity is within limits set by the Companys guidelines and the Companys balance sheet is liability sensitive. A liability sensitive balance sheet suggests that in falling interest rate environment, net interest
margin would increase and during an increasing interest rate environment, net interest margin would decrease.



Net Interest Income Simulation



In order to measure interest rate risk, the Company uses a simulation model to project changes in net interest income that result from forecasted changes
in interest rates. This analysis calculates the difference between net interest income forecasted using a rising and a falling interest rate scenario and a net interest income forecast using a base market interest rate derived from the current
treasury yield curve. The income simulation model includes various assumptions regarding the repricing relationships for each of the Companys products. Many of the Companys assets are floating rate loans, which are assumed to reprice
immediately, and to the same extent as the change in market rates according to contracted indexes. Some loans and investment securities include the opportunity of prepayment, and, accordingly, the simulation model uses national indexes to estimate
these prepayments and reinvest their proceeds at current yields. The Companys nonterm deposit products reprice more slowly, usually changing less than the change in market rates and at the Companys discretion.



This analysis summarizes the impact of changes in net interest income for the
given set of rate changes and assumptions. It assumes growth in the balance sheet. It does not account for all factors that impact this analysis, including changes by management to mitigate the impact of interest rate changes or secondary impacts
such as changes to the Companys credit risk profile as interest rates change. Furthermore, loan prepayment rate estimates and spread relationships change regularly. Interest rate changes create changes in actual loan prepayment rates that will
differ from the market estimates incorporated in this analysis. Changes that vary significantly from the assumptions may have significant effects on net interest income.



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As of December 31, 2006, the following table summarizes forecasted net interest income and net
interest margin using a base market rate and the estimated change to the base scenario given upward and downward movement in interest rates of 100 basis points and 200 basis points (dollars in thousands).



|                       |  |                            |        |                           |       |    |                    |      |   |                                           |       |  
|---------------------- |  | -------------------------- | ------ | ------------------------- | ----- | -- | ------------------ | ---- | - | ----------------------------------------- | ----- | -
|Interest rate scenario |  | Adjusted netinterestincome |        | Percentagechangefrom base |       |    | Net interestmargin |      |   | Net interestmarginchange (inbasis points) |      
|Up 200 basis points    |  | $                          | 49,776 |                           | (7.57 | )% |                    | 4.51 | % |                                           | (0.37 | )
|Up 100 basis points    |  |                            | 51,834 |                           | (3.75 | )  |                    | 4.70 |   |                                           | (0.18 | )
|BASE CASE              |  |                            | 53,854 |                           |      |    |                    | 4.88 |   |                                           |      |  
|Down 100 basis points  |  |                            | 55,602 |                           | 3.25  |    |                    | 5.04 |   |                                           | 0.16  |  
|Down 200 basis points  |  |                            | 57,250 |                           | 6.31  |    |                    | 5.19 |   |                                           | 0.31  |  



The simulation results
as of December 31, 2006 indicate the Companys interest rate risk position was liability sensitive as the simulated impact of an downward movement in interest rates of 100 basis points would result in a 3.25% increase in net interest
income over the subsequent 12 month period while an upward movement in interest rates of 100 basis points would result in a 3.75% decrease in net interest income over the next 12 months. The simulation results indicate that a 100 basis point
downward shift in interest rates would result in a 16 basis point increase in net interest margin, assuming all other variables remained unchanged. Conversely, a 100 basis point increase in interest rates would cause a 18 basis point decrease in net
interest margin. The projected negative impact on the Companys net interest income for the twelve month period does not exceed the 20% threshold prescribed by the Asset  Liability Committees policy.



Liquidity



General



The term liquidity refers to the ability of the Company
to generate adequate amounts of cash to meet its operating needs. Management determines the desired level of liquidity for the Company in conjunction with the Companys Asset-Liability Committee. Liquidity management ensures that adequate funds
are available to meet deposit withdrawals, fund loan and capital expenditure commitments, maintain reserve requirements, pay operating expenses, provide funds for dividends and debt service, manage operations on an ongoing basis, and capitalize on
new business opportunities. Funds are primarily provided by the Bank through customers deposits, borrowings, principal and interest payments on loans, loan sales, sales of securities available for sale, maturities and paydowns of securities,
and earnings. Securities classified as available for sale, which are not pledged, may be sold in response to changes in interest rates or liquidity needs. Approximately 62% of the investment securities portfolio was pledged to secure public deposits
as of December 31, 2006 as compared with 83% at December 31, 2005. Of the Companys $116.6 million available for sale investment securities balance at December 31, $44.7 million was available as a liquidity source. The decline in
pledged securities between these periods was the result of a diversification of assets pledged to secure public deposits, securities sold under agreements to repurchase, and for other purposes as required or permitted by law as noted below with
regard to the FHLB line of credit. Management believes that cash flows from investments, in addition to its available borrowing capacity and efforts to grow deposits, are sufficient to provide the necessary funding for 2007.



In managing its liquidity needs, the Company focuses on its existing assets
and liabilities, as well as its ability to enter into additional borrowings, and on the manner in which they combine to provide adequate liquidity to meet its needs. The following table summarizes future contractual obligations as of
December 31, 2006 (in thousands). The table does not include estimated 2007 funding of the pension and other postretirement benefits plans. See Item 8. Financial Statements and Supplementary Data, Note 13 contained herein for further
discussion regarding the Companys postretirement benefits. The table does not include payments required for interest and income taxes. See Item 8. Financial Statements and Supplementary Data, Consolidated Statements of Cash Flows
contained herein for further discussion regarding interest and income taxes paid during 2006.



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|                                     |  |                                                                  |         |                     |        |                       |        |                        |       |                |     |       |        
|------------------------------------ |  | ---------------------------------------------------------------- | ------- | ------------------- | ------ | --------------------- | ------ | ---------------------- | ----- | -------------- | --- | ----- | -------
|                                     |  | Contractual Obligations Payments Due by Period December 31, 2006
|                                     |  | Withinone year                                                   |         | Over oneto twoyears |        | Over twoto threeyears |        | Over threeto fiveyears |       | Over fiveyears |     | Total
|Time deposits                        |  | $                                                                | 300,776 |                     | 56,133 |                       | 18,065 |                        | 4,309 |                | 301 |       | 379,584
|Federal funds purchased              |  |                                                                  | 6,000   |                     |       |                       |       |                        |      |                |    |       | 6,000  
|FHLB borrowingslongterm            |  |                                                                  | 10,000  |                     |       |                       |       |                        |      |                |    |       | 10,000 
|Real property operating leases       |  |                                                                  | 743     |                     | 614    |                       | 467    |                        | 345   |                | 31  |       | 2,200  
|                                     |  |                                                                  |         |                     |        |                       |        |                        |       |                |     |       |        
|Total future contractual obligations |  | $                                                                | 317,519 |                     | 56,747 |                       | 18,532 |                        | 4,654 |                | 332 |       | 397,784
|                                     |  |                                                                  |         |                     |        |                       |        |                        |       |                |     |       |        



Net cash provided by
operations and deposits from customers have been the primary sources of liquidity for the Company. Competition for deposits is intense in the markets served by the Company. However, the Company has been able to attract deposits through pricing
adjustments, expansion of its geographic market area, level of quality customer service, and through the Companys reputation in the communities served. The Company maximizes its liquidity provided through acquiring new deposits through the
Banks established branch network and placing less reliance on borrowings. The Company believes its deposit base is diversified with no one deposit or type of customer accounting for a significant portion of the portfolio. Liquidity needs are a
factor in developing deposit pricing structure, which may be altered to retain or grow deposits if deemed necessary.



Each of the Companys sources of liquidity is subject to various uncertainties beyond the control of the Company. As a measure of protection,
additional funding sources have been arranged through federal funds lines at correspondent banks, through the Federal Reserve Discount Window, and through the FHLB. FHLB borrowings are an alternative to other funding sources with similar maturities.
At December 31, 2006, of its approximately $103 million available credit based on qualifying loans to serve as collateral against short-term or long-term borrowings from the FHLB, the Company employed $10.0 million in borrowings, all of which
was determined to be long-term when employed, and employed $79.0 million in a letter of credit used to secure public deposits as required or permitted by law. At December 31, 2006, the Company had additional funding sources totaling $34 million
that were accessible at the Companys option.



The Bank
enters into agreements, in the normal course of business, to extend credit to meet the financial needs of its customers. See Item 7.    Managements Discussion and Analysis of Financial Condition and Results of
OperationsOff-Balance Sheet Arrangements for further discussion regarding such agreements. Increased demand for funds under these agreements would reduce the Companys available liquidity and could require additional sources of liquidity.



As discussed above in Capital Resources, the Company will
relocate its corporate headquarters to downtown Greenville in 2008. Management is currently in negotiations of a build-to-suit ground and building lease for the new corporate headquarters. As such, the real property operating lease obligations in
the preceding table include the Companys obligations under its current lease with regard to its East North Street banking office. No real property operating lease obligations related to the new corporate headquarters are included in the
preceding table due to the fact that the Company is currently in negotiations with regards to such obligations.



Additionally, real property operating lease obligations summarized in the preceding table are net of payments to be received under a sublease agreement
with a third party with regard to the Companys previous Blackstock Road banking office location.



See Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsFinancial ConditionBorrowings for
further discussion regarding the Companys borrowings, Item 8. Financial Statements and Supplementary Data, Note 1 contained herein for further discussion regarding the Companys significant accounting policies with regard to FHLB
borrowings, and Note 10 and Note 11 also contained herein for further discussion regarding the Companys borrowings.



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See Item 8. Financial Statements and Supplementary Data, Consolidated Statements of Cash Flow
contained herein to review factors that impacted liquidity during the years presented.



Borrowings



The Company
utilizes both short-term and long-term borrowing to supplement its supply of lendable funds, to assist in meeting deposit withdrawal requirements, and to fund growth of interest-earning assets in excess of traditional deposit growth. Retail
repurchase agreements, commercial paper, federal funds purchased, and FHLB borrowings serve as the Companys primary sources of such funds. Typically, the Companys retail repurchase agreements, commercial paper, federal funds purchased,
and short-term FHLB borrowings represent overnight borrowings that mature daily. As such, these borrowings are not included in the contractual obligations table previously presented.



Of the $23.0 million in long-term FHLB borrowings outstanding at December 31, 2005, $13.0 million matured during June
2006 leaving a remaining balance of $10.0 million in long-term borrowings with the FHLB at December 31, 2006. See Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsFinancial
ConditionBorrowings for further discussion regarding the Companys long-tem borrowings, Item 8. Financial Statements and Supplementary Data, Note 1 contained herein for further discussion regarding the Companys significant
accounting policies with regard to FHLB borrowings, and Note 10 also contained herein for further discussion regarding the Companys FHLB borrowings.



Lease Agreements



Obligations under noncancelable real property operating lease agreements are payable over several years with the longest obligation expiring in 2029.
Contractual obligations relative to these agreements are noted in the table above. Option periods that the Company has not yet exercised are not included in this analysis as they do not represent contractual obligations of the Company until
exercised. See Item 2. Properties and Item 8. Financial Statements and Supplementary Data, Note 15 both contained herein for further discussion regarding the Companys real property lease agreements.



The Company enters into agreements with third parties with respect to the
leasing, servicing, and maintenance of equipment. However, because the Company believes that these agreements are immaterial when considered individually, or in the aggregate, with regard to the Companys Consolidated Financial Statements, the
Company has not included such agreements in this analysis. As such, management believes that noncompliance with terms of such agreements would not have a material impact on the Companys financial condition or results of operations.
Furthermore, as most such commitments are entered into for a 12-month period with option extensions, costs beyond 2007 cannot be reasonably estimated at this time.



Also during the first quarter of 2006, the Bank entered into a one-year lease agreement with regard to the banking office
used temporarily during the construction of the new Boiling Springs banking office opened in 2006.



Capital Expenditures



Although the Company expects to make capital expenditures during 2007, such requests and resulting approvals are reviewed by management on an as
requested basis. As such, the Company does not have a current estimate of capital expenditures that it will make during 2007.



Lending Commitments



See Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsOff-Balance Sheet Arrangements and
Item 8. Financial Statements and Supplementary Data, Note 15 and Note 16 all contained herein for further discussion regarding the potential impact the Companys lending commitments could have on liquidity at December 31, 2006.



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Palmetto Bancshares



The holding company conducts its business through its banking subsidiary by offering commercial paper as an alternative
investment tool for its commercial customers (master note program). Commercial paper is only issued in conjunction with the automated sweep account customer agreement on deposit accounts at the Bank level. At December 31, 2006, the holding
company had $21.0 million in commercial paper compared with a balance of $17.9 million and $17.1 million at December 31, 2005 and 2004, respectively. The table set forth below summarizes the Companys weighted average borrowing costs with
respect to commercial paper for the periods indicated.



|                 |  |                               |   |  |                               |  |                              
|---------------- |  | ----------------------------- | - |  | ----------------------------- |  | -----------------------------
|                 |  | For the yearendedDecember 31, |   |  | For the yearendedDecember 31, |  | For the yearendedDecember 31,
|                 |  | 2006                          |   |  | 2005                          |  | 2004                         
|Commercial paper |  | 4.13                          | % |  | 2.33                          |  | 0.75                         



Potential sources of
the holding companys payment for periodic stock purchases and dividends include dividends from the Bank and funds received through stock option exercises.



Current federal law prohibits, except under certain circumstances and with prior regulatory approval, an insured depository institution, such as the
Bank, from paying dividends or making any other capital distribution if, after making the payment or distribution, the institution would be considered undercapitalized as that term is defined in applicable regulations. In addition, as a South
Carolina chartered bank, the Bank is subject to legal limitations on the amount of dividends it is permitted to pay. Such restrictions have not had and are not expected to have an impact on the ability of the holding company to meet its cash
obligations.



See Item 1. BusinessDividends,
Item 5. Market For Registrants Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities, and Item 8. Financial Statements and Supplementary Data, Note 18 and Note 19 all contained herein for further
discussion regarding common stock dividend payment determination and restrictions.



Other



During the
second quarter of 2006, as a result of a software upgrade, the Company experienced a temporary delay in check processing and electronic check processing. At December 31, 2006, the Bank had exposure, and reserved for in Other Noninterest Expense
in the Consolidated Statements of Income, of approximately $174 thousand related to items uncollected at that date. At the time of this filing, the Bank had collected virtually all of these items. As such, this reserve was reversed during the
first quarter of 2007.



Off-Balance Sheet Arrangements



In the normal course of business, the Company engages in a variety of financial transactions that, in accordance with generally accepted accounting principles, are not recorded in its financial statements or are recorded in amounts that
differ from the notional amounts. These transactions involve elements of credit, interest rate, and liquidity risk.



The Companys off-balance sheet arrangements principally include lending commitments, guarantees, and derivatives.



Lending Commitments



In the normal course of business, the Company makes contractual commitments
to extend credit that are legally binding agreements to lend money to customers at predetermined interest rates for a specific period of time.



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The Company also provides standby letters of credit. These lending commitments are provided to customers in the normal course of business, and the
Companys credit policies and standards are applied when making these commitments. These instruments are not recorded until funds are advanced under the commitments.



The following table summarizes the Companys contractual commitments to extend credit, by collateral type, at
December 31, 2006 (in thousands).



|                                                     |  |   |        
|---------------------------------------------------- |  | - | -------
|Commercial and industrial                            |  | $ | 32,377 
|                                                     | 
|Real estate1 - 4 family                             |  |   | 81,571 
|Real estateconstruction                             |  |   | 9,232  
|Real estateother                                    |  |   | 83,850 
|                                                     |  |   |        
|Total contractual commitments secured by real estate |  |   | 174,653
|                                                     | 
|Bankcards                                            |  |   | 39,756 
|Others                                               |  |   | 19,025 
|                                                     |  |   |        
|Total contractual commitments                        |  | $ | 265,811
|                                                     |  |   |        



See Item 8.
Financial Statements and Supplementary Data, Note 15 contained herein for further discussion regarding the Companys lending commitments.



Guarantees



Standby letters of credit represent an obligation of the Company to a third party contingent upon the failure of the Companys customer to perform
under the terms of an underlying contract with the third party or an obligation of the Company to guarantee or stand as surety for the benefit of the third party. Under the terms of a standby letter of credit, generally, drafts will be drawn only
when the underlying event fails to occur. The Company has legal recourse to its customers for amounts paid, and these obligations are secured or unsecured, depending on the customers creditworthiness. Commitments under standby letters of
credit are typically for one year or less. The Company applies the same credit standards used in the lending process when extending these The Company evaluates its obligation to perform as a guarantor and records reserves as deemed necessary. At
December 31, 2006, the Company recorded no reserve for its obligation to perform as a guarantor under standby letters of credit. The maximum potential amount of undiscounted future payments related to standby letters of credit at
December 31, 2006 was $8.3 million compared with $2.2 million at December 31, 2005. The increase in standby letters of credit during 2006 was related primarily to three letters of credit issued to support large development loans. Past
experience indicates that standby letters of credit will expire unused. However, through its various sources of liquidity, the Company believes that it has the necessary resources available to meet these obligations should the need arise.
Additionally, the Company does not believe that the current fair market value of such guarantees was material at December 31, 2006.



See Item 8. Financial Statements and Supplementary Data, Note 15 contained herein for further discussion regarding the Companys guarantees.



Other Off-Balance Sheet Arrangements



At December 31, 2006, the Company had no interest in nonconsolidated
special purpose entities nor was it involved in other off-balance sheet contractual relationships, unconsolidated related entities that have off-balance sheet arrangements, or transactions that could result in liquidity needs (other than those
discussed herein).



At December 31, 2006, of its
approximately $103 million available credit based on qualifying loans to serve as collateral against short-term or long-term borrowings from the FHLB, the Company employed $10.0 million in borrowings, all of which was determined to be long-term when
employed and employed $79.0 million in a



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letter of credit. FHLB letters of credit provide an attractive alternative to using traditional collateral for various transactions. Advantages of FHLB
letters of credit include enhancing member liquidity (substituting letter of credit for securities as collateralization of public unit deposits) and utilization of residential mortgage loans as collateral for the letters of credit. However, the
utilization of FHLB letters of credit reduces the Companys available credit based on qualifying loans to serve as collateral. The Company uses the FHLB letter of credit for collateralization of public deposits.



Derivatives and Hedging Activities



Derivative transactions may be used by the Company to manage its interest
rate sensitivity risks. The Company recognizes any derivatives as either assets or liabilities on the Consolidated Balance Sheets and reports these instruments at fair market value with realized and unrealized gains and losses included in either
earnings or in other comprehensive income, depending on the purpose for which the derivative is used and whether the derivative qualifies for hedge accounting in accordance with SFAS No. 133, Accounting for Derivative Instruments and
Hedging Activities.



Derivative instruments expose the
Company to credit and market risk. Credit risk, which is the risk that the counterparty to a derivative instrument will fail to perform, is equal to the fair market value gain in a derivative. Credit risk is created when the fair market value of a
derivative contract is positive, since this generally indicates that the counterparty owes the Company. When the fair market value of the derivative contract is negative, no credit risk exists since the Company would owe the counterparty. Credit
risk in derivative instruments can be minimized by entering into transactions with high quality counterparties as evaluated by management. Market risk is the adverse impact on the value of a financial instrument from a change in interest rates or
implied volatility of interest rates. By establishing and monitoring limits as to the types and degrees of risk that is undertaken, the Company can manage market risk associated with interest rate contracts.



At December 31, 2006, the Companys derivative instruments
consisted of forward sales commitments relating to the Companys commitments to originate certain residential loans held for sale.



The Company originates certain residential loans with the intention of selling these loans. Between the time that the Company enters into an interest rate
lock or a commitment to originate a fixed-rate residential loan with a potential borrower and the time the closed loan is sold, the Company is subject to variability in market prices. The Company believes that it is prudent to limit the variability
of expected proceeds from the sales through forward sales of loans.



Outstanding commitments on mortgage loans not yet closed (primarily single-family loan commitments) amounted to approximately $3.8 million at December 31, 2006. The fair market value of derivative assets related to commitments to
originate such residential loans held for sale and forward sales commitments was not significant at December 31, 2006.



Commitments to extend credit are agreements to lend to borrowers absent any violation of the conditions established by the commitment letter. Commitments
generally have fixed expiration dates or other termination clauses. The majority of commitments are funded within a 12-month period. The Company evaluates each customers creditworthiness on a case-by-case basis. The amount of collateral
obtained is based on managements credit evaluation of the borrower. Collateral held consists of residential properties.



See Item 8. Financial Statements and Supplementary Data, Note 1 contained herein for further discussion regarding the Companys significant
accounting policies with regard to the Companys derivative instruments and Item 8. Financial Statements and Supplementary Data, Note 16 contained herein for further discussion regarding the Companys derivative instruments.



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Earnings Review



Overview



The following information is intended to supplement any
information relating to the Consolidated Statements of Income contained within Item 8 of this Annual Report on Form 10-K.



PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Consolidated Statements of Income

(dollars in thousands, except common and per share data)



|                                                           |  |                                 |           |                |           |      |                 |  |        |   |  |       |  
|---------------------------------------------------------- |  | ------------------------------- | --------- | -------------- | --------- | ---- | --------------- |  | ------ | - |  | ----- | -
|                                                           |  | For the year ended December 31, |           | Dollarvariance |           |      | Percentvariance | 
|                                                           |  | 2006                            |           | 2005           |           | 2004 |                 | 
|Interest income                                            |  |                                 |           |                |           |      |                 |  |        |   |  |       |  
|Interest and fees on loans                                 |  | $                               | 70,339    |                | 57,380    |      | 46,228          |  | 12,959 |   |  | 22.6  | %
|Interest on investment securities available for sale       |  |                                 | 4,852     |                | 4,987     |      | 4,668           |  | (135   | ) |  | (2.7  | )
|Interest on federal funds sold                             |  |                                 | 1,071     |                | 251       |      | 57              |  | 820    |   |  | 326.7 |  
|Dividends on FHLB stock                                    |  |                                 | 184       |                | 165       |      | 76              |  | 19     |   |  | 11.5  |  
|                                                           |  |                                 |           |                |           |      |                 |  |        |   |  |       |  
|Total interest income                                      |  |                                 | 76,446    |                | 62,783    |      | 51,029          |  | 13,663 |   |  | 21.8  |  
|Interest expense                                           |  |                                 |           |                |           |      |                 |  |        |   |  |       |  
|Interest on deposits                                       |  |                                 | 24,980    |                | 14,392    |      | 10,189          |  | 10,588 |   |  | 73.6  |  
|Interest on retail repurchase agreements                   |  |                                 | 731       |                | 493       |      | 123             |  | 238    |   |  | 48.3  |  
|Interest on securities sold under agreements to repurchase |  |                                 |          |                |          |      | 32              |  |       |   |  |      |  
|Interest on commercial paper                               |  |                                 | 867       |                | 439       |      | 124             |  | 428    |   |  | 97.5  |  
|Interest on federal funds purchased                        |  |                                 | 44        |                | 111       |      | 70              |  | (67    | ) |  | (60.4 | )
|Interest on FHLB borrowingsshort-term                     |  |                                 | 99        |                | 960       |      | 103             |  | (861   | ) |  | (89.7 | )
|Interest on FHLB borrowingslong-term                      |  |                                 | 576       |                | 884       |      | 536             |  | (308   | ) |  | (34.8 | )
|                                                           |  |                                 |           |                |           |      |                 |  |        |   |  |       |  
|Total interest expense                                     |  |                                 | 27,297    |                | 17,279    |      | 11,177          |  | 10,018 |   |  | 58.0  |  
|                                                           |  |                                 |           |                |           |      |                 |  |        |   |  |       |  
|Net interest income                                        |  |                                 | 49,149    |                | 45,504    |      | 39,852          |  | 3,645  |   |  | 8.0   |  
|Provision for loan losses                                  |  |                                 | 1,625     |                | 2,400     |      | 2,150           |  | (775   | ) |  | (32.3 | )
|                                                           |  |                                 |           |                |           |      |                 |  |        |   |  |       |  
|Net interest income after provision for loan losses        |  |                                 | 47,524    |                | 43,104    |      | 37,702          |  | 4,420  |   |  | 10.3  |  
|                                                           |  |                                 |           |                |           |      |                 |  |        |   |  |       |  
|Noninterest income                                         |  |                                 |           |                |           |      |                 |  |        |   |  |       |  
|Service charges on deposit accounts                        |  |                                 | 8,086     |                | 8,045     |      | 8,348           |  | 41     |   |  | 0.5   |  
|Fees for trust and brokerage services                      |  |                                 | 3,231     |                | 2,856     |      | 2,979           |  | 375    |   |  | 13.1  |  
|Mortgage-banking income                                    |  |                                 | 1,168     |                | 1,271     |      | 776             |  | (103   | ) |  | (8.1  | )
|Investment securities gains                                |  |                                 | 34        |                | 82        |      | 90              |  | (48    | ) |  | (58.5 | )
|Other                                                      |  |                                 | 3,995     |                | 3,148     |      | 2,664           |  | 847    |   |  | 26.9  |  
|                                                           |  |                                 |           |                |           |      |                 |  |        |   |  |       |  
|Total noninterest income                                   |  |                                 | 16,514    |                | 15,402    |      | 14,857          |  | 1,112  |   |  | 7.2   |  
|Noninterest expense                                        |  |                                 |           |                |           |      |                 |  |        |   |  |       |  
|Salaries and other personnel                               |  |                                 | 23,591    |                | 21,890    |      | 19,666          |  | 1,701  |   |  | 7.8   |  
|Occupancy                                                  |  |                                 | 1,537     |                | 1,428     |      | 1,353           |  | 109    |   |  | 7.6   |  
|Furniture and equipment                                    |  |                                 | 1,873     |                | 1,630     |      | 1,496           |  | 243    |   |  | 14.9  |  
|Premises and equipment leases and rentals                  |  |                                 | 1,332     |                | 1,212     |      | 1,162           |  | 120    |   |  | 9.9   |  
|Premises and equipment depreciation                        |  |                                 | 2,033     |                | 2,003     |      | 1,871           |  | 30     |   |  | 1.5   |  
|Marketing                                                  |  |                                 | 1,436     |                | 1,118     |      | 1,085           |  | 318    |   |  | 28.4  |  
|Amortization of core deposit intangibles                   |  |                                 | 48        |                | 144       |      | 144             |  | (96    | ) |  | (66.7 | )
|Other                                                      |  |                                 | 8,985     |                | 8,359     |      | 8,102           |  | 626    |   |  | 7.5   |  
|                                                           |  |                                 |           |                |           |      |                 |  |        |   |  |       |  
|Total noninterest expense                                  |  |                                 | 40,835    |                | 37,784    |      | 34,879          |  | 3,051  |   |  | 8.1   |  
|                                                           |  |                                 |           |                |           |      |                 |  |        |   |  |       |  
|Net income before provision for income taxes               |  |                                 | 23,203    |                | 20,722    |      | 17,680          |  | 2,481  |   |  | 12.0  |  
|Provision for income taxes                                 |  |                                 | 7,962     |                | 6,942     |      | 5,569           |  | 1,020  |   |  | 14.7  |  
|                                                           |  |                                 |           |                |           |      |                 |  |        |   |  |       |  
|Net income                                                 |  | $                               | 15,241    |                | 13,780    |      | 12,111          |  | 1,461  |   |  | 10.6  | %
|                                                           |  |                                 |           |                |           |      |                 |  |        |   |  |       |  
|Common and per Share Data                                  |  |                                 |           |                |           |      |                 |  |        |   |  |       |  
|Net Incomebasic                                           |  | $                               | 2.40      |                | 2.18      |      | 1.93            |  | 0.22   |   |  | 10.1  | %
|Net Incomediluted                                         |  |                                 | 2.37      |                | 2.15      |      | 1.90            |  | 0.22   |   |  | 10.2  |  
|Cash dividends                                             |  |                                 | 0.73      |                | 0.66      |      | 0.58            |  | 0.07   |   |  | 10.6  |  
|Book value                                                 |  |                                 | 15.76     |                | 14.05     |      | 12.82           |  | 1.71   |   |  | 12.2  |  
|                                                           |  |                                 |           |                |          
|Weighted average common shares outstandingbasic           |  |                                 | 6,353,752 |                | 6,317,110 |      | 6,272,594       |  |        |   |  |       |  
|Weighted average common shares outstandingdiluted         |  |                                 | 6,421,742 |                | 6,417,358 |      | 6,378,787       |  |        |   |  |       |  



60



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Net interest margin for the year ended December 31, 2006 was 4.72% compared with 4.65% and 4.57% for
the years ended December 31, 2005 and 2004, respectively. Average interest-earning assets increased $64.6 million, or 6.6% during fiscal year 2006.



Earnings resulted in a return on average shareholders equity of 16.03%, 16.06% and 15.82% for the years ended December 31, 2006, 2005, and
2004, respectively. Return on average assets was 1.37%, 1.32%, and 1.30% for the same periods.



Net Interest Income



Net interest income is the difference between interest and fees on interest-earning assets, primarily loans and investment securities, and interest paid on interest-bearing deposits and other interest-bearing liabilities. This measure
represents the largest component of earnings for the Company. The net interest margin measures how effectively the Company manages the difference between the yield on interest-earning assets and the rate paid on funds to support those assets.
Balances of interest-earning assets and successful management of the net interest margin determine the level of net interest income. Changes in interest rates earned on interest-earning assets and interest rates paid on interest-bearing liabilities,
the rate of growth of the asset and liability base, the ratio of interest-earning assets to interest-bearing liabilities, and the management of interest rate sensitivity factor into changes in net interest income.



The following table summarizes the Companys average balance sheets and
net interest income analysis for the periods indicated (dollars in thousands). The Companys yield on interest-earning assets and cost of interest-bearing liabilities shown in the table are derived by dividing interest income and expense by the
average balances of interest-earning assets or interest-bearing liabilities. The following table does not include a tax-equivalent adjustment to net interest income adjusting the yield for interest-earning assets earning tax-exempt income to a
comparable yield on a taxable basis.



61



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|                                                         |  |                                  |           |   |                |   |            |      |      |                |  |   |                |   |            |   |        |                |      |   |                |   |            |   |  |   |        |  |      |  
|-------------------------------------------------------- |  | -------------------------------- | --------- | - | -------------- | - | ---------- | ---- | ---- | -------------- |  | - | -------------- | - | ---------- | - | ------ | -------------- | ---- | - | -------------- | - | ---------- | - |  | - | ------ |  | ---- | -
|                                                         |  | For the years ended December 31, |          
|                                                         |  | 2006                             |           |   | 2005           |   |            | 2004 |     
|                                                         |  | AverageBalance                   |           |   | Income/Expense |   | Yield/Rate |      |      | AverageBalance |  |   | Income/Expense |   | Yield/Rate |   |        | AverageBalance |      |   | Income/Expense |   | Yield/Rate |  
|ASSETS                                                   |  |                                  |           |   |                |   |            |      |      |                |  |   |                |   |            |   |        |                |      |   |                |   |            |   |  |   |        |  |      |  
|Interest-earnings assets                                 |  |                                  |           |   |                |   |            |      |      |                |  |   |                |   |            |   |        |                |      |   |                |   |            |   |  |   |        |  |      |  
|Loans, net of unearned (1)                               |  | $                                | 898,028   |   |                | $ | 70,339     |      | 7.83 | %              |  | $ | 833,353        |   |            | $ | 57,380 |                | 6.89 | % |                | $ | 730,430    |   |  | $ | 46,228 |  | 6.33 | %
|Investment securities available for sale, nontaxable (2) |  |                                  | 53,682    |   |                |   | 1,936      |      | 3.61 |                |  |   | 61,214         |   |            |   | 2,263  |                | 3.70 |   |                |   | 63,920     |   |  |   | 2,372  |  | 3.71 |  
|Investment securities available for sale, taxable (2)    |  |                                  | 66,713    |   |                |   | 2,916      |      | 4.37 |                |  |   | 71,495         |   |            |   | 2,724  |                | 3.81 |   |                |   | 70,934     |   |  |   | 2,296  |  | 3.24 |  
|Federal funds sold                                       |  |                                  | 20,935    |   |                |   | 1,071      |      | 5.12 |                |  |   | 7,218          |   |            |   | 251    |                | 3.48 |   |                |   | 4,791      |   |  |   | 57     |  | 1.19 |  
|FHLB stock                                               |  |                                  | 2,931     |   |                |   | 184        |      | 6.28 |                |  |   | 4,399          |   |            |   | 165    |                | 3.75 |   |                |   | 2,178      |   |  |   | 76     |  | 3.49 |  
|                                                         |  |                                  |           |   |                |   |            |      |      |                |  |   |                |   |            |   |        |                |      |   |                |   |            |   |  |   |        |  |      |  
|Total interest-earning assets                            |  |                                  | 1,042,289 |   |                |   | 76,446     |      | 7.33 |                |  |   | 977,679        |   |            |   | 62,783 |                | 6.42 |   |                |   | 872,253    |   |  |   | 51,029 |  | 5.85 |  
|                                                         |  |                                  |           |   |                |   |            |      |      |                |  |   |                |   |            |   |        |                |      |   |                |   |            |   |  |   |        |  |      |  
|Noninterest-earning assets                               |  |                                  |           |   |                |   |            |      |      |                |  |   |                |   |            |   |        |                |      |   |                |   |            |   |  |   |        |  |      |  
|Cash and due from banks                                  |  |                                  | 35,566    |   |                |   |            |      |      |                |  |   | 31,943         |   |            |   |        |                |      |   |                |   | 26,163     |   |  |   |        |  |      |  
|Allowance for loan losses                                |  |                                  | (8,681    | ) |                |   |            |      |      |                |  |   | (8,012         | ) |            |   |        |                |      |   |                |   | (7,830     | ) |  |   |        |  |      |  
|Premises and equipment, net                              |  |                                  | 23,767    |   |                |   |            |      |      |                |  |   | 22,498         |   |            |   |        |                |      |   |                |   | 22,190     |   |  |   |        |  |      |  
|Goodwill                                                 |  |                                  | 3,688     |   |                |   |            |      |      |                |  |   | 3,688          |   |            |   |        |                |      |   |                |   | 3,688      |   |  |   |        |  |      |  
|Other intangible assets                                  |  |                                  | 151       |   |                |   |            |      |      |                |  |   | 250            |   |            |   |        |                |      |   |                |   | 394        |   |  |   |        |  |      |  
|Accrued interest receivable                              |  |                                  | 5,434     |   |                |   |            |      |      |                |  |   | 4,543          |   |            |   |        |                |      |   |                |   | 3,920      |   |  |   |        |  |      |  
|Other                                                    |  |                                  | 12,339    |   |                |   |            |      |      |                |  |   | 11,308         |   |            |   |        |                |      |   |                |   | 11,894     |   |  |   |        |  |      |  
|                                                         |  |                                  |           |   |                |   |            |      |      |                |  |   |                |   |            |   |        |                |      |   |                |   |            |   |  |   |        |  |      |  
|Total noninterest-earning assets                         |  |                                  | 72,264    |   |                |   |            |      |      |                |  |   | 66,218         |   |            |   |        |                |      |   |                |   | 60,419     |   |  |   |        |  |      |  
|                                                         |  |                                  |           |   |                |   |            |      |      |                |  |   |                |   |            |   |        |                |      |   |                |   |            |   |  |   |        |  |      |  
|Total assets                                             |  | $                                | 1,114,553 |   |                |   |            |      |      |                |  | $ | 1,043,897      |   |            |   |        |                |      |   |                | $ | 932,672    |   |  |   |        |  |      |  
|                                                         |  |                                  |           |   |                |   |            |      |      |                |  |   |                |   |            |   |        |                |      |   |                |   |            |   |  |   |        |  |      |  
|LIABILITIES AND SHAREHOLDERS EQUITY                     |  |                                  |           |   |                |   |            |      |      |                |  |   |                |   |            |   |        |                |      |   |                |   |            |   |  |   |        |  |      |  
|Liabilities                                              |  |                                  |           |   |                |   |            |      |      |                |  |   |                |   |            |   |        |                |      |   |                |   |            |   |  |   |        |  |      |  
|Interest-bearing liabilities                             |  |                                  |           |   |                |   |            |      |      |                |  |   |                |   |            |   |        |                |      |   |                |   |            |   |  |   |        |  |      |  
|Transaction and money market deposit accounts            |  | $                                | 388,872   |   |                | $ | 9,403      |      | 2.42 | %              |  | $ | 309,871        |   |            | $ | 3,239  |                | 1.05 | % |                | $ | 264,505    |   |  | $ | 985    |  | 0.37 | %
|Savings deposit accounts                                 |  |                                  | 45,239    |   |                |   | 147        |      | 0.32 |                |  |   | 48,158         |   |            |   | 143    |                | 0.30 |   |                |   | 46,511     |   |  |   | 133    |  | 0.29 |  
|Time deposit accounts                                    |  |                                  | 387,939   |   |                |   | 15,430     |      | 3.98 |                |  |   | 367,918        |   |            |   | 11,010 |                | 2.99 |   |                |   | 354,095    |   |  |   | 9,071  |  | 2.56 |  
|                                                         |  |                                  |           |   |                |   |            |      |      |                |  |   |                |   |            |   |        |                |      |   |                |   |            |   |  |   |        |  |      |  
|Total interest-bearing deposits                          |  |                                  | 822,050   |   |                |   | 24,980     |      | 3.04 |                |  |   | 725,947        |   |            |   | 14,392 |                | 1.98 |   |                |   | 665,111    |   |  |   | 10,189 |  | 1.53 |  
|                                                         |  |                                  |           |   |                |   |            |      |     
|Retail repurchase agreements                             |  |                                  | 17,639    |   |                |   | 731        |      | 4.14 |                |  |   | 20,690         |   |            |   | 493    |                | 2.38 |   |                |   | 20,215     |   |  |   | 123    |  | 0.61 |  
|Securities sold under agreements to repurchase           |  |                                  |          |   |                |   |           |      |     |                |  |   |               |   |            |   |       |                |     |   |                |   | 2,508      |   |  |   | 32     |  | 1.28 |  
|Commercial paper (Master notes)                          |  |                                  | 21,009    |   |                |   | 867        |      | 4.13 |                |  |   | 18,833         |   |            |   | 439    |                | 2.33 |   |                |   | 16,447     |   |  |   | 124    |  | 0.75 |  
|Federal funds purchased                                  |  |                                  | 847       |   |                |   | 44         |      | 5.19 |                |  |   | 4,098          |   |            |   | 111    |                | 2.71 |   |                |   | 4,643      |   |  |   | 70     |  | 1.51 |  
|FHLB borrowingsshort-term                               |  |                                  | 2,140     |   |                |   | 99         |      | 4.63 |                |  |   | 26,745         |   |            |   | 960    |                | 3.59 |   |                |   | 4,990      |   |  |   | 103    |  | 2.06 |  
|FHLB borrowingslong-term                                |  |                                  | 15,841    |   |                |   | 576        |      | 3.64 |                |  |   | 26,145         |   |            |   | 884    |                | 3.38 |   |                |   | 16,475     |   |  |   | 536    |  | 3.25 |  
|                                                         |  |                                  |           |   |                |   |            |      |      |                |  |   |                |   |            |   |        |                |      |   |                |   |            |   |  |   |        |  |      |  
|Total interest-bearing liabilities                       |  |                                  | 879,526   |   |                |   | 27,297     |      | 3.10 |                |  |   | 822,458        |   |            |   | 17,279 |                | 2.10 |   |                |   | 730,389    |   |  |   | 11,177 |  | 1.53 |  
|                                                         |  |                                  |           |   |                |   |            |      |      |                |  |   |                |   |            |   |        |                |      |   |                |   |            |   |  |   |        |  |      |  
|Noninterest-bearing liabilities                          |  |                                  |           |   |                |   |            |      |      |                |  |   |                |   |            |   |        |                |      |   |                |   |            |   |  |   |        |  |      |  
|Noninterest-bearing deposits                             |  |                                  | 133,215   |   |                |   |            |      |      |                |  |   | 130,165        |   |            |   |        |                |      |   |                |   | 121,291    |   |  |   |        |  |      |  
|Accrued interest payable                                 |  |                                  | 2,248     |   |                |   |            |      |      |                |  |   | 1,441          |   |            |   |        |                |      |   |                |   | 1,057      |   |  |   |        |  |      |  
|Other                                                    |  |                                  | 4,487     |   |                |   |            |      |      |                |  |   | 4,043          |   |            |   |        |                |      |   |                |   | 3,369      |   |  |   |        |  |      |  
|                                                         |  |                                  |           |   |                |   |            |      |      |                |  |   |                |   |            |   |        |                |      |   |                |   |            |   |  |   |        |  |      |  
|Total noninterest-bearing liabilities                    |  |                                  | 139,950   |   |                |   |            |      |      |                |  |   | 135,649        |   |            |   |        |                |      |   |                |   | 125,717    |   |  |   |        |  |      |  
|                                                         |  |                                  |           |   |                |   |            |      |      |                |  |   |                |   |            |   |        |                |      |   |                |   |            |   |  |   |        |  |      |  
|Total liabilities                                        |  |                                  | 1,019,476 |   |                |   |            |      |      |                |  |   | 958,107        |   |            |   |        |                |      |   |                |   | 856,106    |   |  |   |        |  |      |  
|Shareholders equity                                     |  |                                  | 95,077    |   |                |   |            |      |      |                |  |   | 85,790         |   |            |   |        |                |      |   |                |   | 76,566     |   |  |   |        |  |      |  
|                                                         |  |                                  |           |   |                |   |            |      |      |                |  |   |                |   |            |   |        |                |      |   |                |   |            |   |  |   |        |  |      |  
|Total liabilities and shareholders equity               |  | $                                | 1,114,553 |   |                |   |            |      |      |                |  | $ | 1,043,897      |   |            |   |        |                |      |   |                | $ | 932,672    |   |  |   |        |  |      |  
|                                                         |  |                                  |           |   |                |   |            |      |      |                |  |   |                |   |            |   |        |                |      |   |                |   |            |   |  |   |        |  |      |  
|NET INTEREST INCOME / NET YIELD ON                       |  |                                  |           |   |                |   |            |      |      |                |  |   |                |   |            |   |        |                |      |   |                |   |            |   |  |   |        |  |      |  
|INTEREST-EARNING ASSETS                                  |  |                                  |           |   |                | $ | 49,149     |      | 4.72 | %              |  |   |                |   |            | $ | 45,504 |                | 4.65 | % |                |   |            |   |  | $ | 39,852 |  | 4.57 | %
|                                                         |  |                                  |           |   |                |   |            |      |      |                |  |   |                |   |            |   |        |                |      |   |                |   |            |   |  |   |        |  |      |  

---

|(1) |  | Calculated including mortgage loans held for sale. Nonaccrual loans are included in average balances for yield computations. The effect of foregone interest income as a result of
loans on nonaccrual was not considered in the above analysis. All loans and deposits are domestic.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) |  | The average balances for investment securities include the unrealized gain or loss recorded for available for sale securities.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------



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Net interest income for the year ended December 31, 2006 increased $3.6 million, or 8.0%, to $49.1
million from $45.5 million for the year ended December 31, 2005. During fiscal year 2006, the Company experienced increases in average yields on interest-earning assets consistent with the increase in the average cost of interest-bearing
liabilities. The average yield on interest-earning assets increased 91 basis points to 7.33% for the year ended December 31, 2006 from 6.42% for the year ended December 31, 2005. The average cost of interest-bearing liabilities increased
100 basis points to 3.10% for the year ended December 31, 2006 from 2.10% for the year ended December 31, 2005. Net interest income for the year ended December 31, 2004 was $39.9 million, and the net yield on interest-earning assets
was 5.85%. The net cost of interest-bearing liabilities was 1.53% for the year ended December 31, 2004. Average interest-earning assets increased $64.6 million in fiscal year 2006, primarily within the loan portfolio, while interest-bearing
liabilities increased $57.1 million. Rates earned and paid for the year ended December 31, 2006 increased from those for the year ended December 31, 2005 primarily due to the action of the Federal Reserve Open Market Committee. Since the
second quarter of 2004, the federal funds rate has increased from 1.0% to 5.25% in a series of seventeen moves.



The following rate / volume analysis summarizes the dollar amount of changes in interest income and interest expense attributable to changes in volume and
the amount attributable to changes in rate when comparing the year ended December 31, 2006 to the year ended December 31, 2005 (in thousands). The impact of the combination of rate and volume change has been divided equally between the
rate change and volume change.



|                                         |  |                                                                                  |        |   |      |       |   |       |        |  
|---------------------------------------- |  | -------------------------------------------------------------------------------- | ------ | - | ---- | ----- | - | ----- | ------ | -
|                                         |  | For the year endedDecember 31, 2006 comparedwith the year endedDecember 31, 2005 |       
|                                         |  | Volume                                                                           |        |   | Rate |       |   | Total |       
|Interest-earnings assets                 |  |                                                                                  |        |   |      |       |   |       |        |  
|Loans, net of unearned                   |  | $                                                                                | 4,674  |   |      | 8,285 |   |       | 12,959 |  
|Investment securities available for sale |  |                                                                                  | (616   | ) |      | 481   |   |       | (135   | )
|Federal funds sold                       |  |                                                                                  | 657    |   |      | 163   |   |       | 820    |  
|FHLB stock                               |  |                                                                                  | (19    | ) |      | 38    |   |       | 19     |  
|                                         |  |                                                                                  |        |   |      |       |   |       |        |  
|Total interest-earning assets            |  | $                                                                                | 4,696  |   |      | 8,967 |   |       | 13,663 |  
|Interest-bearing liabilities             |  |                                                                                  |        |   |      |       |   |       |        |  
|Interest-bearing deposits                |  | $                                                                                | 2,107  |   |      | 8,481 |   |       | 10,588 |  
|Retail repurchase agreements             |  |                                                                                  | (59    | ) |      | 297   |   |       | 238    |  
|Commercial paper                         |  |                                                                                  | 56     |   |      | 372   |   |       | 428    |  
|Federal funds purchased                  |  |                                                                                  | 427    |   |      | (494  | ) |       | (67    | )
|FHLB borrowingsshort-term               |  |                                                                                  | (1,255 | ) |      | 394   |   |       | (861   | )
|FHLB borrowingslong-term                |  |                                                                                  | (381   | ) |      | 73    |   |       | (308   | )
|                                         |  |                                                                                  |        |   |      |       |   |       |        |  
|Total interest-bearing liabilities       |  | $                                                                                | 895    |   |      | 9,123 |   |       | 10,018 |  
|                                         |  |                                                                                  |        |   |      |       |   |       |        |  
|NET INTEREST INCOME                      |  | $                                                                                | 3,801  |   |      | (156  | ) |       | 3,645  |  
|                                         |  |                                                                                  |        |   |      |       |   |       |        |  



Provision for Loan
Losses



The provision for loan losses is a charge to
earnings in a given period in order to maintain the Allowance at an adequate level defined by the Companys Allowance model. The provision for loan losses is adjusted each month to allow for loans charged-offs, recoveries, and other factors
that impact managements assessment of the adequacy of the Allowance.



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The following table summarizes the Companys provision for loan losses and experienced net loans
charged-offs for the periods indicated (dollars in thousands).



|                                           |  |              |       |   |      |       |      |      
|------------------------------------------ |  | ------------ | ----- | - | ---- | ----- | ---- | -----
|                                           |  | December 31,
|                                           |  | 2006         |       |   | 2005 |       | 2004
|Provision for loan losses                  |  | $            | 1,625 |   |      | 2,400 |      | 2,150
|Net loans charged-off                      |  |              | 1,529 |   |      | 1,588 |      | 1,994
|Net loans charged-off to average loans (1) |  |              | 0.17  | % |      | 0.19  |      | 0.27 

---

|(1) |  | Calculated using loans excluding mortgage loans held for sale, net of unearned, excluding the Allowance
|--- |  | -------------------------------------------------------------------------------------------------------



The provision for loan losses decreased in 2006 due primarily to lower incurred and expected losses within the loan
portfolio, particularly within the loans secured by real estate segment of the portfolio.



In evaluating the adequacy of the allowance for loan losses and determining the related provision for loan losses, if any, management may consider, though not intended to be an all-inclusive list, historical loss
experience and change in the size and mix of the overall portfolio composition, specific allocations based on probable losses identified during the review of the portfolio, delinquency trends in the portfolio and the composition of nonperforming
loans, including the percent of nonperforming loans with supplemental mortgage insurance or secured by real estate, and subjective factors, including local and general economic business factors and trends, industry and interest rate trends, new
lending products, changes in underwriting criteria, and portfolio concentrations.



The following table summarizes the Companys allowance for loan losses and selected percentages for the periods indicated (dollars in thousands).



|                                               |  |              |       |   |      |      
|---------------------------------------------- |  | ------------ | ----- | - | ---- | -----
|                                               |  | December 31,
|                                               |  | 2006         |       |   | 2005
|Allowance for loan losses                      |  | $            | 8,527 |   |      | 8,431
|Allowance as a percentage of loans (1)         |  |              | 0.90  | % |      | 0.97 
|Nonaccrual loans as a percentage of loans (1)  |  |              | 0.74  | % |      | 1.14 
|Allowance to nonaccrual loans                  |  |              | 1.2   | x |      | 0.9  
|Classified assets as a percentage of loans (1) |  |              | 1.80  | % |      | 2.47 
|Allowance to classified assets                 |  |              | 0.5   | x |      | 0.4  

---

|(1) |  | Calculated using loans excluding mortgage loans held for sale, net of unearned, excluding the Allowance
|--- |  | -------------------------------------------------------------------------------------------------------



See Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsAllowance
for Loan Losses contained herein for further discussion regarding net loans charged-off during the periods noted. See Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsLoans contained herein
for further discussion regarding the growth in the loan portfolio during fiscal year 2006. Also, see Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsFinancial ConditionLoans and
Allowance for Loan Losses and Item 8. Financial Statements and Supplementary Data, Note 1 and Note 4 all contained herein for further discussion regarding the Companys accounting policies related to, factors impacting, and methodology for
analyzing the adequacy of the Companys Allowance.



Noninterest Income



Noninterest income for the
year ended December 31, 2006 increased $1.1 million, or 7.2%, to $16.5 million from $15.4 million in the year ended December 31, 2005. Noninterest income for the year ended December 31, 2004 was $14.9 million.



64



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##### Table of Contents

The increase in noninterest income during the year ended December 31, 2006 over the year ended 2005
resulted primarily from decreases in mortgage-banking income, partially offset by increases in fees for trust and brokerage accounts and other noninterest income.



The Company sells most of its residential mortgage loans it originates in the secondary market with servicing rights
retained. At December 31, 2006, the mortgage-servicing rights portfolio for loans sold had an aggregate principal balance of $325.1 million compared with $304.2 million at December 31, 2005. Mortgage-banking income decreased $103 thousand,
or 8.1%, during the year ended December 31, 2006 over the year ended December 31, 2005. The following table summarizes the components of mortgage-banking income for the periods indicated (in thousands).



|                                                                  |  |              |       |   |      |       |   |      |      |  
|----------------------------------------------------------------- |  | ------------ | ----- | - | ---- | ----- | - | ---- | ---- | -
|                                                                  |  | December 31, |      
|                                                                  |  | 2006         |       |   | 2005 |       |   | 2004 |     
|Mortgage-servicing fees                                           |  | $            | 784   |   |      | 716   |   |      | 675  |  
|Gain on sale of loans                                             |  |              | 772   |   |      | 968   |   |      | 616  |  
|Mortgage-serciving right amortization, impairment, and recoveries |  |              | (604  | ) |      | (620  | ) |      | (700 | )
|Other mortgage-banking income                                     |  |              | 216   |   |      | 207   |   |      | 185  |  
|                                                                  |  |              |       |   |      |       |   |      |      |  
|Total mortgage-banking income                                     |  | $            | 1,168 |   |      | 1,271 |   |      | 776  |  
|                                                                  |  |              |       |   |      |       |   |      |      |  



The increase in
mortgage-servicing fees correlates to the increase in mortgage loans serviced for others.



During June 2005, the Company securitized and sold approximately $10 million of its residential mortgage loans from the Companys retained loan portfolio. The goal of this securitization was to provide enhanced
liquidity, to improve capital ratios, and to provide growth in revenues from mortgage-servicing activities. In addition, the Company sold approximately $4 million of residential mortgage loans during June 2005 from the loans receivable portfolio.
These transactions, as well as increases in mortgage loan sales in the normal course of business during 2005, contributed to increased gains on sale of loans. The Company engaged in no mortgage loan securitizations during 2006.



Amortization, impairment, and recoveries within the mortgage-servicing rights
portfolio continued to decline during 2006. Since the second quarter of 2004, the federal funds rate has increased from 1.0% to 5.25% in a series of seventeen moves. As interest rates have risen over this period, refinancing activity has slowed. As
such, the component of mortgage-servicing rights amortization, impairment, and recoveries relative to refinancing activity (prepayment speeds) slowed as well thereby positively impacting the amortization, impairment, and recoveries within the
Companys mortgage-servicing rights portfolio.



Management
anticipates that the volume of loan sales in 2007 will be relatively consistent with the level of sales during fiscal year 2006. The Company estimates the amortization of its mortgage-servicing rights portfolio recorded at December 31, 2006
will approximate $688 thousand during fiscal year 2007.



See
Item 8. Financial Statements and Supplementary Data, Note 1 contained herein for further discussion regarding the Companys significant accounting policies with regard to its general loan portfolio, mortgage-servicing rights portfolio, and
transfer of financial assets transactions and Note 6 also contained herein for a further discussion regarding the Companys mortgage-servicing rights portfolio.



Fees from trust and brokerage services include fees earned through the Banks subsidiary, Palmetto Capital and the
Banks trust department. At December 31, 2005, assets under Palmetto Capitals management totaled $151.2 million as compared with the assets under management at December 31, 2006 of $169.5 million. At December 31, 2005,
assets under the trust departments management totaled $281.2 million as compared with the assets under management at December 31, 2006 of $313.2 million. The increase in fees earned correlates to the level of assets under management.
Levels of assets under management are a function of the flow of money into and out of the fund, as well as the change in market valuation.



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Other noninterest income also increased during the year ended December 31, 2006 over the same period
of 2005. This increase resulted from fluctuations in several accounts that in the aggregate resulted in an increase of $847 thousand.



Noninterest income for the year ended December 31, 2005 increased $545 thousand, or 3.7%, to $15.4 million from $14.9 million in the year ended
December 31, 2004.



Noninterest income during the year
ended December 31, 2005 over the year ended 2004 resulted from decreases in service changes on deposit accounts and fees for trust and brokerage accounts, partially offset by increases in mortgage-banking income and other noninterest income.



Service charges on deposit accounts comprise a significant
component of noninterest income and comprised 52.2% of noninterest income during fiscal year 2005 compared with 56.2% of noninterest income during fiscal year 2004. Service charges on deposit accounts decreased $303 thousand, or 3.6% when comparing
the same periods. Management believes that the decline in service charges on deposit accounts is primarily related to nonsufficient funds and overdraft service charge declines due to an increase in alternative transaction methods such as debit
cards. This increased use of debit cards has decreased the Companys service charge opportunities, since the merchant typically declines transactions that would otherwise result in overdrafts. The Company periodically monitors competitive fee
schedules and examines alternative opportunities to ensure that the Company realizes the maximum contribution to earnings from this area.



At December 31, 2005, assets under Palmetto Capitals management totaled $151.2 million as compared with the assets under management at
December 31, 2004 of $145.4 million. At December 31, 2005, assets under the trust departments management totaled $281.2 million as compared with the assets under management at December 31, 2004 of $263.8 million. Although
managed assets increased over the periods noted, fees for trust and brokerage services declined slightly from fiscal year 2004 to fiscal year 2005 primarily as a result of declines in market value due to equity returns.



Other noninterest income also increased during the year ended
December 31, 2005 over the same period of 2004. This increase resulted from fluctuations in several accounts that in the aggregate resulted in an increase of $484 thousand. The increase in noninterest income was attributed primarily to an
increase in fees related to electronic payments.



Noninterest Expense



Noninterest expense for
the year ended December 31, 2006 increased $3.1 million, or 8.1%, to $40.8 million from $37.8 million in the year ended December 31, 2005. Noninterest expense for the year ended December 31, 2004 totaled $34.9 million. The primary
contributor to the increase from fiscal year 2005 to fiscal year 2006 was the increase in salaries and other personnel expense.



Comprising 57.8% of noninterest expense during fiscal year 2006 and 57.9% of noninterest expense during fiscal year 2005, salaries and other personnel
expense increased by $1.7 million to $23.6 million in fiscal year 2006 from $21.9 million in fiscal year 2005. The majority of the increase in salaries and other personnel expense resulted from annual merit raises for employees and officers and the
addition of new officer positions including those positions created in connection with the opening of the new Boiling Springs banking office during 2006. The Company also continued to experience increased medical insurance premiums during 2006
compared with 2005 due to the increasing number of employees as well as increased premiums. Medical insurance expense increased $322 thousand over these periods. Full time equivalent employees increased from 387 at December 31, 2005 to 400 at
December 31, 2006.



The increase in salaries and other
personnel expense during 2006 was also impacted by the Companys adoption of the fair value recognition provisions of SFAS No. 123(R) on January 1, 2006. During 2006, the Company recognized compensation cost of $163 thousand with
regard to all share-based payments vesting



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during 2006 that were granted prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the
original provisions of SFAS No. 123, and compensation cost for all share-based payments vesting during 2006 that were granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of
SFAS No. 123(R). See Item 8. Financial Statements and Supplementary Data, Note 1 and Note 13 all contained herein for further discussion regarding the Companys stock option plans.



Marketing and advertising expense increased $318 thousand during the year
ended December 31, 2006 compared with the year ended December 31, 2005 primarily as a result of costs associated with the Companys 100-year anniversary celebration as well as increased advertising with regard to the Banks
mortgage and deposit products.



Noninterest expense for the
year ended December 31, 2005 increased $2.9 million, or 8.3%, to $37.8 million from $34.9 million in the year ended December 31, 2004.



Salaries and other personnel expense increased by $2.2 million to $21.9 million in fiscal year 2005 from $19.7 million in fiscal year 2004. The majority
of the increase in salaries and other personnel expense resulted from annual merit raises for employees and officers as well as increases in expense associated with the Companys Officer Incentive Compensation Plan and the addition of new
officer positions including those positions created with regard to the opening of the new Easley banking office during the third quarter of 2005.



Several factors contributed to the increases in both furniture and equipment expense and furniture and equipment depreciation during fiscal year 2005 over
fiscal year 2004 totaling $266 thousand in the aggregate. One factor contributing to the increase was the move of the Banks East Blackstock Road banking office in Spartanburg, South Carolina to W.O. Ezell Boulevard in Spartanburg, South
Carolina during the fourth quarter of 2005. Also contributing to these increases was the completion of the building of the Easley banking office during 2005 resulting in increased expense, including, but not limited to, depreciation. Additionally,
in conjunction with the Emerging Issues Task Forces (EITF) issuance of EITF 05-06, Determining the Amortization Period for Leasehold Improvements during June 2005, the Company reevaluated its leasehold improvements to
ensure useful lives were limited to lease terms including renewals that are deemed to be reasonably assured. This evaluation resulted in additional depreciation expense with regard to leasehold improvements during fiscal year 2005. See Item 8.
Financial Statements and Supplementary Data, Note 5 contained herein for further discussion regarding depreciation of the Companys premises and equipment.



Other noninterest expense increased $257 thousand during fiscal year 2005 over fiscal year 2004. This increase was the result of changes in several
accounts, none of which constituted material fluctuations.



Provision for Income Taxes



Income tax expense
totaled $8.0 million for the year ended December 31, 2006, compared with $6.9 million for the year ended December 31, 2005, and $5.6 million for the year ended December 31, 2004. The Companys effective tax rate was 34.3% in
2006, 33.5% in 2005, and 31.5% in 2004. The Company anticipates the effective income tax rate to increase to between 34% and 36% for 2007.



See Item 8. Financial Statements and Supplementary Data, Note 12 contained herein for further discussion regarding the Companys income tax
expense.



Accounting and Reporting Matters



The following is a summary of recent authoritative pronouncements that could impact the accounting, reporting, and / or disclosure of financial information by the Company.



In February 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 155, Accounting for
Certain Hybrid Financial Instrumentsan amendment of FASB Statements No. 133 and 140. This



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Statement amends SFAS No. 133 and SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities. This Statement resolves issues addressed in SFAS No. 133 Implementation Issue No. D1, Application of Statement 133 to Beneficial Interests in Securitized Financial Assets. SFAS No. 155 permits fair value
re-measurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, clarifies which interest only-strips and principal-only strips are not subject to the requirements of SFAS
No. 133, establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation,
clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives, and amends SFAS No. 140 to eliminate the prohibition on a qualifying special purpose entity from holding a derivative financial instrument
that pertains to a beneficial interest other than another derivative financial instrument. SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of an entitys first fiscal year that begins after
September 15, 2006. The Company does not believe the adoption of SFAS No. 155 will have a material impact on its financial position, results of operations, and cash flows.



In March 2006, the FASB issued SFAS No. 156, Accounting for Servicing of Financial Assetsan amendment of
FASB Statement No. 140. This Statement amends SFAS No. 140 with respect to the accounting for separately recognized servicing assets and servicing liabilities. SFAS No. 156 requires an entity to recognize a servicing asset or
servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract; requires all separately recognized servicing assets and servicing liabilities to be initially measured at fair value, if
practicable; permits an entity to choose its subsequent measurement methods for each class of separately recognized servicing assets and servicing liabilities; at its initial adoption, permits a one-time reclassification of available-for-sale
securities to trading securities by entities with recognized servicing rights, without calling into question the treatment of other available-for-sale securities under SFAS No. 115, Accounting for Certain Investments in Debt and Equity
Securities provided that the available-for-sale securities are identified in some manner as offsetting the entitys exposure to changes in fair value of servicing assets or servicing liabilities that a servicer elects to subsequently
measure at fair value; and requires separate presentation of servicing assets and servicing liabilities subsequently measured at fair value in the statement of financial position and additional disclosures for all separately recognized servicing
assets and servicing liabilities. SFAS No. 156 is effective as of the beginning of its first fiscal year that begins after September 15, 2006. The Company does not believe the adoption of SFAS No. 156 will have a material impact on
its financial position, results of operations and cash flows.



In July 2006, the FASB issued FASB Interpretation No. 48 (FIN No. 48), Accounting for Uncertainty in Income Taxes. FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized in a
companys financial statements in accordance with SFAS No. 109, Accounting for Income Taxes. FIN No. 48 prescribes a recognition threshold and measurement attributable for the financial statement recognition and
measurement of a tax position taken or expected to be taken in a tax return. FIN No. 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosures and transitions. FIN No. 48
is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the impact that the adoption of FIN No. 48 will have on its financial position, results of operations, and cash flows.



In September 2006, the FASB issued SFAS No. 157, Fair Value
Measurements. SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This standard does not require any new
fair value measurements but rather eliminates inconsistencies found in various prior pronouncements. SFAS No. 157 is effective for the Company on January 1, 2008. The Company does not believe the adoption of SFAS No. 157 will have a
material impact on its financial position, results of operations and cash flows.



In September 2006, the FASB issued SFAS No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans, which amends SFAS No. 87 and SFAS No. 106 to require
recognition of the overfunded or underfunded status of pension and other postretirement benefit plans on the balance sheet. Under



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SFAS No. 158, gains and losses, prior service costs and credits, and any remaining transition amounts under SFAS No. 87 and SFAS No. 106 that
have not yet been recognized through net periodic benefit cost will be recognized in accumulated other comprehensive income, net of tax effects, until they are amortized as a component of net periodic cost. The measurement datethe date at
which the benefit obligation and plan assets are measuredis required to be the companys fiscal year end. The recognition and disclosure provisions of SFAS No. 158 differ for an employer that is an issuer of publicly traded equity
securities (as defined by the Standard) and an employer that is not. As the Company does not meet the definition of an issuer of publicly traded equity securities (as defined by the Standard) for purposes of this Standard, the Company is not
required to recognize the funded status of a defined benefit postretirement plan and to provide the required disclosures until the end of the fiscal year ending after June 15, 2007 with the exception of the provisions for the measurement date
which are effective for fiscal years ending after December 15, 2008. The Company is currently evaluating the impact that the adoption of SFAS No. 158 will have on its financial position, results of operations, and cash flows.



In September 2006, the SEC issued Staff Accounting Bulletin
(SAB) No. 108. SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a potential current year misstatement. Prior to SAB No. 108,
companies might evaluate the materiality of financial statement misstatements using either the income statement or balance sheet approach, with the income statement approach focusing on new misstatements added in the current year, and the balance
sheet approach focusing on the cumulative amount of misstatement present in a companys balance sheet. Misstatements that would be material under one approach could be viewed as immaterial under another approach and not be corrected. SAB
No. 108 now requires that companies view financial statement misstatements as material if they are material according to either the income statement or balance sheet approach. The Company does not believe that SAB No. 108 will have a
material impact on its financial position, results of operations and cash flows.



Other accounting standards have been issued or proposed by the FASB or other standards-setting bodies that are not applicable to the Companys business or are not expected to have a material impact on the
Companys financial position, results of operations and cash flows upon adoption.



|Item7A.Quantitative | and Qualitative Disclosures about Market Risk
|------------------- | ---------------------------------------------



See Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsDisclosures Regarding Market Risk
contained herein for discussion regarding the Companys quantitative and qualitative disclosure about market risk.



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|Item 8.Financial | Statements and Supplementary Data
|---------------- | ---------------------------------



MANAGEMENTS REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING



To provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements
for external purposes in accordance with generally accepted accounting principles, management is responsible for establishing and maintaining effective internal control management. In establishing such internal controls, management weighs the costs
of such systems against the benefits it believes such systems will provide. All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable
assurance with respect to financial statement preparation and presentation. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that
the degree of compliance with the policies or procedures may deteriorate.



Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting and for assessing the effectiveness of internal control over financial reporting, as such
term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Management has assessed the effectiveness of the Companys internal control over financial reporting based on the criteria established in Internal ControlIntegrated
Framework, issued by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. Based on that assessment and criteria, management has determined that the Company has maintained effective internal control over
financial reporting as of December 31, 2006.



Elliott
Davis, LLC, the independent registered public accounting firm that audited the Consolidated Financial Statements of the Company included in its Annual Report on Form 10-K for the year ended December 31, 2006, has issued an attestation report on
managements assessment of the effectiveness of the Companys internal control over financial reporting as of December 31, 2006. Their report, which expresses an unqualified opinion on managements assessment and on the
effectiveness of the Companys internal control over financial reporting as of December 31, 2006, is included in this Annual Report on Form 10-K. Elliott Davis, LLCs audit on managements assessment of the effectiveness of the
Companys internal control over financial reporting was performed in accordance with standards of the Public Company Accounting Oversight Board (United States).



|                                     |  |                                      
|------------------------------------ |  | -------------------------------------
|LOGO                                 |  | LOGO                                 
|L. Leon Patterson                    |  | Paul W. Stringer                     
|Chairman and Chief Executive Officer |  | President and Chief Operating Officer
|                                     |  | (Chief Accounting Officer)           



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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



The Board of Directors

Palmetto Bancshares, Inc. and Subsidiary

Laurens, South Carolina



We
have audited the accompanying consolidated balance sheets of Palmetto Bancshares, Inc. as of December 31, 2006 and 2005, and the related consolidated statements of income, shareholders equity and comprehensive income, and cash flows for
each of the years in the three-year period ended December 31, 2006. We also have audited managements assessment, included in the accompanying Managements Report on Internal Control Over Financial Reporting, that Palmetto Bancshares,
Inc. maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO). The Companys management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial
reporting. Our responsibility is to express an opinion on these consolidated financial statements, an opinion on managements assessment, and an opinion on the effectiveness of the Companys internal control over financial reporting based
on our audits.



We conducted our audits in accordance with the
standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material
misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an
understanding of internal control over financial reporting, evaluating managements assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary
in the circumstances. We believe that our audits provide a reasonable basis for our opinions.



A companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of consolidated financial
statements for external purposes in accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that,
in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of consolidated financial
statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide
reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the consolidated financial statements.



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



In our
opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Palmetto Bancshares, Inc. as of December 31, 2006 and 2005, and the results of their operations and their cash
flows for each of the years in the three-year period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion,



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managements assessment that Palmetto Bancshares, Inc. maintained effective internal control over financial reporting as of December 31, 2006, is
fairly stated, in all material respects, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Furthermore, in our opinion, Palmetto
Bancshares, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission (COSO).



LOGO



Greenville, South Carolina

March 7, 2007



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Consolidated Balance Sheets

(dollars in thousands, except common and per share data)



|                                                                                                                                                                 |  |                  |           |   |                  |           |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------- | --------- | - | ---------------- | --------- | -
|                                                                                                                                                                 |  | December 31,2006 |           |   | December 31,2005 |          
|ASSETS                                                                                                                                                           |  |                  |           |   |                  |           |  
|Cash and cash equivalents                                                                                                                                        |  |                  |           |   |                  |           |  
|Cash and due from banks                                                                                                                                          |  | $                | 43,084    |   |                  | 36,978    |  
|Federal funds sold                                                                                                                                               |  |                  | 3,582     |   |                  | 998       |  
|                                                                                                                                                                 |  |                  |           |   |                  |           |  
|Total cash and cash equivalents                                                                                                                                  |  |                  | 46,666    |   |                  | 37,976    |  
|                                                                                                                                                                 |  |                 
|Federal Home Loan Bank (FHLB) stock, at cost                                                                                                                   |  |                  | 2,599     |   |                  | 3,786     |  
|Investment securities available for sale, at fair market value                                                                                                   |  |                  | 116,567   |   |                  | 125,988   |  
|(amortized cost of $117,696 and $127,461 thousand, respectively)                                                                                                 |  |                  |           |   |                  |           |  
|Mortgage loans held for sale                                                                                                                                     |  |                  | 1,675     |   |                  | 4,821     |  
|                                                                                                                                                                 |  |                 
|Loans                                                                                                                                                            |  |                  | 945,913   |   |                  | 866,181   |  
|Less: allowance for loan losses                                                                                                                                  |  |                  | (8,527    | ) |                  | (8,431    | )
|                                                                                                                                                                 |  |                  |           |   |                  |           |  
|Loans, net                                                                                                                                                       |  |                  | 937,386   |   |                  | 857,750   |  
|                                                                                                                                                                 |  |                 
|Premises and equipment, net                                                                                                                                      |  |                  | 24,494    |   |                  | 22,676    |  
|Goodwill                                                                                                                                                         |  |                  | 3,691     |   |                  | 3,691     |  
|Other intangible assets                                                                                                                                          |  |                  | 127       |   |                  | 175       |  
|Accrued interest receivable                                                                                                                                      |  |                  | 6,421     |   |                  | 5,226     |  
|Other                                                                                                                                                            |  |                  | 13,510    |   |                  | 12,926    |  
|                                                                                                                                                                 |  |                  |           |   |                  |           |  
|Total assets                                                                                                                                                     |  | $                | 1,153,136 |   |                  | 1,075,015 |  
|                                                                                                                                                                 |  |                  |           |   |                  |           |  
|LIABILITIES AND SHAREHOLDERS EQUITY                                                                                                                             |  |                  |           |   |                  |           |  
|Liabilities                                                                                                                                                      |  |                  |           |   |                  |           |  
|Deposits                                                                                                                                                         |  |                  |           |   |                  |           |  
|Noninterest-bearing                                                                                                                                              |  | $                | 133,623   |   |                  | 131,157   |  
|Interest-bearing                                                                                                                                                 |  |                  | 859,958   |   |                  | 772,226   |  
|                                                                                                                                                                 |  |                  |           |   |                  |           |  
|Total deposits                                                                                                                                                   |  |                  | 993,581   |   |                  | 903,383   |  
|                                                                                                                                                                 |  |                 
|Retail repurchase agreements                                                                                                                                     |  |                  | 14,427    |   |                  | 16,728    |  
|Commercial paper (Master notes)                                                                                                                                  |  |                  | 20,988    |   |                  | 17,915    |  
|Federal funds purchased                                                                                                                                          |  |                  | 6,000     |   |                  | 1,000     |  
|FHLB borrowingsshort-term                                                                                                                                       |  |                  |          |   |                  | 16,900    |  
|FHLB borrowingslong-term                                                                                                                                        |  |                  | 10,000    |   |                  | 23,000    |  
|Accrued interest payable                                                                                                                                         |  |                  | 1,584     |   |                  | 1,275     |  
|Other                                                                                                                                                            |  |                  | 6,180     |   |                  | 5,873     |  
|                                                                                                                                                                 |  |                  |           |   |                  |           |  
|Total liabilities                                                                                                                                                |  |                  | 1,052,760 |   |                  | 986,074   |  
|                                                                                                                                                                 |  |                  |           |   |                  |           |  
|Commitments and contingencies (Note 15)                                                                                                                          |  |                  |           |   |                  |           |  
|                                                                                                                                                                 |  |                 
|Shareholders Equity                                                                                                                                             |  |                  |           |   |                  |           |  
|Common stockpar value $5.00 per share; authorized 10,000,000 shares; issued and outstanding 6,367,450 and 6,331,335 at December 31,
2006 and 2005, respectively |  |                  | 31,837    |   |                  | 31,656    |  
|Capital surplus                                                                                                                                                  |  |                  | 1,102     |   |                  | 659       |  
|Retained earnings                                                                                                                                                |  |                  | 68,132    |   |                  | 57,532    |  
|Accumulated other comprehensive loss, net of tax                                                                                                                 |  |                  | (695      | ) |                  | (906      | )
|                                                                                                                                                                 |  |                  |           |   |                  |           |  
|Total shareholders equity                                                                                                                                       |  |                  | 100,376   |   |                  | 88,941    |  
|                                                                                                                                                                 |  |                  |           |   |                  |           |  
|Total liabilities and shareholders equity                                                                                                                       |  | $                | 1,153,136 |   |                  | 1,075,015 |  
|                                                                                                                                                                 |  |                  |           |   |                  |           |  



See Notes to
Consolidated Financial Statements.



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Consolidated Statements of Income

(dollars in thousands, except common and per share data)



|                                                           |  |                                 |           |      |           |      |          
|---------------------------------------------------------- |  | ------------------------------- | --------- | ---- | --------- | ---- | ---------
|                                                           |  | For the year ended December 31,
|                                                           |  | 2006                            |           | 2005 |           | 2004
|Interest income                                            |  |                                 |           |      |           |      |          
|Interest and fees on loans                                 |  | $                               | 70,339    |      | 57,380    |      | 46,228   
|Interest on investment securities available for sale:      |  |                                 |           |      |           |      |          
|Government-sponsored enterprises (taxable)                 |  |                                 | 1,963     |      | 834       |      | 291      
|State and municipal (nontaxable)                           |  |                                 | 1,936     |      | 2,263     |      | 2,372    
|Mortgage-backed securities (taxable)                       |  |                                 | 953       |      | 1,890     |      | 2,005    
|Interest on federal funds sold                             |  |                                 | 1,071     |      | 251       |      | 57       
|Dividends on FHLB stock                                    |  |                                 | 184       |      | 165       |      | 76       
|                                                           |  |                                 |           |      |           |      |          
|Total interest income                                      |  |                                 | 76,446    |      | 62,783    |      | 51,029   
|Interest expense                                           |  |                                 |           |      |           |      |          
|Interest on deposits                                       |  |                                 | 24,980    |      | 14,392    |      | 10,189   
|Interest on retail repurchase agreements                   |  |                                 | 731       |      | 493       |      | 123      
|Interest on securities sold under agreements to repurchase |  |                                 |          |      |          |      | 32       
|Interest on commercial paper                               |  |                                 | 867       |      | 439       |      | 124      
|Interest on federal funds purchased                        |  |                                 | 44        |      | 111       |      | 70       
|Interest on FHLB borrowingsshort-term                     |  |                                 | 99        |      | 960       |      | 103      
|Interest on FHLB borrowingslong-term                      |  |                                 | 576       |      | 884       |      | 536      
|                                                           |  |                                 |           |      |           |      |          
|Total interest expense                                     |  |                                 | 27,297    |      | 17,279    |      | 11,177   
|                                                           |  |                                 |           |      |           |      |          
|Net interest income                                        |  |                                 | 49,149    |      | 45,504    |      | 39,852   
|Provision for loan losses                                  |  |                                 | 1,625     |      | 2,400     |      | 2,150    
|                                                           |  |                                 |           |      |           |      |          
|Net interest income after provision for loan losses        |  |                                 | 47,524    |      | 43,104    |      | 37,702   
|                                                           |  |                                 |           |      |           |      |          
|Noninterest income                                         |  |                                 |           |      |           |      |          
|Service charges on deposit accounts                        |  |                                 | 8,086     |      | 8,045     |      | 8,348    
|Fees for trust and brokerage services                      |  |                                 | 3,231     |      | 2,856     |      | 2,979    
|Mortgage-banking income                                    |  |                                 | 1,168     |      | 1,271     |      | 776      
|Investment securities gains                                |  |                                 | 34        |      | 82        |      | 90       
|Other                                                      |  |                                 | 3,995     |      | 3,148     |      | 2,664    
|                                                           |  |                                 |           |      |           |      |          
|Total noninterest income                                   |  |                                 | 16,514    |      | 15,402    |      | 14,857   
|                                                           |  |                                 |          
|Noninterest expense                                        |  |                                 |           |      |           |      |          
|Salaries and other personnel                               |  |                                 | 23,591    |      | 21,890    |      | 19,666   
|Occupancy                                                  |  |                                 | 1,537     |      | 1,428     |      | 1,353    
|Furniture and equipment                                    |  |                                 | 1,873     |      | 1,630     |      | 1,496    
|Premises and equipment leases and rentals                  |  |                                 | 1,332     |      | 1,212     |      | 1,162    
|Premises and equipment depreciation                        |  |                                 | 2,033     |      | 2,003     |      | 1,871    
|Marketing                                                  |  |                                 | 1,436     |      | 1,118     |      | 1,085    
|Amortization of core deposit intangibles                   |  |                                 | 48        |      | 144       |      | 144      
|Other                                                      |  |                                 | 8,985     |      | 8,359     |      | 8,102    
|                                                           |  |                                 |           |      |           |      |          
|Total noninterest expense                                  |  |                                 | 40,835    |      | 37,784    |      | 34,879   
|                                                           |  |                                 |           |      |           |      |          
|Net income before provision for income taxes               |  |                                 | 23,203    |      | 20,722    |      | 17,680   
|Provision for income taxes                                 |  |                                 | 7,962     |      | 6,942     |      | 5,569    
|                                                           |  |                                 |           |      |           |      |          
|Net income                                                 |  | $                               | 15,241    |      | 13,780    |      | 12,111   
|                                                           |  |                                 |           |      |           |      |          
|Common and Per Share Data                                  |  |                                 |           |      |           |      |          
|Net incomebasic                                           |  | $                               | 2.40      |      | 2.18      |      | 1.93     
|Net incomediluted                                         |  |                                 | 2.37      |      | 2.15      |      | 1.90     
|Cash dividends                                             |  |                                 | 0.73      |      | 0.66      |      | 0.58     
|Book value                                                 |  |                                 | 15.76     |      | 14.05     |      | 12.82    
|Weighted average common shares outstandingbasic           |  |                                 | 6,353,752 |      | 6,317,110 |      | 6,272,594
|Weighted average common shares outstandingdiluted         |  |                                 | 6,421,742 |      | 6,417,358 |      | 6,378,787



See Notes to
Consolidated Financial Statements.



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Consolidated Statements of Changes in Shareholders Equity and
Comprehensive Income

(dollars in thousands, except common and per share data)



|                                                                                   |  |                      |  |             |        |                |   |                  |  |   |                                                 |   |  |       |        |   |  |   |         |  
|---------------------------------------------------------------------------------- |  | -------------------- |  | ----------- | ------ | -------------- | - | ---------------- |  | - | ----------------------------------------------- | - |  | ----- | ------ | - |  | - | ------- | -
|                                                                                   |  | Shares ofcommonstock |  | Commonstock |        | Capitalsurplus |   | Retainedearnings |  |   | Accumulatedothercomprehensiveincome (loss), net |   |  | Total |       
|Balance at December 31, 2003                                                       |  | 6,263,210            |  | $           | 31,316 |                | $ | 250              |  | $ | 39,454                                          |   |  | $     | 969    |   |  | $ | 71,989  |  
|Net income                                                                         |  |                      |  |             |        |                |   |                  |  |   | 12,111                                          |   |  |       |        |   |  |   | 12,111  |  
|Other comprehensive income, net of tax:                                            |  |                      |  |             |        |                |   |                  |  |   |                                                 |   |  |       |        |   |  |   |         |  
|Unrealized holding losses arising during period, net of tax effect of $6           |  |                      |  |             |        |                |   |                  |  |   |                                                 |   |  |       | (9     | ) |  |   |         |  
|Less: reclassification adjustment included in net income, net of tax effect of $35 |  |                      |  |             |        |                |   |                  |  |   |                                                 |   |  |       | (55    | ) |  |   |         |  
|Net unrealized losses on securities                                                |  |                      |  |             |        |                |   |                  |  |   |                                                 |   |  |       |        |   |  |   | (64     | )
|                                                                                   |  |                      |  |             |        |                |   |                  |  |   |                                                 |   |  |       |        |   |  |   |         |  
|Comprehensive income                                                               |  |                      |  |             |        |                |   |                  |  |   |                                                 |   |  |       |        |   |  |   | 12,047  |  
|Cash dividend declared and paid ($0.58 per share)                                  |  |                      |  |             |        |                |   |                  |  |   | (3,642                                          | ) |  |       |        |   |  |   | (3,642  | )
|Stock option activity                                                              |  | 34,075               |  |             | 170    |                |   | 198              |  |   |                                                 |   |  |       |        |   |  |   | 368     |  
|                                                                                   |  |                      |  |             |        |                |   |                  |  |   |                                                 |   |  |       |        |   |  |   |         |  
|Balance at December 31, 2004                                                       |  | 6,297,285            |  | $           | 31,486 |                | $ | 448              |  | $ | 47,923                                          |   |  | $     | 905    |   |  | $ | 80,762  |  
|                                                                                   |  |                      |  |             |        |                |   |                  |  |   |                                                 |   |  |       |        |   |  |   |         |  
|Net income                                                                         |  |                      |  |             |        |                |   |                  |  |   | 13,780                                          |   |  |       |        |   |  |   | 13,780  |  
|Other comprehensive income, net of tax:                                            |  |                      |  |             |        |                |   |                  |  |   |                                                 |   |  |       |        |   |  |   |         |  
|Unrealized holding losses arising during period, net of tax effect of $1,102       |  |                      |  |             |        |                |   |                  |  |   |                                                 |   |  |       | (1,761 | ) |  |   |         |  
|Less: reclassification adjustment included in net income, net of tax effect of $32 |  |                      |  |             |        |                |   |                  |  |   |                                                 |   |  |       | (50    | ) |  |   |         |  
|Net unrealized losses on securities                                                |  |                      |  |             |        |                |   |                  |  |   |                                                 |   |  |       |        |   |  |   | (1,811  | )
|                                                                                   |  |                      |  |             |        |                |   |                  |  |   |                                                 |   |  |       |        |   |  |   |         |  
|Comprehensive income                                                               |  |                      |  |             |        |                |   |                  |  |   |                                                 |   |  |       |        |   |  |   | 11,969  |  
|Cash dividend declared and paid ($0.66 per share)                                  |  |                      |  |             |        |                |   |                  |  |   | (4,171                                          | ) |  |       |        |   |  |   | (4,171  | )
|Stock option activity                                                              |  | 34,050               |  |             | 170    |                |   | 211              |  |   |                                                 |   |  |       |        |   |  |   | 381     |  
|                                                                                   |  |                      |  |             |        |                |   |                  |  |   |                                                 |   |  |       |        |   |  |   |         |  
|Balance at December 31, 2005                                                       |  | 6,331,335            |  | $           | 31,656 |                | $ | 659              |  | $ | 57,532                                          |   |  | $     | (906   | ) |  | $ | 88,941  |  
|                                                                                   |  |                      |  |             |        |                |   |                  |  |   |                                                 |   |  |       |        |   |  |   |         |  
|Net income                                                                         |  |                      |  |             |        |                |   |                  |  |   | 15,241                                          |   |  |       |        |   |  |   | 15,241  |  
|Other comprehensive income, net of tax:                                            |  |                      |  |             |        |                |   |                  |  |   |                                                 |   |  |       |        |   |  |   |         |  
|Unrealized holding gains arising during period, net of tax effect of $145          |  |                      |  |             |        |                |   |                  |  |   |                                                 |   |  |       | 232    |   |  |   |         |  
|Plus: reclassification adjustment included in net income, net of tax effect of $13 |  |                      |  |             |        |                |   |                  |  |   |                                                 |   |  |       | (21    | ) |  |   |         |  
|Net unrealized gains on securities                                                 |  |                      |  |             |        |                |   |                  |  |   |                                                 |   |  |       |        |   |  |   | 211     |  
|                                                                                   |  |                      |  |             |        |                |   |                  |  |   |                                                 |   |  |       |        |   |  |   |         |  
|Comprehensive income                                                               |  |                      |  |             |        |                |   |                  |  |   |                                                 |   |  |       |        |   |  |   | 15,452  |  
|Cash dividend declared and paid ($0.73 per share)                                  |  |                      |  |             |        |                |   |                  |  |   | (4,641                                          | ) |  |       |        |   |  |   | (4,641  | )
|Compensation expense related to stock options                                      |  |                      |  |             |        |                |   | 163              |  |   |                                                 |   |  |       |        |   |  |   | 163     |  
|Exercise of stock options                                                          |  | 36,115               |  |             | 181    |                |   | 280              |  |   |                                                 |   |  |       |        |   |  |   | 461     |  
|                                                                                   |  |                      |  |             |        |                |   |                  |  |   |                                                 |   |  |       |        |   |  |   |         |  
|Balance at December 31, 2006                                                       |  | 6,367,450            |  | $           | 31,837 |                | $ | 1,102            |  | $ | 68,132                                          |   |  | $     | (695   | ) |  | $ | 100,376 |  
|                                                                                   |  |                      |  |             |        |                |   |                  |  |   |                                                 |   |  |       |        |   |  |   |         |  



See Notes to
Consolidated Financial Statements.



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Consolidated Statements of Cash Flows

(in thousands)



|                                                                                                   |  |                                 |         |   |      |          |   |      |          |  
|-------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------- | - | ---- | -------- | - | ---- | -------- | -
|                                                                                                   |  | For the year ended December 31, |        
|                                                                                                   |  | 2006                            |         |   | 2005 |          |   | 2004 |         
|Cash flows from operating activities                                                               |  |                                 |         |   |      |          |   |      |          |  
|Net income                                                                                         |  | $                               | 15,241  |   |      | 13,780   |   |      | 12,111   |  
|Adjustments to reconcile net income to net cash provided by operating activities                   |  |                                 |         |   |      |          |   |      |          |  
|Depreciation, amortization, and accretion, net                                                     |  |                                 | 2,118   |   |      | 2,621    |   |      | 3,128    |  
|Investment securities gains                                                                        |  |                                 | (34     | ) |      | (82      | ) |      | (90      | )
|Provision for loan losses                                                                          |  |                                 | 1,625   |   |      | 2,400    |   |      | 2,150    |  
|Origination of mortgage loans held for sale                                                        |  |                                 | (39,877 | ) |      | (52,441  | ) |      | (36,494  | )
|Proceeds from sale of mortgage loans held for sale                                                 |  |                                 | 43,795  |   |      | 54,417   |   |      | 37,655   |  
|Gain on sale of mortgage loans                                                                     |  |                                 | (772    | ) |      | (968     | ) |      | (616     | )
|Compensation expense related to stock options granted                                              |  |                                 | 163     |   |      |         |   |      |         |  
|Loss (gain) on sale of premises and equipment                                                      |  |                                 | 9       |   |      | 9        |   |      | (9       | )
|Loss on disposition of other real estate owned                                                     |  |                                 | 146     |   |      | 219      |   |      | 187      |  
|Impairment loss (recovery) from write down of mortgage-servicing rights                            |  |                                 | (31     | ) |      | (98      | ) |      | 12       |  
|Deferred income tax expense                                                                        |  |                                 | 768     |   |      | 758      |   |      | 394      |  
|Increase of other assets, net                                                                      |  |                                 | (3,051  | ) |      | (4,042   | ) |      | (837     | )
|(Decrease) increase of other liabilities, net                                                      |  |                                 | (284    | ) |      | 2,161    |   |      | 1,236    |  
|                                                                                                   |  |                                 |         |   |      |          |   |      |          |  
|Net cash provided by operating activities                                                          |  |                                 | 19,816  |   |      | 18,734   |   |      | 18,827   |  
|Cash flows from investing activities                                                               |  |                                 |         |   |      |          |   |      |          |  
|Purchase of investment securities available for sale                                               |  |                                 | (22,752 | ) |      | (81,048  | ) |      | (67,128  | )
|Maturities, redemption, calls, and principal repayment of investment securities available for sale |  |                                 | 19,440  |   |      | 20,959   |   |      | 31,811   |  
|Proceeds from sales of investment securities available for sale                                    |  |                                 | 13,073  |   |      | 88,367   |   |      | 19,297   |  
|Redemption (purchase) of FHLB stock, net                                                           |  |                                 | 1,187   |   |      | 80       |   |      | (1,998   | )
|Origination of loans, net                                                                          |  |                                 | (81,555 | ) |      | (109,538 | ) |      | (84,503  | )
|Proceeds on sale of other real estate owned                                                        |  |                                 | 1,451   |   |      | 1,283    |   |      | 2,001    |  
|Proceeds on sale of premises and equipment                                                         |  |                                 | 49      |   |      | 31       |   |      | 54       |  
|Purchases of premises and equipment                                                                |  |                                 | (3,909  | ) |      | (2,578   | ) |      | (2,333   | )
|                                                                                                   |  |                                 |         |   |      |          |   |      |          |  
|Net cash used in investing activities                                                              |  |                                 | (73,016 | ) |      | (82,444  | ) |      | (102,799 | )
|Cash flows from financing activities                                                               |  |                                 |         |   |      |          |   |      |          |  
|Deposits, net                                                                                      |  |                                 | 90,198  |   |      | 75,936   |   |      | 55,699   |  
|(Decrease) increase of retail repurchase agreements, net                                           |  |                                 | (2,301  | ) |      | 331      |   |      | 2,872    |  
|Increase in commercial paper, net                                                                  |  |                                 | 3,073   |   |      | 864      |   |      | 881      |  
|(Decrease) increase of federal funds purchased, net                                                |  |                                 | 5,000   |   |      | 1,000    |   |      | (18,000  | )
|(Decrease) increase of other short-term borrowings, net                                            |  |                                 | (16,900 | ) |      | 900      |   |      | 16,000   |  
|(Payment) issuance of long-term debt                                                               |  |                                 | (13,000 | ) |      | (7,000   | ) |      | 30,000   |  
|Other common stock activity                                                                        |  |                                 | 461     |   |      | 381      |   |      | 368      |  
|Cash dividends paid on common stock                                                                |  |                                 | (4,641  | ) |      | (4,171   | ) |      | (3,642   | )
|                                                                                                   |  |                                 |         |   |      |          |   |      |          |  
|Net cash provided by financing activities                                                          |  |                                 | 61,890  |   |      | 68,241   |   |      | 84,178   |  
|                                                                                                   |  |                                 |         |   |      |          |   |      |          |  
|Net increase of cash and cash equivalents                                                          |  |                                 | 8,690   |   |      | 4,531    |   |      | 206      |  
|Cash and cash equivalents, beginning of the period                                                 |  |                                 | 37,976  |   |      | 33,445   |   |      | 33,239   |  
|                                                                                                   |  |                                 |         |   |      |          |   |      |          |  
|Cash and cash equivalents, end of the period                                                       |  | $                               | 46,666  |   |      | 37,976   |   |      | 33,445   |  
|                                                                                                   |  |                                 |         |   |      |          |   |      |          |  
|Supplemental Cash Flow Data                                                                        |  |                                 |         |   |      |          |   |      |          |  
|Cash paid during the period for                                                                    |  |                                 |         |   |      |          |   |      |          |  
|Interest expense                                                                                   |  | $                               | 26,988  |   |      | 17,046   |   |      | 11,017   |  
|                                                                                                   |  |                                 |         |   |      |          |   |      |          |  
|Income taxes                                                                                       |  |                                 | 7,426   |   |      | 6,592    |   |      | 4,392    |  
|                                                                                                   |  |                                 |         |   |      |          |   |      |          |  
|Significant noncash investing and financing activities                                             |  |                                 |         |   |      |          |   |      |          |  
|(Decrease) increase of unrealized loss on investment securities available for sale                 |  | $                               | (343    | ) |      | 2,945    |   |      | 105      |  
|                                                                                                   |  |                                 |         |   |      |          |   |      |          |  
|Loans securitized into mortgage-backed securities                                                  |  |                                 |        |   |      | 13,952   |   |      |         |  
|                                                                                                   |  |                                 |         |   |      |          |   |      |          |  
|Loans transferred to other real estate owned, at fair market value                                 |  |                                 | 294     |   |      | 1,096    |   |      | 2,468    |  
|                                                                                                   |  |                                 |         |   |      |          |   |      |          |  





See Notes to Consolidated Financial Statements.



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements



1.Summary of Significant Accounting Policies



Principles of Consolidation



The accompanying Consolidated Financial Statements include the accounts of
Palmetto Bancshares, Inc. (the Company), which includes its wholly owned subsidiary, The Palmetto Bank (the Bank), and the Banks wholly owned subsidiary, Palmetto Capital, Inc. (Palmetto Capital). In
managements opinion, all significant intercompany accounts and transactions have been eliminated in consolidation, and all adjustments necessary for a fair presentation of the financial condition and results of operations for periods presented
have been included. Any such adjustments are of a normal and recurring nature. Assets held by the Company or its subsidiary in a fiduciary or agency capacity for customers are not included in the Companys Consolidated Financial Statements as
such items do not represent assets of the Company or its subsidiary.



Use of Estimates



The accounting and reporting
policies of the Company conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry. In preparing its Consolidated Financial Statements, the Companys management makes
estimates and assumptions that impact the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities as of the date of the Consolidated Financial Statements for the years presented. Actual results could differ
from these estimates and assumptions. As such, the results of operations for the year ended December 31, 2006 are not necessarily indicative of the results of operations that may be expected in future periods.



Reclassifications



Certain amounts previously presented in the Companys Consolidated
Financial Statements for prior periods have been reclassified to conform to current classifications. All such reclassifications had no impact on the prior years net income or retained earnings as previously reported.



During 2006, the Company made the following reclassifications that resulted
in prior period reclassifications within the Consolidated Balance Sheets and Consolidated Statements of Income.



| |  |  | Due to the nature of the account, the Company began classifying its interest bearing overnight investment account at the Federal Home Loan Bank as federal funds
sold. Prior to 2006, this account had been classified within the Cash and Due from Banks financial statement line item within the Consolidated Balance Sheets.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | In an effort to provide more transparent information to readers of financial statements, the Company began classifying
| | - |  | ----------------------------------------------------------------------------------------------------------------------



| |  |  | Certain accounts related to service charges on deposit account that were not previously included within the Service Charges on Deposit Accounts financial statement
line item in that financial statement line item within the Consolidated Statements of Income. Prior to 2006, these accounts had been classified within the Other Noninterest Income and Other Noninterest Expense financial statement line items within
the Consolidated Statements of Income.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Premises and Equipment Leases and Rentals and Premises and Equipment Depreciation as financial statement line items within the Consolidated Statements of Income.
Accounts within these financial statement line items were previously classified within the Occupancy and Furniture and Equipment financial statement line items within the Consolidated Statements of Income.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Amortization of Core Deposit Intangibles as a financial statement line item within the Consolidated Statements of Income. Accounts within these financial statement
line items were
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



77



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



| | previously classified within the Other Noninterest Expense financial statement line items within the Consolidated Statements of Income.
| | ---------------------------------------------------------------------------------------------------------------------------------------



| |  |  | During 2006, the Company determined that expenses of one account within the Marketing financial statement line item within the Consolidated Statements of Income
more often than not included expenses applicable to general branch operations instead of expenses for creating, communicating, and delivering value to customers and for managing customer relationships. As such, the Company began classifying this
account within the Other Noninterest Expense financial statement line item within the Consolidated Statements of Income.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Risks and Uncertainties



In the normal course of its business, the Company encounters two significant types of risk: economic and regulatory. There are three main components of
economic risk: interest rate, credit, and market risk. The Company is subject to interest rate risk to the degree that its interest-bearing liabilities mature or reprice at different speeds, or on different bases, than its interest-earning assets.
Credit risk is the risk of default on the Companys loan portfolio that results from borrowers inability or unwillingness to make contractually required payments. Market risk reflects changes in the value of collateral underlying loans,
the valuation of real estate held by the Company, and the valuation of it mortgage loans held for sale, investment securities available for sale, and mortgage-servicing rights portfolio.



The Company is subject to the regulations of various government agencies. These regulations can and do change significantly
from period to period. The Company is subject to periodic examinations by regulatory agencies that may subject it to further changes with respect to asset valuation, amount of required loss allowances, and operating restrictions resulting from the
regulators judgments based on information available to them at the time of their examinations.



Federal Home Loan Bank Stock



The FHLB System is under the jurisdiction of the Federal Housing Finance Board. The Bank, as a member of the Federal Home Loan Bank, is required to
acquire and hold shares of capital stock in that Federal Home Loan Bank. A members FHLB capital stock requirement is an amount equal to the sum of a membership requirement and an activity-based requirement as described in the FHLBs
Capital Plan.



Investment Securities Available for Sale



The Company accounts for its investment securities in
accordance with the Financial Accounting Standards Boards (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities. SFAS
No. 115 addresses accounting and reporting requirements for investments in equity securities that have readily determinable fair market values other than those accounted for under the equity method, those accounted for as investments in
consolidated subsidiaries, and all investments in debt securities. Under SFAS No. 115, investments are classified into three categories. Held to maturity investment securities include debt securities that the Company has the intent and ability
to hold until maturity and are reported at amortized cost. Trading investment securities include debt and equity securities that are bought and held for the purpose of sale in the near term and are reported at fair market value with unrealized gains
and losses included in earnings. Available for sale investment securities include debt and equity investment securities that, at the time of purchase, the Company determines may be sold at a future date or which the Company does not have the intent
or ability to hold to maturity. Available for sale investment securities are reported at fair market value with unrealized gains and losses excluded from earnings and reported as a separate



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Notes To Consolidated Financial Statements(Continued)



component of shareholders equity, net of income taxes. Unrealized losses on available for sale investment securities, reflecting a decline in value
determined to be other-than-temporary, are charged to expense. Realized gains or losses on available for sale investment securities are computed on a specific identification basis.



The Company periodically evaluates its investment securities portfolio for other-than-temporary impairment. If a security is
considered to be other-than-temporarily impaired, the related unrealized loss is charged to operations, and a new cost basis is established. Factors considered include the reasons for the impairment, the severity and duration of the impairment,
changes in value subsequent to period-end, and forecasted performance of the security issuer. Impairment is considered other-than-temporary unless the holder of the security has both the intent and ability to hold the security until the fair value
recovers and evidence supporting the recovery outweighs evidence to the contrary.



See Note 3 for further discussion regarding the Companys investment securities available for sale portfolio.



Loans and Mortgage Loans Held for Sale



Interest on loans is accrued and credited to income based on the principal amount and contract rate on the loan. The accrual of interest is discontinued
when, in the opinion of management, there is an indication that the borrower may be unable to meet future payments as they become due, generally when a loan becomes 90 days delinquent. The accrual of interest on some loans, however, may continue
even after the loan becomes 90 days delinquent in special circumstances deemed appropriate by management. When interest accrual is discontinued, all unpaid accrued interest is reversed. While a loan is in nonaccrual status, interest is recognized as
cash is received. Loans are returned to accrual status when the loan is brought current and ultimate collectibility of principal and interest is no longer in doubt.



While the Company originates adjustable-rate loans for its own portfolio, fixed-rate loans are generally made on terms that
will permit sale in the secondary market. The Company participates in secondary market activities by selling whole loans and participations in loans to the FHLB under its Mortgage Partnership Program, the Federal Home Loan Mortgage Corporation
(FHLMC), and other institutional investors. This practice enables the Company to satisfy the demand for these loans in its local communities, to meet asset and liability objectives of management, and to develop a source of fee income
through the servicing of loans.



Loans, excluding mortgage
loans held for sale, are carried at principal amounts outstanding net of unearned amounts. Mortgage loans originated with the intent of sale are reported at the lower of cost or estimated fair market value on an aggregate loan basis. Net unrealized
losses, if necessary, are provided for in a valuation allowance charged to operations. Gains or losses realized on the sale of mortgage loans are recognized at the time of sale and are determined by the difference between the net sale proceeds and
the carrying value of loans sold.



See Note 4 for further
discussion regarding the Companys loan portfolio.



Allowance for Loan Losses (the Allowance)



The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a
loan balance is confirmed. Subsequent recoveries, if any, are credited to the Allowance.



The Allowance is analyzed on a monthly basis by management using an internal analysis model and is based upon managements periodic review of the collectibility of loans in light of historical experience, the
nature and



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Notes To Consolidated Financial Statements(Continued)



volume of the loan portfolio, adverse situations that may impact the borrowers ability to repay, estimated value of any underlying collateral and
prevailing economic conditions. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available. On a quarterly basis, the Companys Allowance model and
conclusions are reviewed and approved by senior management.



The Allowance consists of specific, general, and unallocated components. The specific component related to loans that are classified as doubtful, substandard, or special mention. For such loans that are also classified as impaired, an
allowance is established when the discounted case flows of the impaired loan is lower that the carrying value of that loan. The general component covers nonclassified loans and is based on historical loss experience adjusted for qualitative factors.
An unallocated component is maintained to cover uncertainties that could impact managements estimate of probable losses. The unallocated component of the Allowance reflects the margin of imprecision inherent in the underlying assumptions used
in the methodologies for estimating specific and general losses in the portfolio.



Various regulatory agencies, as an integral part of their examination process, periodically review the Companys allowance for loan losses. Such agencies may require the Company to recognize additions to the
allowance based on their judgments about information available to them at the time of their examination. While the Company uses available information to recognize inherent losses on loans, future adjustments to the allowance for loan losses may be
necessary based on changes in economic conditions and other factors and the impact of such changes on the Banks borrowers.



The fair market value of mortgage loans held for sale is based on prices for outstanding commitments to sell such loans. Typically, the carrying amount
approximates fair market value due to the short-term nature of these instruments. As such, such instruments are not included in the assumptions related to the Companys Allowance model.



Impaired Loans



The Bank accounts for its impaired loans in accordance with SFAS
No. 114, Accounting by Creditors for Impairment of a Loan, as amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosuresan amendment of FASB Statement
No. 114, which requires that creditors value all specifically reviewed nonhomogenous loans, for which it is probable that the creditors will be unable to collect all amounts due according to the terms of the loan agreements, at their
respective fair market values. Fair market value may be determined based upon the present value of expected cash flows, market price of the loan, if available, or value of the underlying collateral. Expected cash flows are required to be discounted
at the loans effective interest rate. SFAS No. 114 was amended by SFAS No. 118 to allow a creditor to use existing methods for recognizing interest income on impaired loans and to require additional disclosures about the manner in
which a creditor recognizes interest income related to impaired loans.



The Company considers a loan to be impaired when, based upon current information and events, management believes it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan
agreement. The Companys impaired loans include loans identified as impaired through review of its nonhomogeneous portfolio and troubled debt restructurings. SFAS No. 114 specifically states that the pronouncement need not be applied to
large groups of smaller-balance homogeneous loans that are collectively evaluated for impairment. Thus, the Company determined that SFAS No. 114 does not apply to its installment, credit card, or residential mortgage loan portfolios, except
that it may choose to apply such provision to certain specific larger loans as determined by management. Specific allowances are established on impaired loans, if deemed necessary, for the difference between the loan amount and the fair market value
less estimated selling costs. Impaired loans may be left on accrual status during the period the Company is pursuing repayment of the loan. Impairment losses are recognized through a charge to the Allowance and a corresponding charge to



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Notes To Consolidated Financial Statements(Continued)



the provision for loan losses. Adjustments to impairment losses due to changes in the fair market value of the collateral properties for impaired loans are
also recognized through a charge to the Allowance and a corresponding charge to the provision for loan losses. When an impaired loan is sold, transferred to the Companys real estate portfolio, or written-down, any specific allowance is
removed, as it is no longer necessary to properly record the loan at its fair market value.



See Note 4 for further discussion regarding the Companys impaired loans.



Loan Fees and Costs



In accordance with SFAS No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct
Costs of Leasesan amendment of FASB Statements No. 13, 60, and 65 and a rescission of FASB Statement No. 17, nonrefundable fees and certain direct costs associated with the origination of loans are deferred and recognized as a
yield adjustment over the contractual life of the related loans, or if the related loan is held for resale, until such time that the loan is sold. Recognition of deferred fees and costs is discontinued on nonaccrual loans until they return to
accrual status or are charged-off.



Transfer of Financial
Assets



Transfers of financial assets are accounted for as
sales, when control over the assets has been surrendered. Control over the transferred assets is deemed to be surrendered when: (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions
that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their
maturity. The Company reviews all sales of loans by evaluating specific terms in the sales documents and believes that the criteria discussed above with regard to qualification for sales treatment has been met as loans have been transferred for cash
and the notes and mortgages for all loans in each sale are endorsed and assigned to the transferee. As stated in the commitment document, we have no recourse with these loans except in the case of fraud. The Company typically retains the mortgage
servicing rights related to sold loans which are evaluated and appropriately measured at date of sale.



From time to time, the Company packages and sells loan receivables as securities to investors. These transactions are recorded as sales in accordance with
SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilitiesa replacement of SFAS No. 125, when control over these assets has been surrendered. In conjunction with such
transactions, the Company does not retain any interest in the loan or securities other than the right to service such loans. During June 2005, the Company securitized and sold approximately $10 million of its residential mortgage loans. Any gains or
losses and mortgage-servicing rights recorded associated with this securitization transaction and the subsequent investment security sale were included in the Consolidated Balance Sheets and / or Consolidated Statement of Income for the year ended
December 31, 2005.



Premises and Equipment



Premises and equipment are reported net at cost less
accumulated depreciation. Maintenance and repairs of such assets are charged to expense as incurred. Improvements that extend the useful lives of the respective assets are capitalized. Accelerated depreciation is utilized on certain assets for
income tax purposes as allowed by taxing authorities.



See Note
5 for further discussion regarding the Companys premises and equipment.



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Notes To Consolidated Financial Statements(Continued)



Mortgage-Servicing Rights



The Company accounts for its mortgage-servicing rights (MSR) portfolio in accordance with SFAS No. 140
which requires the recognition of MSRs as assets by allocating total costs incurred between the originated loan and the MSR retained based on relative fair market value. SFAS No. 140 also requires the recognition of purchased MSRs at fair
market value, which is presumed to be the price paid for the rights. The Companys MSR portfolio is included in Other Assets on the Consolidated Balance Sheets.



The Company utilizes the expertise of a third party consultant on a quarterly basis to assess the portfolios value
including, but not limited to, capitalization, impairment, and amortization rates. The consultant utilizes estimates for the amount and timing of estimated prepayment rates, credit loss experience, costs to service loans, and discount rates to
determine an estimate of the fair market value of the Companys MSR portfolio. Management believes that the modeling techniques and assumptions used by the consultant are reasonable. Amortization of MSRs is based on the ratio of net servicing
income received in the current period to total net servicing income projected to be realized from the MSR portfolio. Projected net servicing income is in turn determined on the basis of the estimated future balance of the underlying mortgage loan
portfolio that declines over time from prepayments and scheduled loan amortization. Future prepayment rates are estimated based on current interest rate levels, other economic conditions, market forecasts, and relevant characteristics of the MSR,
such as loan types, interest rate stratification, and recent prepayment experience.



SFAS No. 140 requires that all MSR portfolios be evaluated for impairment based on the excess of the carrying amount over their fair market value. For purposes of measuring impairment, the MSR portfolio is
reviewed quarterly. Such valuations are based on projections using discounted cash flow methods that include assumptions regarding prepayments, interest rates, servicing costs, and other factors. Impairment is measured on a disaggregated basis for
each stratum of the MSR portfolio, which is segregated based on predominate risk characteristics, including interest rate and loan type. The Company has established an impairment valuation allowance to record estimated impairment within the MSR
portfolio. Subsequent increases in value are recognized only to the extent of the impairment valuation allowance.



See Note 6 for further discussion regarding the Companys mortgage-servicing rights portfolio.



Intangible Assets



Intangible assets, included in Other Assets on the Consolidated Balance
Sheets, include goodwill and other identifiable assets, such as customer lists, resulting from acquisitions. Goodwill, in this context, is the excess of the purchase price in an acquisition transaction over the fair market value of the net assets
acquired. Customer list intangibles are amortized on a hybrid double-declining, straight-line basis over such assets estimated useful life. In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, goodwill is not
amortized but is tested annually for impairment or at any time an event occurs, or circumstances change, that may trigger a decline in the value of the reporting unit. Such impairment testing calculations include estimates. Furthermore, the
determination of which intangible assets have finite lives is subjective as is the determination of the amortization period for such intangible assets. The Company tests for goodwill impairment by determining the fair market value for each reporting
unit and comparing the fair market value to the carrying amount of the applicable reporting unit. If the carrying amount exceeds fair market value, the potential for impairment exists, and a second step of impairment testing is performed. In the
second step, the fair market value of the reporting units goodwill is determined by allocating the reporting units fair market value to all of its assets (recognized and unrecognized) and liabilities as if the reporting unit had been
acquired in a business combination at the date of the impairment test. If the implied fair market value of reporting unit goodwill is less than its carrying amount, goodwill is impaired and is written-down to its fair market value. The loss
recognized is limited to the carrying



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Notes To Consolidated Financial Statements(Continued)



amount of goodwill. Once an impairment loss is recognized, future increases in fair market value will not result in the reversal of previously recognized
losses. The Company performs its annual impairment testing as of June 30 by applying the above process to its reportable operating segment of banking. The Companys impairment testing as of June 30, 2006, June 30, 2005, and
June 30, 2004 indicated that no impairment charge was required as of those dates.



See Note 7 for further discussion regarding the Companys intangible assets.



Real Estate Acquired in Settlement of Loans



Real estate acquired in settlement of loans is recorded in Other Assets on the Consolidated Balance Sheets at the lower of cost or fair market value minus
estimated selling costs. Fair market value of such real estate is reviewed regularly and writedowns are recorded when it is determined that the carrying value of the real estate exceeds the fair market value less estimated costs to sell. Write-downs
resulting from the periodic reevaluation of such properties, costs related to holding such properties, and gains and losses on the sale of foreclosed properties are charged to the Companys result of operations. Costs relating to the
development and improvement of such property are capitalized.



See Note 8 for further discussion regarding the Companys real estate acquired in settlement of loans.



Bank-Owned Life Insurance



The Company has purchased life insurance policies on certain key employees. Such policies are recorded in Other Assets on the Consolidated Balance Sheets
at their cash surrender value, or the amount that can be realized and any income from these policies and changes in the net cash surrender value are recorded in Other Noninterest Income on the Consolidated Statements of Income.



Federal Home Loan Bank Borrowings



FHLB borrowings are a source of funding which the Company utilizes depending
on the current level of deposits, the desirability of raising deposits through market promotions, the Companys unused FHLB borrowing capacity, and the availability of collateral to secure FHLB borrowings. The Company uses these borrowings to
fund increases in interest-earning assets in times of declines in alternative funding sources. Short-term borrowings typically represent overnight borrowings, and long-term borrowings typically have maturities greater than one year when made.
Interest rates on such borrowings vary in response to general economic conditions. FHLB borrowings are an alternative to other funding sources with similar maturities. The FHLB allows securities, qualifying loans, deposits, and stock of the FHLB
owned by the Company to be pledged to secure any advances from the FHLB.



See Note 10 for further discussion regarding the Companys borrowings from the FHLB.



Income Taxes



Under the asset and liability method of SFAS No. 109, Accounting for Income Taxes, deferred tax assets or liabilities are initially
recognized for differences between the financial statement carrying amount and the tax basis of assets and liabilities that will result in future deductible or taxable amounts. A valuation allowance is then established to reduce the deferred tax
asset to the level at which it is more likely than not that the tax benefits will be realized. Realization of tax benefits of future deductible temporary differences depends on having sufficient taxable income of an appropriate character within the
carryback and carryforward periods.



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



Sources of taxable income that may allow for the realization of tax benefits include taxable income in the current year or prior years that is available
through carryback, future taxable income that will result from the reversal of existing taxable temporary differences, and / or taxable income generated by future operations.



See Note 12 for further discussion regarding the Companys income taxes.



Postretirement Benefits



The Company has a noncontributory, defined benefit pension plan that covers
all full-time employees having at least twelve months continuous service and having attained age 21. The plan is designed to produce a designated retirement benefit, and benefits are fully vested after five years of service. No vesting occurs until
five years of service has been achieved. The Companys trust department administers the plans assets. Contributions to the plan are made as required by the Employee Retirement Income Security Act of 1974 (ERISA). The Company
accounts for this plan in accordance with SFAS No. 87, Employers Accounting for Pensions, and follows the disclosure requirements of SFAS No. 132 as revised which revises employers disclosures about pension plans
and other postretirement benefit plans. It does not change the measurement or recognition of those plans required by SFAS No. 87 and SFAS No. 106, Employers Accounting for Postretirement Benefits Other Than Pensions.



See Note 13 for further discussion regarding the
Companys postretirement benefits.



Stock Option Plans



Prior to January 1, 2006, the Company accounted for
its 1997 Stock Compensation Plan under the recognition and measurement provisions of APB No. 25, Accounting for Stock Issued to Employees, as permitted by SFAS No. 123, Accounting for Stock-Based Compensation and
SFAS No. 148, Accounting for Stock-Based CompensationTransition and Disclosure. As such, prior to 2006, no stock-based employee compensation expense was recognized in the Consolidated Statements of Income for options granted
as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS
No. 123(R), Share-Based Payment, using the modified prospective transition method. Under that transition method, compensation cost recognized in fiscal year 2006 includes compensation cost for all share-based payments vesting during
2006 that were granted prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the original provisions of SFAS No. 123, and compensation cost for all share-based payments vesting
during 2006 that were granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123(R). Results for prior periods were not been restated.



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Notes To Consolidated Financial Statements(Continued)



The following table summarizes the impact on net income and net income per share as if the fair value
recognition provisions of SFAS No. 123 had been applied to all outstanding and unvested awards for the periods indicated (in thousands, except common share data). For purposes of this pro forma disclosure, the value of the options is estimated
using the Black-Scholes option-pricing formula and amortized to expense over the options vesting periods (in thousands, except per share data).



|                                                                                                                                    |  |                                 |        |   |      |        |   |      |        |  
|----------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ---- | ------ | - | ---- | ------ | -
|                                                                                                                                    |  | For the years endedDecember 31, |       
|                                                                                                                                    |  | 2006                            |        |   | 2005 |        |   | 2004 |       
|Net income, as reported                                                                                                             |  | $                               | 15,241 |   |      | 13,780 |   |      | 12,111 |  
|Add: stock-based compensation expense included in reported net income, net of related tax effects                                   |  |                                 | 156    |   |      |       |   |      |       |  
|                                                                                                                                    |  |                                 |       
|Deduct: stock-based compensation expense determined under fair market value based method for all awards, net of related tax
effects |  |                                 | (156   | ) |      | (120   | ) |      | (124   | )
|                                                                                                                                    |  |                                 |        |   |      |        |   |      |        |  
|Pro forma net income including stock-based compensation expense based on fair market value method                                   |  | $                               | 15,241 |   |      | 13,660 |   |      | 11,987 |  
|                                                                                                                                    |  |                                 |        |   |      |        |   |      |        |  
|Per Share Data                                                                                                                      |  |                                 |        |   |      |        |   |      |        |  
|Net incomebasic, as reported                                                                                                       |  | $                               | 2.40   |   |      | 2.18   |   |      | 1.93   |  
|Net incomebasic, pro forma                                                                                                         |  |                                 | 2.40   |   |      | 2.16   |   |      | 1.91   |  
|                                                                                                                                    |  |                                 |       
|Net incomediluted, as reported                                                                                                     |  | $                               | 2.37   |   |      | 2.15   |   |      | 1.90   |  
|Net incomediluted, pro forma                                                                                                       |  |                                 | 2.37   |   |      | 2.13   |   |      | 1.88   |  



See Note 13 for
further discussion regarding the Companys stock option plans.



Net Income per Common Share



Basic earnings
per common share exclude dilution and are computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted earnings per common share reflect the potential dilution that
could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock.



See Note 14 for further discussion regarding the Companys net income per common share computations.



Derivative Financial Instruments and Hedging Activities



The Company may use derivatives as part of our interest rate management
activities. In accordance with Staff Accounting Bulleting (SAB) No. 105, Application of Accounting Principles to Loan Commitments, the Company recognizes the servicing value when a loan is sold. SFAS No. 133,
Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS Nos. 137, 138 and 149, establishes accounting and reporting standards for derivatives and hedging activities. The Company recognizes any derivatives as
either assets or liabilities on the Consolidated Balance Sheets and reports these instruments at fair market value with realized and unrealized gains and losses included in either earnings or in other comprehensive income, depending on the purpose
for which the derivative is used and whether the derivative qualifies for hedge accounting in accordance with SFAS No. 133.



Derivative instruments expose the Company to credit and market risk. Credit risk, which is the risk that the counterparty to a derivative instrument will
fail to perform, is equal to the fair market value gain in a derivative. Credit risk is created when the fair market value of a derivative contract is positive, since this generally indicates



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Notes To Consolidated Financial Statements(Continued)



that the counterparty owes the Company. When the fair market value of the derivative contract is negative, no credit risk exists since the Company would owe
the counterparty. Credit risk in derivative instruments can be minimized by entering into transactions with high quality counterparties as evaluated by management. Market risk is the adverse impact on the value of a financial instrument from a
change in interest rates or implied volatility of interest rates. By establishing and monitoring limits as to the types and degrees of risk that are undertaken, the Company can manage market risk associated with interest rate contracts.



The Company does not currently engage in any activities that qualify for
hedge accounting under SFAS No. 133.



See Note 16 for
further discussion regarding the Companys derivative financial instruments.



Fair Market Value of Financial Instruments



SFAS No. 107, Disclosures about Fair Value of Financial Instruments, requires disclosure of fair market value information about financial instruments, whether or not recognized in the Companys
Consolidated Balance Sheets, when it is practicable to estimate fair market value. Disclosures include estimated fair market values for financial instruments for which it is practicable to estimate fair market value. These estimates are made at a
specific point in time based on relevant market data and information about the financial instruments. These estimates do not reflect any premium or discount that could result from offering the Companys entire holdings of a particular financial
instrument for sale at one time, nor do they attempt to estimate the value of anticipated future business related to the instruments. SFAS No. 107 defines a financial instrument as cash, evidence of an ownership interest in an entity or
contractual obligations, which require the exchange of cash, or other financial instruments. Certain items are specifically excluded from the disclosure requirements, including the Companys common stock, premises and equipment, accrued
interest receivable and payable, and other assets and liabilities. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.



The following information is intended to summarize the methods and assumptions used by the Company in estimating the fair
market value of certain financial instruments.



Fair value
approximates book value for the following financial instruments due to the short-term nature of the instrument: cash and due from banks, including interest-bearing bank balances and federal funds sold, federal funds purchased, short-term repurchase
agreements, and other short-term borrowings. Additionally, loan commitments and letters of credit, which are off-balance-sheet financial instruments, are short-term and typically based on current market rates. As such, fair value approximates book
value for these instruments.



No ready market exists for FHLB
stock, and it has no quoted market value. However, redemption of this stock has historically been at par value. Therefore, the carrying amount approximates fair market value.



Fair market values of investment securities available for sale are based on quoted market prices, where available. If quoted
market prices are not available, fair market values are estimated using quoted market prices for similar securities and indications of value provided by brokers.



The fair market value of mortgage loans held for sale is based on prices for outstanding commitments to sell these loans.
Typically, the carrying amount approximates fair market value due to the short-term nature of these instruments.



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Notes To Consolidated Financial Statements(Continued)



Fair value for loans is based on the discounted present value of the estimated future cash flows.
Discount rates used in these computations approximate the rates currently offered for similar loans of comparable terms and credit quality. The remaining loan types are at adjustable-rates, which reprice frequently with no significant change in
credit risk, and, therefore, fair market values are based on carrying values. No value has been placed on underlying credit card relationship rights.



Fair value for demand deposit accounts and interest-bearing accounts with no fixed maturity date is equal to the carrying value. Certificate of deposit
accounts are estimated by discounting cash flows from expected maturities using current interest rates on similar instruments. Under SFAS No. 107, the fair market value estimates for deposits do not include the benefit that results from the low
cost funding provided by the deposit liabilities as compared with the cost of alternative forms of funding. No value has been estimated for the Companys long-term relationships with customers (commonly known as the core deposit intangible)
since such intangible assets are not a financial instrument pursuant to the definitions contained in SFAS No. 107.



Fair value for long-term debt is based on discounted cash flows using current market rates for similar instruments.



The fair market values of long-term FHLB advances are estimated by
discounting scheduled cash flows through the estimated maturity using estimated market discount rates through the use of key rate projections as well as global spreads. Maturity projections are based on contractual terms.



Commitments to extend credit are primarily for adjustable-rate loans. For
these commitments, there are no differences between the committed amounts and their fair market values. Commitments to fund fixed-rate loans and letters of credit are at rates that approximate fair value at each reporting date.



Comprehensive Income



The Company reports comprehensive income in accordance with SFAS
No. 130, Reporting Comprehensive Income, which establishes standards for the reporting and presentation of comprehensive income and its components in financial statements. In accordance with SFAS No. 130, the Company has
elected to disclose changes in comprehensive income in its Consolidated Statements of Changes in Shareholders Equity and Comprehensive Income.



The Companys other comprehensive income (loss) for the years ended December 31, 2006, 2005 and 2004 and accumulated other comprehensive income
(loss) as of December 31, 2006, 2005 and 2004 were comprised solely of unrealized gains and losses on investment securities available for sale.



Business Segments



The Company adheres to the provisions of the Statement of Financial Accounting Standards (SFAS) No. 131, Disclosures About Segments
of an Enterprise and Related Information. Operating segments are components of an enterprise about which separate financial information is available that are evaluated regularly by the chief operating decision maker in deciding how to allocate
resources and assess performance. SFAS No. 131 requires that a public enterprise report a measure of segment profit or loss, certain specific revenue and expense items, segment assets, and information about the way that the operating segments
were determined, among other items.



The Company considers
business segments by analyzing distinguishable components that are engaged in providing individual products, services or a groups of related products or services and that are subject to risks and returns that are different from those of other
business segments. To this end, when determining whether products and services are related, the Company considers the nature of the products or services, the nature of the



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Notes To Consolidated Financial Statements(Continued)



production processes, the type or class of customer for the products or services, and the methods used to distribute the products or provide the services.



Within the general loan portfolio, the Bank offers
mortgage-banking services and indirect lending products. These services have similar production processes and are targeted to similar customers using similar distribution channels as those employed for the entire Bank loan portfolio. Additionally,
decisions are not made by chief decision makers based on the results of these services alone. Instead, decisions with regard to mortgage-banking services indirect lending products are typically made in conjunction with decisions made with regard to
the entire loan portfolio. As such, the Company has concluded that these products are not considered to represent an operating segment separate from the banking segment.



Additionally, the Bank offers trust and investment services to its customers through similar distribution channels utilized
by the Bank. Such services are not routinely evaluated separately from the Bank. Additionally at December 31, 2006, fees for such services represented 3% of the Companys total revenues. As such, are not considered to represent an
operating segment separate from the banking segment.



Management also uses its judgment in determining the composition of its business segments based on factors such as risk and returns, internal organization and management structure, and the Companys process of internal reporting to
chief decision makers.



At December 31, 2006, the Company
determined it had one reportable operating segment, banking. As such, separate segment information is not presented herein as management believes that the Consolidated Financial Statements contained herein within Item 8 report the information
required by SFAS No. 131 with regard to the Companys banking segment



Impairment of Long-Lived Assets



The Company periodically reviews the carrying value of its long-lived assets including, but not limited to, premises, equipment, and core deposit intangibles, for impairment when events or circumstances indicate that the carrying amount of
such assets may not be fully recoverable. For long-lived assets to be held and used, impairments are recognized when the carrying amount of a long-lived asset is not recoverable and exceed its fair market value. The carrying amount of a long-lived
asset is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset. An impairment loss is measured as the amount by which the carrying amount of a long-lived asset
exceeds its fair market value. The Company determined that no such impairment loss was necessary for the years ended December 31, 2006 and December 31, 2005.



Long-lived assets to be disposed of by abandonment or in an exchange for a similar productive long-lived asset are
classified as held for sale and used until disposed. The Company had no such assets at December 31, 2006 or December 31, 2005.



Long-lived assets to be sold are classified as held for sale and are no longer depreciated. Certain criteria must be met in order for the long-lived asset
to be classified as held for sale including that a sale is probable and expected to occur within a one year period. Long-lived assets classified as held for sale are recorded at the lower of carrying amount or fair market value less the estimated
costs to sell. The Company had no such assets at December 31, 2006 or December 31, 2005.



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



Recently Adopted Accounting Pronouncements



In December 2004, the FASB issued SFAS No. 123(R). SFAS No. 123(R)
is a revision of SFAS No. 123, Accounting for Stock-Based Compensation. This Statement supersedes APB Opinion No. 25, and its related implementation guidance. SFAS No. 123(R) establishes standards for the accounting for
transactions in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods and services that are based on the fair value of the entitys
equity instruments or that may be settled by the issuance of those equity instruments. This Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based transactions.
SFAS No. 123(R) does not change the accounting guidance for share-based payment transactions with parties other than employees provided in SFAS No. 123 as originally issued and FASBs Emerging Issues Task Force (EITF)
Issue No. 96-18, Accounting for Equity Instruments That are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. Additionally, this statement does not address the accounting for employee
share ownership plans, which are subject to AICPA Statement of Position (SOP) 93-6, Employers Accounting for Employee Stock Ownership Plans.



The Company adopted SFAS 123(R) effective January 1, 2006. The adoption of this Statement did not have a material
impact on the Companys financial position, results of operations, and cash flows. See Note 13 for further discussion regarding the Companys current method of accounting for stock-based compensation and its previous method of accounting
for stock-based compensation.



Other accounting standards have
been issued or proposed by the FASB or other standards-setting bodies that are not applicable to the Companys business or are not expected to have a material impact on the Companys financial condition or the results of operations upon
adoption.



2.Cash and Cash
Equivalents



The following table summarizes the
composition of cash and cash equivalents at the dates indicated (in thousands).



|                                                   |  |              |        |      |       
|-------------------------------------------------- |  | ------------ | ------ | ---- | ------
|                                                   |  | December 31,
|                                                   |  | 2006         |        | 2005
|Cash working funds                                 |  | $            | 9,190  |      | 8,377 
|Noninterest-earning demand deposits in other banks |  |              | 23,511 |      | 18,911
|In-transit funds                                   |  |              | 10,383 |      | 9,690 
|Interest-earning federal funds sold                |  |              | 3,582  |      | 998   
|                                                   |  |              |        |      |       
|Total cash and cash equivalents                    |  | $            | 46,666 |      | 37,976
|                                                   |  |              |        |      |       



Liability management
continues to be critical to enhancing the Companys profitability. The balance in costs between asset-based and liability-based liquidity and which funding alternatives are most effective are factors the Company considers with regard to its
liquidity and funds management.



The average outstanding
federal funds sold for fiscal years 2006 and 2005 were $20.9 million and $7.2 million, respectively. The maximum amount of federal funds sold at any month-end during fiscal years 2006 and 2005 were $45.5 million and $14.4 million, respectively.



The Company is required to maintain average reserve balances
computed by applying prescribed percentages to its various types of deposits. At December 31, 2006, the Federal Reserve required that the Company maintain $9.5 million in reserve balances. These required reserves were met through vault cash and
deposits at the Federal Reserve and correspondent banks.



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



3.Investment Securities Available for Sale



The following tables summarize the amortized cost, gross unrealized gains,
gross unrealized losses, and fair market values of investment securities available for sale at the dates indicated (in thousands).



|                                               |  |                   |         |                      |     |                       |        |   |                  |        
|---------------------------------------------- |  | ----------------- | ------- | -------------------- | --- | --------------------- | ------ | - | ---------------- | -------
|                                               |  | December 31, 2006
|                                               |  | Amortizedcost     |         | Grossunrealizedgains |     | Grossunrealizedlosses |        |   | Fair marketvalue
|Government-sponsored enterprises               |  | $                 | 42,554  |                      |    |                       | (171   | ) |                  | 42,383 
|State and municipal                            |  |                   | 48,780  |                      | 56  |                       | (822   | ) |                  | 48,014 
|Mortgage-backed                                |  |                   | 26,362  |                      | 72  |                       | (264   | ) |                  | 26,170 
|                                               |  |                   |         |                      |     |                       |        |   |                  |        
|Total investment securities available for sale |  | $                 | 117,696 |                      | 128 |                       | (1,257 | ) |                  | 116,567
|                                               |  |                   |         |                      |     |                       |        |   |                  |        
|                                               | 
|                                               |  | December 31, 2005
|                                               |  | Amortizedcost     |         | Grossunrealizedgains |     | Grossunrealizedlosses |        |   | Fair marketvalue
|Government-sponsored enterprises               |  | $                 | 50,257  |                      |    |                       | (297   | ) |                  | 49,960 
|State and municipal                            |  |                   | 56,766  |                      | 185 |                       | (945   | ) |                  | 56,006 
|Mortgage-backed                                |  |                   | 20,438  |                      | 1   |                       | (417   | ) |                  | 20,022 
|                                               |  |                   |         |                      |     |                       |        |   |                  |        
|Total investment securities available for sale |  | $                 | 127,461 |                      | 186 |                       | (1,659 | ) |                  | 125,988
|                                               |  |                   |         |                      |     |                       |        |   |                  |        



During the year ended
December 31, 2005, the Company had realized gains of $92 thousand and realized losses amounting to $58 thousand on sales of investment securities available for sale compared with realized gains of $721 thousand and realized losses amounting to
$639 thousand in fiscal year 2005. During 2004, realized gains of $141 thousand and realized losses amounting to $51 thousand were recognized. Specific identification is the basis on which cost is determined in computing realized gains and losses on
sales of investment securities.



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



The following table summarizes the gross unrealized losses, fair market value, and the number of
securities in each category of investment securities available for sale, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2006 and 2005 (dollars
in thousands).



|                                               |  |                     |  |                     |       |                       |   |    |  |                 |  |                       |  |       |  |                 |  |                       |  |      
|---------------------------------------------- |  | ------------------- |  | ------------------- | ----- | --------------------- | - | -- |  | --------------- |  | --------------------- |  | ----- |  | --------------- |  | --------------------- |  | -----
|                                               |  | December 31, 2006  
|                                               |  | Less than 12 months |  | 12 months or longer |       | Total                
|                                               |  | #                   |  | Fairmarketvalue     |       | Grossunrealizedlosses |   | #  |  | Fairmarketvalue |  | Grossunrealizedlosses |  | #     |  | Fairmarketvalue |  | Grossunrealizedlosses
|Government-sponsored enterprises               |  | 3                   |  | $                   | 2,980 |                       | $ | 3  |  | 10              |  | 39,402                |  | 168   |  | 13              |  | 42,382                |  | 171  
|State and municipal                            |  | 10                  |  |                     | 4,898 |                       |   | 52 |  | 91              |  | 34,437                |  | 770   |  | 101             |  | 39,335                |  | 822  
|Mortgage-backed                                |  |                    |  |                     |      |                       |   |   |  | 30              |  | 16,327                |  | 264   |  | 30              |  | 16,327                |  | 264  
|                                               |  |                     |  |                     |       |                       |   |    |  |                 |  |                       |  |       |  |                 |  |                       |  |      
|Total investment securities available for sale |  | 13                  |  | $                   | 7,878 |                       | $ | 55 |  | 131             |  | 90,166                |  | 1,202 |  | 144             |  | 98,044                |  | 1,257
|                                               |  |                     |  |                     |       |                       |   |    |  |                 |  |                       |  |       |  |                 |  |                       |  |      



|                                               |  |                     |  |                     |        |                       |   |     |  |                 |  |                       |  |     |  |                 |  |                       |  |      
|---------------------------------------------- |  | ------------------- |  | ------------------- | ------ | --------------------- | - | --- |  | --------------- |  | --------------------- |  | --- |  | --------------- |  | --------------------- |  | -----
|                                               |  | December 31, 2005  
|                                               |  | Less than 12 months |  | 12 months or longer |        | Total                
|                                               |  | #                   |  | Fairmarketvalue     |        | Grossunrealizedlosses |   | #   |  | Fairmarketvalue |  | Grossunrealizedlosses |  | #   |  | Fairmarketvalue |  | Grossunrealizedlosses
|U.S. Government agencies                       |  | 12                  |  | $                   | 43,062 |                       | $ | 218 |  | 3               |  | 6,897                 |  | 79  |  | 15              |  | 49,959                |  | 297  
|State and municipal                            |  | 65                  |  |                     | 25,582 |                       |   | 459 |  | 43              |  | 13,870                |  | 486 |  | 108             |  | 39,452                |  | 945  
|Mortgage-backed                                |  | 13                  |  |                     | 7,602  |                       |   | 135 |  | 19              |  | 12,290                |  | 282 |  | 32              |  | 19,892                |  | 417  
|                                               |  |                     |  |                     |        |                       |   |     |  |                 |  |                       |  |     |  |                 |  |                       |  |      
|Total investment securities available for sale |  | 90                  |  | $                   | 76,246 |                       | $ | 812 |  | 65              |  | 33,057                |  | 847 |  | 155             |  | 109,303               |  | 1,659
|                                               |  |                     |  |                     |        |                       |   |     |  |                 |  |                       |  |     |  |                 |  |                       |  |      



Management believes
that the above summarized unrealized losses are due to interest rate changes, rather than credit quality, on investments that the Company classifies to indicate that sale is a possibility but also for which the Company has the ability to hold until
maturity. The following table summarizes the debt ratings of the securities within the investment securities available for sale portfolio at December 31, 2006 based on Standard and Poors debt rating criteria (dollars in thousands).



|                                 |  |     |        |         |       |         |       |           |        |       |        
|-------------------------------- |  | --- | ------ | ------- | ----- | ------- | ----- | --------- | ------ | ----- | -------
|                                 |  | AAA |        | AA + /- |       | A + / - |       | No Rating |        | Total
|Government-sponsored enterprises |  | $   | 42,383 |         |      |         |      |           |       |       | 42,383 
|State and municipal              |  |     | 31,789 |         | 1,986 |         | 1,725 |           | 12,514 |       | 48,014 
|Mortgage-backed                  |  |     | 742    |         |      |         |      |           | 25,428 |       | 26,170 
|                                 |  |     |        |         |       |         |       |           |        |       |        
|                                 |  | $   | 74,914 |         | 1,986 |         | 1,725 |           | 37,942 |       | 116,567
|                                 |  |     |        |         |       |         |       |           |        |       |        



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



The nonrated securities at December 31, 2006 based on the Standard and Poors debt rating
criteria as summarized above were rated as follows based on Moodys rating criteria (dollars in thousands).



|                                 |  |     |        |          |   |        |     |       |       
|-------------------------------- |  | --- | ------ | -------- | - | ------ | --- | ----- | ------
|                                 |  | AAA |        | AA + / - |   | A + /- |     | Total
|Government-sponsored enterprises |  | $   |       |          |  |        |    |       |      
|State and municipal              |  |     | 12,414 |          |  |        | 100 |       | 12,514
|Mortgage-backed                  |  |     | 25,428 |          |  |        |    |       | 25,428
|                                 |  |     |        |          |   |        |     |       |       
|                                 |  | $   | 37,842 |          |  |        | 100 |       | 37,942
|                                 |  |     |        |          |   |        |     |       |       



The following table
summarizes the debt ratings of the securities within the investment securities available for sale portfolio at December 31, 2006 based on both the Standard and Poors debt and Moodys rating criteria (in thousands).



|                                                                          |  |     |         |   |         |       |   |         |       |   |       |         |  
|------------------------------------------------------------------------- |  | --- | ------- | - | ------- | ----- | - | ------- | ----- | - | ----- | ------- | -
|                                                                          |  | AAA |         |   | AA + /- |       |   | A + / - |       |   | Total |        
|Government-sponsored enterprises                                          |  | $   | 42,383  |   |         |      |   |         |      |   |       | 42,383  |  
|State and municipal                                                       |  |     | 44,203  |   |         | 1,986 |   |         | 1,825 |   |       | 48,014  |  
|Mortgage-backed                                                           |  |     | 26,170  |   |         |      |   |         |      |   |       | 26,170  |  
|                                                                          |  |     |         |   |         |       |   |         |       |   |       |         |  
|                                                                          |  | $   | 112,756 |   |         | 1,986 |   |         | 1,825 |   |       | 116,567 |  
|                                                                          |  |     |         |   |         |       |   |         |       |   |       |         |  
|As a percentage of the investment securities available for sale portfolio |  |     | 96.7    | % |         | 1.7   | % |         | 1.6   | % |       | 100.0   | %



If liquidity is
needed, the Company does not automatically chose an impaired or the most impaired security to sell to provide needed liquidity, but rather considers many constraints including, but not limited to, asset  liability management. Since the Company
has the ability and intent to hold these investments until a market price recovery or maturity, management does not consider these investments to be other-than-temporarily impaired.



State and municipal investment securities are debt investment securities issued by a state, municipality, or county in order
to finance its capital expenditures. The most substantial risk associated with buying state and municipal investment securities is the financial risk associated with the municipality from which the securities are purchased. Although municipal bonds
in smaller municipalities can sometimes be difficult to sell quickly, the Company does not currently anticipate that it will liquidate this portfolio in the near term.



Mortgage-backed investment securities include investment instruments that represent ownership of an undivided interest in a
group of mortgages. Principal and interest from the individual mortgages are used to pay principal and interest on the mortgage-backed investment security. Most mortgage-backed investment securities are either fully backed or sponsored by the United
States (U.S.) Government and provide income with less risk than other investment options. In addition, generally such investments are traded actively, so liquidity risk is minimal. Monthly income from mortgage-backed investment
securities may fluctuate as interest rates change due to the volume that mortgages prepayments.



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



The following summarizes the maturity distribution and related yields of investment securities
available for sale relative to December 31, 2006 (dollars in thousands).



|                                                                    |  |                    |        |           |      |   |                                |        |           |      |                                |        |           |      |                    |       |           |      |       |        
|------------------------------------------------------------------- |  | ------------------ | ------ | --------- | ---- | - | ------------------------------ | ------ | --------- | ---- | ------------------------------ | ------ | --------- | ---- | ------------------ | ----- | --------- | ---- | ----- | -------
|                                                                    |  | Due withinone year |        | Bookyield |      |   | Due afterone throughfive years |        | Bookyield |      | Due afterfive throughten years |        | Bookyield |      | Due afterten years |       | Bookyield |      | Total
|Government-sponsored enterprises                                    |  | $                  | 37,998 |           | 4.37 | % |                                | 4,385  |           | 4.19 |                                |       |           |     |                    |      |           |     |       | 42,383 
|State and municipal                                                 |  |                    | 1,387  |           | 4.43 |   |                                | 15,730 |           | 3.32 |                                | 29,327 |           | 3.53 |                    | 1,570 |           | 3.82 |       | 48,014 
|Mortgage-backed                                                     |  |                    | 1,775  |           | 4.05 |   |                                | 9,304  |           | 4.13 |                                | 8,369  |           | 5.20 |                    | 6,722 |           | 5.38 |       | 26,170 
|                                                                    |  |                    |        |           |      |   |                                |        |           |      |                                |        |           |      |                    |       |           |      |       |        
|Total fair market value of investment securities available for sale |  | $                  | 41,160 |           | 4.36 | % |                                | 29,419 |           | 3.71 |                                | 37,696 |           | 3.90 |                    | 8,292 |           | 5.08 |       | 116,567
|                                                                    |  |                    |        |           |      |   |                                |        |           |      |                                |        |           |      |                    |       |           |      |       |        
|Total amortized cost of investment securities available for sale    |  | $                  | 41,289 |           |      |   |                                | 29,867 |           |      |                                | 38,145 |           |      |                    | 8,395 |           |      |       | 117,696
|                                                                    |  |                    |        |           |      |   |                                |        |           |      |                                |        |           |      |                    |       |           |      |       |        

Approximately 62% of the investment securities portfolio was pledged to secure public deposits as
of December 31, 2006 as compared with 83% at December 31, 2005. Of the Companys $116.6 million available for sale investment securities balance at December 31, $44.7 million was available as a liquidity source. The decline in
pledged securities between these periods was the result of a diversification of assets pledged to secure public deposits, securities sold under agreements to repurchase, and for other purposes as required or permitted by law as further discussed in
Note 10 contained herein with regard to the Companys borrowings from the FHLB.



Concentrations of Credit Risk. Financial instruments, which potentially subject the Company to concentrations of credit risk, consist principally of loans, investment securities, federal funds sold and due from bank
balances.



The Companys investment portfolio consists
principally of securities issued by government-sponsored enterprises, and securities issued by states and municipalities within the United States. The Company places its deposits and correspondent accounts with, and sells its federal funds to, high
quality institutions. Management believes credit risk associated with correspondent accounts is not significant.



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



4.Loans



The following table summarizes loans, by loan purpose, excluding those
mortgage loans held for sale, by classification at the dates indicated (dollars in thousands).



|                              |  |                   |         |   |                   |       |   |       |         |   |            |       |  
|----------------------------- |  | ----------------- | ------- | - | ----------------- | ----- | - | ----- | ------- | - | ---------- | ----- | -
|                              |  | December 31, 2006 |         |   | December 31, 2005 |      
|                              |  | Total             |         |   | % of Total        |       |   | Total |         |   | % of Total |      
|Commercial business           |  | $                 | 112,264 |   |                   | 12.0  | % |       | 90,345  |   |            | 10.5  |  
|Commercial real estate        |  |                   | 593,377 |   |                   | 63.3  |   |       | 561,574 |   |            | 65.5  |  
|Installment                   |  |                   | 22,139  |   |                   | 2.4   |   |       | 18,677  |   |            | 2.2   |  
|Installment real estate       |  |                   | 66,161  |   |                   | 7.0   |   |       | 55,682  |   |            | 6.5   |  
|Indirect                      |  |                   | 43,634  |   |                   | 4.7   |   |       | 30,481  |   |            | 3.6   |  
|Credit line                   |  |                   | 1,982   |   |                   | 0.2   |   |       | 2,022   |   |            | 0.2   |  
|Prime access                  |  |                   | 53,883  |   |                   | 5.7   |   |       | 54,296  |   |            | 6.3   |  
|Residential mortgage          |  |                   | 35,252  |   |                   | 3.8   |   |       | 34,453  |   |            | 4.0   |  
|Bankcards                     |  |                   | 11,813  |   |                   | 1.2   |   |       | 11,744  |   |            | 1.4   |  
|Business manager              |  |                   | 370     |   |                   |      |   |       | 230     |   |            |      |  
|Other                         |  |                   | 1,793   |   |                   | 0.2   |   |       | 2,059   |   |            | 0.2   |  
|                              |  |                   |         |   |                   |       |   |       |         |   |            |       |  
|Loans, gross                  |  | $                 | 942,668 |   |                   | 100.5 | % |       | 861,563 |   |            | 100.4 |  
|Allowance for loan losses     |  |                   | (8,527  | ) |                   | (0.9  | ) |       | (8,431  | ) |            | (1.0  | )
|Loans in process              |  |                   | 2,587   |   |                   | 0.3   |   |       | 3,857   |   |            | 0.5   |  
|Deferred loans fees and costs |  |                   | 658     |   |                   | 0.1   |   |       | 761     |   |            | 0.1   |  
|                              |  |                   |         |   |                   |       |   |       |         |   |            |       |  
|Loans, net                    |  | $                 | 937,386 |   |                   | 100.0 | % |       | 857,750 |   |            | 100.0 |  
|                              |  |                   |         |   |                   |       |   |       |         |   |            |       |  



Loans included in the
table are net of participations sold, and mortgage loans sold and serviced for others. Mortgage loans serviced for the benefit of others amounted to $325.1 million, $304.2 million, and $265.7 million at December 31, 2006, 2005, and 2004
respectively. Net gains on the sale of mortgage loans included in Mortgage Banking Income in the Companys Consolidated Statements of Income totaled $772 thousand, $968 thousand, and $616 thousand for the years ending December 31, 2006,
2005, and 2004, respectively.



Management monitors whether or
not the Company has exposure to credit risk from other lending practices such as loans that subject borrowers to substantial payment increases (e.g. principal deferral periods, loans with initial interest-only periods, etc.) and loans with high
loan-to-value ratios. Management has determined that, at December 31, 2006, the Company has no concentrations in such loans, nor does the Company typically engage in such lending practices. There are industry practices that could subject the
Company to increased credit risk should economic conditions change over the course of a loans life. For example, the Company makes adjustable-rate loans and fixed-rate principal-amortizing loans with maturities prior to the loan being fully
paid (i.e. balloon-term loans). These loans are underwritten and monitored to manage the associated risks. Therefore, management believes that these particular practices do not subject the Company to unusual credit risk.



The following table summarizes nonaccrual loans and loans past due 90 days
and still accruing interest at the dates indicated (in thousands).



|                                              |  |             |       |      |       
|--------------------------------------------- |  | ----------- | ----- | ---- | ------
|                                              |  | December 31
|                                              |  | 2006        |       | 2005
|Nonaccrual loans                              |  | $           | 6,999 |      | 9,913 
|Loans past due 90 days and still accruing (1) |  |             | 260   |      | 207   
|                                              |  |             |       |      |       
|                                              |  | $           | 7,259 |      | 10,120
|                                              |  |             |       |      |       

---

|(1) |  | Substantially all of these loans are bankcard loans
|--- |  | ---------------------------------------------------



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



The foregone interest income related to loans on nonaccrual amounted to $574 thousand, $440 thousand,
and $187 thousand for the years ended December 31, 2006, 2005, and 2004, respectively. Interest collected since the loan was placed in nonaccrual status amounted to $13 thousand, $6 thousand, and $4 thousand for the years ended
December 31, 2006, 2005, and 2004, respectively.



The
following table summarizes the activity impacting the Allowance for the years indicated (in thousands).



|                               |  |                                |        |   |      |        |   |      |        |  
|------------------------------ |  | ------------------------------ | ------ | - | ---- | ------ | - | ---- | ------ | -
|                               |  | For the year endedDecember 31, |       
|                               |  | 2006                           |        |   | 2005 |        |   | 2004 |       
|Allowance, beginning of period |  | $                              | 8,431  |   |      | 7,619  |   |      | 7,463  |  
|Provision for loan losses      |  |                                | 1,625  |   |      | 2,400  |   |      | 2,150  |  
|                               |  |                                |       
|Loans charged-off              |  |                                | (1,682 | ) |      | (1,792 | ) |      | (2,150 | )
|Loan recoveries                |  |                                | 153    |   |      | 204    |   |      | 156    |  
|                               |  |                                |        |   |      |        |   |      |        |  
|Net loans charged-off          |  |                                | (1,529 | ) |      | (1,588 | ) |      | (1,994 | )
|                               |  |                                |        |   |      |        |   |      |        |  
|                               |  |                                |       
|Allowance, end of period       |  | $                              | 8,527  |   |      | 8,431  |   |      | 7,619  |  
|                               |  |                                |        |   |      |        |   |      |        |  



At December 31,
2006, impaired loans amounted to approximately $8.2 million for which $1.8 million was specifically reserved in the Allowance. During 2006, the average recorded investment in impaired loans was approximately $10.5 million. At December 31, 2005,
impaired loans amounted to approximately $12.8 million $1.9 million was specifically reserved in the Allowance. During 2005, the average recorded investment in impaired loans was approximately $8.4 million. The decrease in impaired loans from
December 31, 2005 to December 31, 2006 resulted primarily from the removal of one impaired loan totaling $3.3 million at December 31, 2005. Because impaired loans are generally classified as nonaccrual, no interest income is
recognized on such loans subsequent to being placed in nonaccrual status. One loan comprised $3.9 million of total impaired loans at December 31, 2006. Management believes that the collateral underlying the loan supported specific allowances
with regard to the loan totaling $878 thousand.



SFAS
No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings, establishes standards of financial accounting and reporting by the debtor and by the creditor for a troubled debt restructuring. Additionally, it requires
that adjustments in payment terms from a troubled debt restructuring generally be considered adjustments of the yield (effective interest rate) of the loan. So long as the aggregate payments (both principal and interest) to be received by the
creditor are not less than the creditors carrying amount of the loan, the creditor recognizes no loss, but instead recognizes a lower yield over the term of the restructured debt. Similarly, the debtor recognizes no gain unless the aggregate
future payments (including amounts contingently payable) are less than the debtors recorded liability. Troubled debt restructurings include loans with respect to which the Company has agreed to modifications of the terms of the loan such as
changes in the interest rate charged and / or other concessions. Troubled debt restructurings entered into by the Company for the years ended December 31, 2006 and December 31, 2005 were reviewed by the Company to ensure loan
classifications were in accordance with applicable regulations. Any specific allocations identified during the review based on probable losses have been included in the Companys Allowance for the applicable period.



The Bank makes contractual commitments to extend credit that are legally
binding agreements to lend money to customers at predetermined interest rates for a specific period of time. The Bank also provides standby letters of credit. See Note 15 for further discussion regarding the Companys commitments.



At December 31, 2006, of its approximately $103 million qualifying
loans available to serve as collateral against borrowings and letters of credit from the FHLB, the Company pledged as collateral $89.0 million.



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



Concentrations of Credit Risk. Financial instruments, which potentially subject the Company to
concentrations of credit risk, consist principally of loans, investment securities, federal funds sold and due from bank balances.



The Company makes loans to individuals and small to medium-sized businesses for various personal and commercial purposes primarily in Upstate, South
Carolina. The Companys loan portfolio is not concentrated in loans to any single borrower or a relatively small number of borrowers. Additionally, management is not aware of any concentrations of loans to classes of borrowers or industries
that would be similarly impacted by economic conditions. Management has identified, and the following table summarizes at the dates indicated, concentrations of types of lending that it monitors (dollars in thousands).



|                                                  |  |                    |         |                              |     |   |                             |    |  
|------------------------------------------------- |  | ------------------ | ------- | ---------------------------- | --- | - | --------------------------- | -- | -
|                                                  |  | December 31, 2006  |        
|                                                  |  | Outstandingbalance |         | As apercentageof totalequity |     |   | As apercentageof totalloans |   
|Loans secured by:                                 |  |                    |         |                              |     |   |                             |    |  
|Commercial and industrial nonmortgage instruments |  | $                  | 126,742 |                              | 126 | % |                             | 13 | %
|Residential mortgage instruments                  |  |                    | 171,828 |                              | 171 |   |                             | 18 |  
|Nonresidential mortgage instruments               |  |                    | 540,869 |                              | 539 |   |                             | 57 |  
|                                                  | 
|                                                  |  | December 31, 2005  |        
|                                                  |  | Outstandingbalance |         | As apercentageof totalequity |     |   | As apercentageof totalloans |   
|Loans secured by:                                 |  |                    |         |                              |     |   |                             |    |  
|Commercial and industrial nonmortgage instruments |  | $                  | 143,334 |                              | 161 | % |                             | 17 | %
|Residential mortgage instruments                  |  |                    | 167,693 |                              | 189 |   |                             | 19 |  
|Nonresidential mortgage instruments               |  |                    | 458,154 |                              | 515 |   |                             | 53 |  



Loans secured by
commercial and industrial nonmortgage instruments are typically of higher risk and are made on the basis of the borrowers ability to make repayment from the cash flow of the borrowers business. Such loans are generally secured by a
variety of collateral types, including, but not limited to, accounts receivable, inventory and equipment.



In addition to monitoring potential concentrations of loans to particular borrowers or groups of borrowers, industries, geographic regions, and loan
types, management monitors whether or not the Company has exposure to credit risk from other lending practices such as loans that subject borrowers to substantial payment increases (e.g. principal deferral periods, loans with initial interest-only
periods, etc.) and loans with high loan-to-value ratios. Management has determined that, at December 31, 2006, the Company has no concentrations in such loans, as the Company does not typically engage in such lending practices.



Additionally, there are industry practices that could subject the Company to
increased credit risk should economic conditions change over the course of a loans life. For example, the Company makes adjustable-rate loans and fixed-rate principal-amortizing loans with maturities prior to the loan being fully paid (i.e.
balloon-term loans). These loans are underwritten and monitored to manage the associated risks. Therefore, management believes that these particular practices do not subject the Company to unusual credit risk.



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



5.    Premises and Equipment, Net



The following table summarizes the Companys premises and equipment
balances at the dates indicated (in thousands).



|                                          |  |              |         |   |      |         |  
|----------------------------------------- |  | ------------ | ------- | - | ---- | ------- | -
|                                          |  | December 31, |        
|                                          |  | 2006         |         |   | 2005 |        
|Land                                      |  | $            | 6,305   |   |      | 5,856   |  
|Buildings                                 |  |              | 17,124  |   |      | 15,552  |  
|Leasehold impovements                     |  |              | 2,847   |   |      | 2,775   |  
|Furniture and equipment                   |  |              | 17,762  |   |      | 16,578  |  
|Software                                  |  |              | 3,194   |   |      | 2,858   |  
|Bank automobiles                          |  |              | 859     |   |      | 816     |  
|                                          |  |              |         |   |      |         |  
|Premises and equipment, gross             |  |              | 48,091  |   |      | 44,435  |  
|Accumulated depreciation and amortization |  |              | (23,597 | ) |      | (21,759 | )
|                                          |  |              |         |   |      |         |  
|Premises and equipment, net               |  | $            | 24,494  |   |      | 22,676  |  
|                                          |  |              |         |   |      |         |  



At December 31,
2006, the Bank had thirty-two full-service banking offices in the Upstate region of South Carolina in the following counties: Laurens County (4), Greenville County (10), Spartanburg County (6), Greenwood County (5), Anderson County (3), Cherokee
County (2), Pickens County (1), and Oconee County (1) in addition to two Palmetto Capital offices independent of banking office locations, 38 automatic teller machine (ATM) locations (including eight in nonbanking office locations),
and five limited service banking offices located in retirement centers in the Upstate.



During 2006, the Company added two new banking office ATM locations, one in conjunction with the opening of the Boiling Springs banking office in Spartanburg County and one at its existing North Harper banking office
in Laurens County, and four new nonbanking office ATM locations at Northside Village Shopping Center in Anderson County, Heritage Pointe Shopping Center in Pickens County, and Roebuck Village Shopping and Crossroads Commons Shopping Centers in
Spartanburg County. One principal banking office is located in each of the following counties: Laurens, Greenville, Spartanburg, Greenwood, and Anderson.



Ten of the Banks current full service banking offices are leased, and the Bank owns the remaining banking offices. Additionally, during the first
quarter of 2006, the Bank completed negotiations with a third party with regard to the sublease of its previous Blackstock Road banking office location. The Bank owns this banking structure that is located on land that the Bank leases pursuant to a
ground lease. Additionally, the Bank owns a banking structure on Haywood Road constructed on land that the Bank leases pursuant to a ground lease. Further, Palmetto Capital leases its Fountain Inn office. The Bank has seven ground leases with regard
to ATMs at nonbanking office locations and four ground leases with regard to real property most often used for parking at existing branch offices.



The Bank entered into a building lease, not included in those noted above for banking office locations, with regard to the temporary Boiling Springs
banking office that was used while the permanent banking office was constructed during 2006. This lease had expired by December 31, 2006.



During 2006, the Bank began an expansion of its Greenwood county Montague banking office. Construction on this office is anticipated to be completed
during the first quarter of 2007.



The Bank owns two parcels of
property to be used in conjunction with the construction of its new corporate headquarters in Greenville County. Additionally, during February 2007, the Bank purchased real estate in



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



Anderson County and plans to relocate its existing Pendleton banking office to that site. The Company and is currently considering land options with regard
to its anticipated Greer banking office relocation.



During
January 2007, the Bank entered into a ground lease agreements for leased property at which the Company will house a new ATM. This lease is not included in those summarized above. This ground lease is located in a market area that the Company
currently serves.



Depreciation with regard to premises and
equipment owned by the Company is recorded using the straight-line method over the estimated useful life of the related asset for financial reporting purposes. Estimated lives range from twelve to thirty-nine years for buildings and improvements and
from five to twelve years for furniture and equipment. Estimated lives range from three to five years for computer software. Estimated lives of Bank automobiles are typically five years. Estimating the useful lives of premises and equipment include
a component of management judgment.



Depreciation with regard
to improvements to premises and equipment leased by the Company is recorded in accordance with EITF No. 05-06, Determining the Amortization Period for Leasehold Improvements.



The table set forth below summarizes the activity impacting accumulated
depreciation for the periods indicated (in thousands). Depreciation balances were impacted during the period by the activity discussed herein.



|                                              |  |                                |        |   |      |        |   |      |        |  
|--------------------------------------------- |  | ------------------------------ | ------ | - | ---- | ------ | - | ---- | ------ | -
|                                              |  | For the year endedDecember 31, |       
|                                              |  | 2006                           |        |   | 2005 |        |   | 2004 |       
|Accumulated depreciation, beginning of period |  | $                              | 21,759 |   |      | 20,089 |   |      | 18,408 |  
|                                              |  |                                |       
|Depreciation                                  |  |                                |        |   |      |        |   |      |        |  
|Buildings                                     |  |                                | 451    |   |      | 439    |   |      | 422    |  
|Leasehold improvements                        |  |                                | 163    |   |      | 155    |   |      | 66     |  
|Furniture and equipment                       |  |                                | 998    |   |      | 985    |   |      | 996    |  
|Software                                      |  |                                | 258    |   |      | 256    |   |      | 238    |  
|Bank automobiles                              |  |                                | 163    |   |      | 168    |   |      | 149    |  
|                                              |  |                                |        |   |      |        |   |      |        |  
|Total depreciation                            |  |                                | 2,033  |   |      | 2,003  |   |      | 1,871  |  
|                                              |  |                                |       
|Disposals                                     |  |                                | (195   | ) |      | (333   | ) |      | (190   | )
|                                              |  |                                |        |   |      |        |   |      |        |  
|Accumulated depreciation, end of period       |  | $                              | 23,597 |   |      | 21,759 |   |      | 20,089 |  
|                                              |  |                                |        |   |      |        |   |      |        |  



The increase
experienced within leasehold improvement depreciation during fiscal year 2005 over fiscal year 2004 was the result of an additional lease, and therefore additional leasehold improvements, entered into with regard to fiscal year 2005 in conjunction
with the move of the Banks banking office on East Blackstock Road in Spartanburg, South Carolina to W.O. Ezell Boulevard in Spartanburg, South Carolina. The Bank also entered into a lease in fiscal year 2005 with regard to the banking office
used temporarily during the construction of the new Easley banking office opened in 2005. The improvements to this leased property in order for it to be suited for banking purposes contributed to the increase in leasehold improvement depreciation
during fiscal year 2005 over fiscal year 2004 as well. Additionally, in conjunction with the issuance of EITF No. 05-06 during June 2005, the Company reevaluated its leasehold improvements to ensure useful lives were limited to lease terms
including renewals that are deemed to be reasonably assured.



6.     Mortgage-Servicing Rights



The Company sells a portion of its originated fixed-rate and adjustable-rate mortgage loans servicing retaining. All of the Companys loan sales have
been without provision for recourse. Mortgage loans serviced for



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



the benefit of others amounted to $325.1 million and $304.2 million at December 31, 2006 and 2005, respectively. Mortgage loans serviced for the benefit
of others are held by the Company or its subsidiary in a fiduciary or agency capacity for customers and, as such, are not included in the Companys Consolidated Financial Statements as such items do not represent assets of the Company or its
subsidiary.



The following table summarizes the changes in the
the Companys mortgage-servicing rights portfolio for the years indicated (in thousands).



|                                                                                                            |  |                                 |       |    |      |       |  
|----------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ----- | -- | ---- | ----- | -
|                                                                                                            |  | For the years endedDecember 31, |      
|                                                                                                            |  | 2006                            |       |    | 2005 |      
|Mortgage-servicing rights portfolio, net of valuation allowance, beginning of period                        |  | $                               | 2,626 |    |      | 2,316 |  
|Capitalized mortgage-servicing rights                                                                       |  |                                 | 626   |    |      | 929   |  
|Mortgage-servicing right portfolio amortization                                                             |  |                                 | (635  | )  |      | (717  | )
|Change in mortgage-servicing right valuation allowance                                                      |  |                                 | 31    |    |      | 98    |  
|                                                                                                            |  |                                 |       |    |      |       |  
|Mortgage-servicing rights portfolio, net of valuation allowance, end of period                              |  | $                               | 2,648 |    |      | 2,626 |  
|                                                                                                            |  |                                 |       |    |      |       |  
|Mortgage-servicing rights portfolio amortization as a percentage for the mortgage-servicing right portfolio |  |                                 | (24.0 | )% |      | (27.3 | )



Mortgage-servicing
rights amortization and valuation allowances are included in Mortgage-Banking Income on the Consolidated Statements of Income.



The aggregate fair market value of the Companys mortgage-servicing rights portfolio at December 31, 2006 and 2005 was $2.7 million and $2.6
million, respectively.



During June 2005, the Company
securitized and sold approximately $10 million of its residential mortgage loans from the Companys retained loan portfolio. The goal of this securitization was to provide enhanced liquidity, to improve capital ratios, and to provide growth in
revenues from mortgage-servicing activities. In addition, the Company sold approximately $4 million of residential mortgage loans during June 2005 from the loans receivable portfolio. These transactions, as well as increases in mortgage loan sales
in the normal course of business during 2005, contributed to higher than historical sales of mortgage of loans and, thus capitalized mortgage-servicing rights. The Company engaged in no mortgage loan securitizations during 2006. As such, capitalized
mortgage-servicing rights during 2006 were only impacted by mortgage loan sales in the normal course of business.



Capitalized mortgage-servicing rights decreased during fiscal year 2006 over fiscal year 2005 due in part to higher than historical capitalizations during
2005 in conjunction with the securitization noted in the preceding paragraph. In addition to this factor, the decline is contributed to the decline in originated and sold mortgage loans held for sale during 2006 compared with 2005.



Amortization, impairment, and recoveries within the mortgage-servicing rights
portfolio continued to decline during 2006. Since the second quarter of 2004, the federal funds rate has increased from 1.0% to 5.25% in a series of seventeen moves. As interest rates have risen over this period, refinancing activity slowed. As
such, the component of mortgage-servicing rights amortization, impairment, and recoveries relative to refinancing activity (prepayment speeds) slowed as well thereby positively impacting the amortization, impairment, and recoveries within the
Companys mortgage-servicing rights portfolio.



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



Amortization, impairment, and recoveries within the mortgage-servicing rights portfolio continued to
decline during 2006. Since the second quarter of 2004, the federal funds rate has increased from 1.0% to 5.25% in a series of seventeen increases. As interest rates have risen over this period, refinancing activity slowed. As such, the component of
mortgage-servicing rights amortization, impairment, and recoveries relative to refinancing activity (prepayment speeds) slowed as well thereby positively impacting the amortization, impairment, and recoveries within the Companys
mortgage-servicing rights portfolio.



The following table
summarizes the activity impacting the valuation allowance for impairment of the mortgage-servicing rights portfolio for the years indicated (in thousands).



|                                                                  |  |                                 |     |   |      |     |   |      |    
|----------------------------------------------------------------- |  | ------------------------------- | --- | - | ---- | --- | - | ---- | ---
|                                                                  |  | For the years endedDecember 31,
|                                                                  |  | 2006                            |     |   | 2005 |     |   | 2004
|Valuation allowance, beginning of year                            |  | $                               | 34  |   |      | 132 |   |      | 120
|Aggregate additions charged and reductions credited to operations |  |                                 | (31 | ) |      | (98 | ) |      | 12 
|                                                                  |  |                                 |     |   |      |     |   |      |    
|Valuation allowance, end of year                                  |  | $                               | 3   |   |      | 34  |   |      | 132
|                                                                  |  |                                 |     |   |      |     |   |      |    



For purposes of
measuring impairment, the mortgage-servicing rights portfolio is reviewed for impairment based upon quarterly external valuations. Such valuations are based on projections using a discounted cash flow method that includes assumptions regarding
prepayments, interest rates, servicing costs, and other factors. The Companys established impairment valuation allowance records estimated impairment for the mortgage-servicing rights portfolio. Subsequent increases in value are recognized by
the Company to the extent of the impairment valuation allowance. In a rising interest rate environment, prepayments typically slow thereby resulting in recoveries of previously established valuation allowances. Should market interest rates increase
from current levels, it is likely the Company could recover additional impairment charges in its mortgage-servicing rights portfolio.



The following table summarizes Companys estimated amortization expense of its mortgage-servicing rights portfolio outstanding at December 31,
2006 during the periods indicated (in thousands).



|                         |  |   |      
|------------------------ |  | - | -----
|Year ending December 31,
|2007                     |  | $ | 688  
|2008                     |  |   | 542  
|2009                     |  |   | 425  
|2010                     |  |   | 330  
|2011                     |  |   | 254  
|Thereafter               |  |   | 406  
|                         |  |   |      
|                         |  | $ | 2,645
|                         |  |   |      



Management is aware of
no material events or uncertainties that would cause reported projected amortization related to its mortgage-servicing rights portfolio not to be indicative of future financial condition or results of operations or that would cause future financial
condition or results of operations to differ material from these projections. However, amortization expense is calculated based on current available information regarding loan payments and prepayments and could change in future periods based on
changes in volume of prepayments and other economic factors.



See Consolidated Statements of Cash Flows for a further discussion of the activity impacting the Companys mortgage-servicing rights portfolio.



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



7.    Intangible Assets



The following table summarizes intangible assets, which are included in
Other Assets on the Consolidated Balance Sheets, net of accumulated amortization, at the dates indicated (in thousands).



|                          |  |              |       |      |      
|------------------------- |  | ------------ | ----- | ---- | -----
|                          |  | December 31,
|                          |  | 2006         |       | 2005
|Goodwill                  |  | $            | 3,691 |      | 3,691
|Customer list intangibles |  |              | 127   |      | 175  
|                          |  |              |       |      |      
|Total intagible assets    |  | $            | 3,818 |      | 3,866
|                          |  |              |       |      |      



The following table
summarizes the activity of intangible assets with finite lives, which are comprised of customer list intangibles, and the related amortization, which is included in Other Noninterest Expense in the Consolidated Statements of Income, for the periods
indicated (in thousands).



|                              |  |                                 |     |   |      |      |   |      |      |  
|----------------------------- |  | ------------------------------- | --- | - | ---- | ---- | - | ---- | ---- | -
|                              |  | For the years endedDecember 31, |    
|                              |  | 2006                            |     |   | 2005 |      |   | 2004 |     
|Balance, at beginning of year |  | $                               | 175 |   |      | 319  |   |      | 463  |  
|Less: amortization            |  |                                 | (48 | ) |      | (144 | ) |      | (144 | )
|                              |  |                                 |     |   |      |      |   |      |      |  
|Balance, at end of year       |  | $                               | 127 |   |      | 175  |   |      | 319  |  
|                              |  |                                 |     |   |      |      |   |      |      |  



The decline in
amortization from fiscal 2005 to fiscal 2006 resulted from finite life intangibles from branch purchases transacted in 1996 being fully depreciated in 2005.



The following table summarizes the gross carrying amount and accumulated amortization of intangible assets with finite lives at the dates indicated (in
thousands).



|                                 |  |                  |        |   |                  |        |  
|-------------------------------- |  | ---------------- | ------ | - | ---------------- | ------ | -
|                                 |  | December 31,2006 |        |   | December 31,2005 |       
|Customer list intangibles, gross |  | $                | 1,779  |   |                  | 1,779  |  
|Less: accumulated amortization   |  |                  | (1,652 | ) |                  | (1,604 | )
|                                 |  |                  |        |   |                  |        |  
|Customer list intangibles, net   |  | $                | 127    |   |                  | 175    |  
|                                 |  |                  |        |   |                  |        |  



The Company estimates
amortization expense related to intangible assets with finite lives of $48 thousand for the year ended December 31, 2007, $45 thousand for the year ended December 31, 2008, and $34 thousand for the year ended December 31, 2009.
Management is aware of no material events or uncertainties that would cause amortization expense related to the Companys intangible assets with finite lives not to be indicative of future financial condition or results of operations or that
would cause future financial condition or results of operations to differ materially from these projections.



The Companys intangible assets with infinite lives (goodwill) are subject to periodic impairment tests that are performed by the Company as of
June 30 annually, or more often, if events or circumstances indicate that there may be impairment. The valuation as of June 30, 2006 indicated that no impairment charge was required as of that date. Management is aware of no material
events or uncertainties that have occurred since June 30, 2006 that would indicate that there might be impairment.



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



8.    Real Estate and Personal Property Acquired in Settlement of
Loans



The following table summarizes real estate and
personal property acquired in settlement of loans for the years indicated (in thousands).



|                                                        |  |              |     |      |      
|------------------------------------------------------- |  | ------------ | --- | ---- | -----
|                                                        |  | December 31,
|                                                        |  | 2006         |     | 2005
|Real estate acquired in settlement of loans             |  | $            | 600 |      | 1,954
|Repossessed automobiles acquired in settlement of loans |  |              | 319 |      | 167  
|                                                        |  |              |     |      |      
|Total property acquired in settlement of loans          |  | $            | 919 |      | 2,121
|                                                        |  |              |     |      |      



The following table
summarizes the changes in the allowances, including the balance at the beginning and end of each period, provision charged to expense, and losses charged to the Allowance related to the Companys real estate acquired in settlement of loans for
the years indicated (in thousands).



|                                                                        |  |                                        |        |   |      |        |   |      |        |  
|----------------------------------------------------------------------- |  | -------------------------------------- | ------ | - | ---- | ------ | - | ---- | ------ | -
|                                                                        |  | At and for the years endedDecember 31, |       
|                                                                        |  | 2006                                   |        |   | 2005 |        |   | 2004 |       
|Real estate acquired in settlement of loans, beginning of period        |  | $                                      | 1,954  |   |      | 2,413  |   |      | 2,170  |  
|Add: New real estate acquired in settlement of loans                    |  |                                        | 294    |   |      | 1,096  |   |      | 2,468  |  
|Less: Sales / recoveries of real estate acquired in settlement of loans |  |                                        | (1,451 | ) |      | (1,283 | ) |      | (2,001 | )
|Less: Provision charged to expense                                      |  |                                        | (197   | ) |      | (272   | ) |      | (224   | )
|                                                                        |  |                                        |        |   |      |        |   |      |        |  
|Real estate acquired in settlement of loans, end of period              |  | $                                      | 600    |   |      | 1,954  |   |      | 2,413  |  
|                                                                        |  |                                        |        |   |      |        |   |      |        |  



Levels of real estate
acquired in settlement of loans decreased from December 31, 2005 to December 31, 2006. Management believes that the main factor contributing to this decline has been the portfolio trend of recent years that is not believed to necessarily
be indicative of historical or future credit trends. The following table summarizes the Companys real estate acquired in settlement of loans portfolio balance at the dates indicated (in thousands).



|                  |  |   |      
|----------------- |  | - | -----
|December 31, 2001 |  | $ | 217  
|December 31, 2002 |  |   | 2,468
|December 31, 2003 |  |   | 2,170
|December 31, 2004 |  |   | 2,413
|December 31, 2005 |  |   | 1,954
|December 31, 2006 |  |   | 600  



Based on the
Companys policies and procedures regarding the regular review of fair market values of real estate acquired in settlement of loans and writedowns taken accordingly, management believes that the properties within the portfolio were properly
valued at December 31, 2006.



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



9.    Deposits



The following table summarizes the Companys deposit composition at the
dates indicated (in thousands).



|                                           |  |              |         |      |        
|------------------------------------------ |  | ------------ | ------- | ---- | -------
|                                           |  | December 31,
|                                           |  | 2006         |         | 2005
|Transaction deposit accounts               |  | $            | 447,236 |      | 351,629
|Money market deposit accounts              |  |              | 124,874 |      | 111,380
|Savings deposit accounts                   |  |              | 41,887  |      | 45,360 
|Time deposit accounts $100,000 and greater |  |              | 126,880 |      | 122,954
|Time deposit accounts less than $100,000   |  |              | 252,704 |      | 272,060
|                                           |  |              |         |      |        
|Total deposit accounts                     |  | $            | 993,581 |      | 903,383
|                                           |  |              |         |      |        



At December 31,
2006, $606 thousand of overdrawn transaction deposit accounts had been reclassified as loan balances compared with $697 thousand at December 31, 2005.



The following table summarizes the maturities of time deposits outstanding at December 31, 2006 during the periods indicated (in thousands).



|                         |  |   |        
|------------------------ |  | - | -------
|Year ending December 31,
|2007                     |  | $ | 300,776
|2008                     |  |   | 56,133 
|2009                     |  |   | 18,065 
|2010                     |  |   | 3,099  
|2011                     |  |   | 1,210  
|                         |  |   |        
|                         |  | $ | 379,283
|                         |  |   |        



The table set forth
below summarizes the Companys interest expense on deposit accounts costs for the periods indicated (in thousands).



|                                           |  |                                |        |      |        |      |       
|------------------------------------------ |  | ------------------------------ | ------ | ---- | ------ | ---- | ------
|                                           |  | For the year endedDecember 31,
|                                           |  | 2006                           |        | 2005 |        | 2004
|Transaction deposit accounts               |  | $                              | 5,424  |      | 1,430  |      | 426   
|Money market deposit accounts              |  |                                | 3,979  |      | 1,809  |      | 559   
|Savings deposit accounts                   |  |                                | 147    |      | 143    |      | 133   
|Time deposit accounts                      |  |                                | 15,430 |      | 11,010 |      | 9,071 
|                                           |  |                                |        |      |        |      |       
|Total interest expense on deposit accounts |  | $                              | 24,980 |      | 14,392 |      | 10,189
|                                           |  |                                |        |      |        |      |       



10.    Borrowings from the Federal Home Loan Bank



In addition to traditional deposit accounts, the Company utilizes both short-term and long-term borrowing to supplement its supply of lendable funds, to
assist in meeting deposit withdrawal requirements, and to fund growth of interest-earning assets in excess of traditional deposit growth.



Short-term and long-term FHLB borrowings are a source of funding that the Company utilizes depending on the current level of deposits, the desirability of
raising deposits through market promotions, the Companys unused FHLB borrowing capacity, and the availability of collateral to secure FHLB borrowings. Short-term



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



borrowings typically represent overnight borrowings, and long-term borrowings have maturities greater than one year when made. Interest rates on such
borrowings vary in response to general economic conditions. FHLB borrowings are an alternative to other funding sources with similar maturities.



The FHLB has established an overall credit limit for each member. This limit is designed to mitigate the FHLBs credit exposure to an individual
member while encouraging members to diversify their funding sources. Generally, this credit limit is 40 percent of the members total assets. However, a members eligibility to borrow in excess of 30 percent of assets is subject to its
meeting eligibility criteria. Under certain circumstances, a member approved for a 40 percent credit limit may request approval to exceed the credit limit.



Qualifying collateral to be pledged to secure any advances from the FHLB may include qualifying securities, loans, deposits, and stock of the FHLB owned
by the Company. The member has certain obligations to the FHLB for its pledged collateral. These obligations include periodic reporting on eligible, pledged collateral and adherence to the FHLBs collateral verification review procedures. At
December 31, 2006, of its approximately $103 million available credit based on qualifying loans to serve as collateral against short-term or long-term borrowings from the FHLB, the Company employed $10.0 million in borrowings, all of which was
determined to be long-term when employed, and employed $79.0 million in a letter of credit used to secure public deposits as required or permitted by law.



The following table summarizes the Companys borrowings from the FHLB at the dates indicated (dollars in thousands).



|                              |  |                   |          
|----------------------------- |  | ----------------- | ---------
|                              |  | December 31, 2006
|                              |  | Long-term        
|Borrowing balance outstanding |  | $                 | 10,000   
|Interest rate                 |  |                   | 3.85     
|Maturity date                 |  |                   | 6/14/2007



|                              |  |                   |           |            |  |           |  |           |  |        |    
|----------------------------- |  | ----------------- | --------- | ---------- |  | --------- |  | --------- |  | ------ | ---
|                              | 
|                              |  | December 31, 2005 |          
|                              |  | Long-term         |           | Short-term |  | Total     | 
|Borrowing balance outstanding |  | $                 | 13,000    |            |  | 10,000    |  | 16,900    |  | 39,900 |    
|Interest rate                 |  |                   | 3.27      | %          |  | 3.85      |  | 4.44      |  | 3.91   | (1)
|Maturity date                 |  |                   | 6/14/2006 |            |  | 6/14/2007 |  | Overnight |  |        |    

---

|(1) |  | Represents weighted average rate at year-end.
|--- |  | ---------------------------------------------



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



The following table summarizes short-term borrowing information at and for the years indicated
(dollars in thousands).



|                                            |  |                                       |        |   |      |        |      |       
|------------------------------------------- |  | ------------------------------------- | ------ | - | ---- | ------ | ---- | ------
|                                            |  | At and for the year endedDecember 31,
|                                            |  | 2006                                  |        |   | 2005 |        | 2004
|Short-term FHLB borrowings                  |  |                                       |        |   |      |        |      |       
|Amount outstanding at year-end              |  | $                                     |       |   |      | 16,900 |      | 16,000
|Average amount outstanding during year      |  |                                       | 2,140  |   |      | 26,745 |      | 4,990 
|Maximum amount outstanding at any month-end |  |                                       | 10,900 |   |      | 51,400 |      | 24,500
|Rate paid at year-end                       |  |                                       |       | % |      | 4.44   |      | 2.44  
|Weighted average rate paid during the year  |  |                                       | 4.63   |   |      | 3.59   |      | 2.08  
|                                            |  |                                       |       
|Long-term FHLB borrowings                   |  |                                       |        |   |      |        |      |       
|Amount outstanding at year-end              |  | $                                     | 10,000 |   |      | 23,000 |      | 30,000
|Average amount outstanding during year      |  |                                       | 15,841 |   |      | 26,145 |      | 16,475
|Maximum amount outstanding at any month-end |  |                                       | 23,000 |   |      | 30,000 |      | 30,000
|Rate paid at year-end                       |  |                                       | 3.85   | % |      | 3.52   |      | 3.24  
|Weighted average rate paid during the year  |  |                                       | 3.64   |   |      | 3.38   |      | 3.25  



The FHLB may assess
fees and charges to cover costs relating to the receipt, holding, redelivery, and reassignment of the Companys collateral. The FHLB publishes a schedule of such fees and charges on its website. In addition, the FHLB may assess fees to cover
collateral verification reviews performed by, or on behalf of, the FHLB. The Company has not yet been charged any such fees and does not anticipate such fees, if assessed, will be significant.



Any FHLB advance with a fixed interest rate is subject to a prepayment fee in
the event of full or partial repayment prior to maturity or the expiration of any interim interest rate period. Management was not aware of any circumstances at December 31, 2006 that would require prepayment of any of the Companys FHLB
advances. Additionally, none of the Companys long-term FHLB advances outstanding at December 31, 2006 had embedded call options.



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



11.Other Borrowings



The following table summarizes short-term borrowing information at and for
the years indicated (dollars in thousands).



|                                              |  |                                       |        |   |      |        |      |       
|--------------------------------------------- |  | ------------------------------------- | ------ | - | ---- | ------ | ---- | ------
|                                              |  | At and for the year endedDecember 31,
|                                              |  | 2006                                  |        |   | 2005 |        | 2004
|Retail repurchase agreements                  |  |                                       |        |   |      |        |      |       
|Amount outstanding at year-end                |  | $                                     | 14,427 |   |      | 16,728 |      | 16,397
|Average amount outstanding during year        |  |                                       | 17,639 |   |      | 20,690 |      | 20,215
|Maximum amount outstanding at any month-end   |  |                                       | 23,344 |   |      | 20,981 |      | 22,308
|Rate paid at year-end*                        |  |                                       | 3.63   | % |      | 2.63   |      | 0.73  
|Weighted average rate paid during the year    |  |                                       | 4.14   |   |      | 2.38   |      | 0.61  
|                                              |  |                                       |       
|Securities sold under agreement to repurchase |  |                                       |        |   |      |        |      |       
|Amount outstanding at year-end                |  | $                                     |       |   |      |       |      |      
|Average amount outstanding during year        |  |                                       |       |   |      |       |      | 2,508 
|Maximum amount outstanding at any month-end   |  |                                       |       |   |      |       |      | 38,220
|Rate paid at year-end                         |  |                                       |       | % |      |       |      |      
|Weighted average rate paid during the year    |  |                                       |       |   |      |       |      | 1.28  
|                                              |  |                                       |       
|Commercial paper                              |  |                                       |        |   |      |        |      |       
|Amount outstanding at year-end                |  | $                                     | 20,988 |   |      | 17,915 |      | 17,051
|Average amount outstanding during year        |  |                                       | 21,009 |   |      | 18,833 |      | 16,447
|Maximum amount outstanding at any month-end   |  |                                       | 25,720 |   |      | 21,877 |      | 18,310
|Rate paid at year-end*                        |  |                                       | 3.81   | % |      | 2.81   |      | 0.85  
|Weighted average rate paid during the year    |  |                                       | 4.13   |   |      | 2.33   |      | 0.75  
|                                              |  |                                       |       
|Federal funds purchased                       |  |                                       |        |   |      |        |      |       
|Amount outstanding at year-end                |  | $                                     | 6,000  |   |      | 1,000  |      |      
|Average amount outstanding during year        |  |                                       | 847    |   |      | 4,098  |      | 4,643 
|Maximum amount outstanding at any month-end   |  |                                       | 6,000  |   |      | 13,320 |      | 17,850
|Rate paid at year-end                         |  |                                       | 5.50   | % |      | 4.37   |      |      
|Weighted average rate paid during the year    |  |                                       | 5.19   |   |      | 2.71   |      | 1.51  

---

|* |  | Rates paid are tiered based on level of deposit. Rate presented represents the average rate for all tiers offered at year-end.
|- |  | ------------------------------------------------------------------------------------------------------------------------------



The Company offers commercial paper as an alternative investment tool for its
commercial customers. Through a master note arrangement between the holding company and the Bank, Palmetto Master Notes are issued as an alternative investment for commercial sweep accounts. These master notes are unsecured but are backed by the
full faith and credit of the holding company. The commercial paper is issued only in conjunction with the automated sweep account customer agreement on deposits at the Bank level.



If needed, alternative funding sources have been arranged through federal funds lines at correspondent banks and through the
Federal Reserve Discount Window. At December 31, 2006, the Company had additional funding sources totaling of $34 million that were accessible at the Companys option.



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



12.Income Taxes



The following table summarizes income tax expense attributable to continuing
operations for the years indicated (in thousands).



|                           |  |                                |       |      |       |      |      
|-------------------------- |  | ------------------------------ | ----- | ---- | ----- | ---- | -----
|                           |  | For the year endedDecember 31,
|                           |  | 2006                           |       | 2005 |       | 2004
|Current                    |  |                                |       |      |       |      |      
|Federal                    |  | $                              | 6,511 |      | 5,565 |      | 4,647
|State                      |  |                                | 683   |      | 619   |      | 528  
|                           |  |                                |       |      |       |      |      
|Total current              |  |                                | 7,194 |      | 6,184 |      | 5,175
|                           |  |                                |       |      |       |      |      
|Deferred                   |  |                                |       |      |       |      |      
|Federal                    |  |                                | 768   |      | 758   |      | 394  
|                           |  |                                |       |      |       |      |      
|Total current and deferred |  | $                              | 7,962 |      | 6,942 |      | 5,569
|                           |  |                                |       |      |       |      |      



The following table
summarizes the Companys reconciliation from the Federal statutory rates to the consolidated effective income tax expense for the years indicated.



|                                               |  |                                |   |  |      |   |  |      |  
|---------------------------------------------- |  | ------------------------------ | - |  | ---- | - |  | ---- | -
|                                               |  | For the year endedDecember 31, |  
|                                               |  | 2006                           |   |  | 2005 |   |  | 2004 |  
|U.S. Federal income tax rate                   |  | 35.0                           | % |  | 35.0 |   |  | 34.0 |  
|Changes from statutory rates resulting from:   |  |                                |   |  |      |   |  |      |  
|Tax-exempt interest income                     |  | (3.1                           | ) |  | (3.8 | ) |  | (4.3 | )
|Expenses not deductible for tax purposes       |  | 0.9                            |   |  | 0.6  |   |  | 0.3  |  
|State taxes, net of Federal income tax benefit |  | 1.9                            |   |  | 2.0  |   |  | 2.0  |  
|Other                                          |  | (0.4                           | ) |  | (0.3 | ) |  | (0.5 | )
|                                               |  |                                |   |  |      |   |  |      |  
|Effective tax rate                             |  | 34.3                           | % |  | 33.5 |   |  | 31.5 |  
|                                               |  |                                |   |  |      |   |  |      |  



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



The following table summarizes the tax impact of temporary differences that give rise to significant
portions of the deferred tax assets and deferred tax liabilities at the dates indicated (in thousands).



|                                                                                                |  |              |        |   |      |        |  
|----------------------------------------------------------------------------------------------- |  | ------------ | ------ | - | ---- | ------ | -
|                                                                                                |  | December 31, |       
|                                                                                                |  | 2006         |        |   | 2005 |       
|Deferred tax assets                                                                             |  |              |        |   |      |        |  
|Loan loss reserves                                                                              |  | $            | 2,984  |   |      | 2,951  |  
|Unrealized loss on investment securities available for sale                                     |  |              | 435    |   |      | 567    |  
|Other                                                                                           |  |              | 423    |   |      | 164    |  
|                                                                                                |  |              |        |   |      |        |  
|Total deferred tax assets, gross                                                                |  |              | 3,842  |   |      | 3,682  |  
|                                                                                                |  |             
|Deferred tax liabilities                                                                        |  |              |        |   |      |        |  
|Premises and equipment, due to depreciation differences                                         |  |              | (1,063 | ) |      | (1,070 | )
|Basis of intangible assets for financial reporting purposes in excess of basis for tax purposes |  |              | (273   | ) |      | (241   | )
|Deferred loan costs deducted for tax purposes as incurred                                       |  |              | (267   | ) |      | (278   | )
|Deferred loan fees recognized under the principal reduction method for tax purposes             |  |              | (2,206 | ) |      | (1,715 | )
|Prepaid pension expense                                                                         |  |              | (1,876 | ) |      | (1,584 | )
|Mortgage-servicing rights                                                                       |  |              | (927   | ) |      | (905   | )
|Other                                                                                           |  |              | (289   | ) |      | (48    | )
|                                                                                                |  |              |        |   |      |        |  
|Total deferred tax liabilities                                                                  |  |              | (6,901 | ) |      | (5,841 | )
|                                                                                                |  |              |        |   |      |        |  
|Net deferred tax liability                                                                      |  | $            | (3,059 | ) |      | (2,159 | )
|                                                                                                |  |              |        |   |      |        |  



A portion of the
change in the net deferred tax liability relates to the change in the unrealized gains and losses on investment securities available for sale. A current period deferred tax charge of $132 thousand related to the change in unrealized gains and losses
on investment securities available for sale of $343 thousand has been recorded directly to shareholders equity. The remainder of the change in the deferred tax liability results from the current period deferred tax expense of $768 thousand.



No valuation allowance for deferred tax assets has been
established at either December 31, 2006 or 2005 as it is managements belief that realization of the deferred tax assets is more likely than not.



13.Employee Benefit Plans



Postretirement Benefits



The Company offers a defined benefit pension plan (the Plan) that it believes is an important part of the Companys total compensation
and benefit plan designed to attract and retain highly skilled and talented employees.



Accounting Policy. As noted in Note 1 contained herein, the Company accounts for its defined benefit pension plan using actuarial models required by SFAS No. 87. These models use an attribution approach that
generally spreads individual events over the service lives of the employees in the Plan. Examples of events are Plan amendments and changes in actuarial assumptions such as discount rate, rate of compensation increases, and mortality.
The principle underlying this required attribution approach is that employees render service over their service lives on a relatively smooth basis and, therefore, the impact on results of operations relative to the Companys defined benefit
pension plan is recognized in, and should follow, the same pattern.



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



One of the principal components of the defined benefit pension expense calculation is the expected
long-term rate of return on plan assets. The required use of expected long-term rates of return on plan assets may result in defined benefit pension expense that is greater or less than the actual returns of Plan assets in any given year. Over time,
however, expected long-term returns are designed to approximate the actual long-term returns and, therefore, result in a pattern of expense recognition that more closely matches the pattern of the services provided by the employees. Differences
between actual and expected returns are recognized in the calculation of defined benefit pension expense as provided for in SFAS No. 87. Expected returns on Plan assets are developed by the Company in conjunction with input from external
advisors and take into account long-term expectations for future returns and investment strategy.



The discount rate assumptions used for a defined benefit pension plan accounting reflect the prevailing rates and rolling returns available on Standard
and Poors 500 Stock Index for stocks and 5 Year Treasury Bonds for debt securities. The rate of compensation increase is another significant assumption used in the actuarial model for pension accounting and is determined by the Company, based
upon its plans for such increases. The company uses a January 1 measurement date for its pension plan.



In September 2006, the FASB issued SFAS No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans,
which amends SFAS No. 87 and SFAS No. 106 to require recognition of the overfunded or underfunded status of pension and other postretirement benefit plans on the balance sheet. Under SFAS No. 158, gains and losses, prior service costs
and credits, and any remaining transition amounts under SFAS No. 87 and SFAS No. 106 that have not yet been recognized through net periodic benefit cost will be recognized in accumulated other comprehensive income, net of tax effects,
until they are amortized as a component of net periodic cost. The measurement datethe date at which the benefit obligation and plan assets are measuredis required to be the companys fiscal year end. The recognition and disclosure
provisions of SFAS No. 158 differ for an employer that is an issuer of publicly traded equity securities (as defined by the Standard) and an employer that is not. As the Company does not meet the definition of an issuer of publicly traded
equity securities (as defined by the Standard) for purposes of this Standard, the Company is not required to recognize the funded status of a defined benefit postretirement plan and to provide the required disclosures until the end of the fiscal
year ending after June 15, 2007 with the exception of the provisions for the measurement date which are effective for fiscal years ending after December 15, 2008. The Company is currently evaluating the impact that the adoption of SFAS
No. 158 will have on its financial position, results of operations, and cash flows.



Cost of Benefit Plan.    The following table summarizes the combined adjusted postretirement benefit expense components for the Companys defined benefit pension plan, which is included in
Salaries and Other Personnel Expense on the Consolidated Statements of Income, at and for the periods indicated (in thousands).



|                                   |  |                                |        |   |      |        |   |      |      |  
|---------------------------------- |  | ------------------------------ | ------ | - | ---- | ------ | - | ---- | ---- | -
|                                   |  | For the year endedDecember 31, |       
|                                   |  | 2006                           |        |   | 2005 |        |   | 2004 |     
|Service cost                       |  | $                              | 898    |   |      | 644    |   |      | 557  |  
|Interest cost                      |  |                                | 849    |   |      | 731    |   |      | 653  |  
|Expected return on plan assets     |  |                                | (1,193 | ) |      | (1,089 | ) |      | (910 | )
|Amortization of prior service cost |  |                                | 4      |   |      | 9      |   |      | 9    |  
|Amortization of loss               |  |                                | 331    |   |      | 108    |   |      | 80   |  
|                                   |  |                                |        |   |      |        |   |      |      |  
|Postretirement benefit expense     |  | $                              | 889    |   |      | 403    |   |      | 389  |  
|                                   |  |                                |        |   |      |        |   |      |      |  



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



Plan Funded Status.    The following table summarizes the combined change in
benefit obligation, plan assets, and funded status of the Companys Plan at and for the years indicated (in thousands).



|                                                    |  |                                        |        |   |      |        |  
|--------------------------------------------------- |  | -------------------------------------- | ------ | - | ---- | ------ | -
|                                                    |  | At and for the yearsended December 31, |       
|                                                    |  | 2006                                   |        |   | 2005 |       
|Change in benefit obligation                        |  |                                        |        |   |      |        |  
|Benefit obligation, beginning of year               |  | $                                      | 14,274 |   |      | 10,542 |  
|Service cost                                        |  |                                        | 898    |   |      | 644    |  
|Interest cost                                       |  |                                        | 849    |   |      | 731    |  
|Actuarial loss and assumption changes               |  |                                        | 193    |   |      | 2,688  |  
|Benefits paid                                       |  |                                        | (435   | ) |      | (331   | )
|                                                    |  |                                        |        |   |      |        |  
|Benefit obligation, end of year                     |  |                                        | 15,779 |   |      | 14,274 |  
|                                                    |  |                                        |        |   |      |        |  
|Change in plan assets                               |  |                                        |        |   |      |        |  
|Fair market value of plan assets, beginning of year |  |                                        | 12,724 |   |      | 11,549 |  
|Return on plan assets                               |  |                                        | 850    |   |      | 307    |  
|Employer contribution                               |  |                                        | 1,233  |   |      | 1,199  |  
|Benefits paid                                       |  |                                        | (435   | ) |      | (331   | )
|                                                    |  |                                        |        |   |      |        |  
|Fair market value of plan assets, end of year       |  |                                        | 14,372 |   |      | 12,724 |  
|                                                    |  |                                        |        |   |      |        |  
|Reconciliation of funded status                     |  |                                        |        |   |      |        |  
|Funded status                                       |  |                                        | (1,407 | ) |      | (1,550 | )
|Unrecognized prior service cost                     |  |                                        | 5      |   |      | 9      |  
|Unrecognized net actuarial (gain) loss              |  |                                        | 6,761  |   |      | 6,067  |  
|                                                    |  |                                        |        |   |      |        |  
|Prepaid benefit cost                                |  | $                                      | 5,359  |   |      | 4,526  |  
|                                                    |  |                                        |        |   |      |        |  
|Accumulated benefit obligation                      |  | $                                      | 12,288 |   |      | 9,826  |  
|                                                    |  |                                        |        |   |      |        |  



Prepaid benefits costs
are included in Other Assets on the Consolidated Balance Sheets.



Plan Assumptions. The following table summarizes the assumptions used in computing the actuarial present value of the Companys postretirement benefit obligation and the net periodic pension expense for the years indicated.



|                                                 |  |                                |   |  |      |  |     
|------------------------------------------------ |  | ------------------------------ | - |  | ---- |  | ----
|                                                 |  | For the year endedDecember 31,
|                                                 |  | 2006                           |   |  | 2005 |  | 2004
|Discount rate                                    |  | 6.00                           | % |  | 7.00 |  | 7.50
|Rate of increase in compensation levels          |  | 5.00                           |   |  | 5.00 |  | 5.00
|Expected long-term rate of return on plan assets |  | 9.00                           |   |  | 9.00 |  | 9.00



Plan Assets. The
following table summarizes the Plans weighted average asset allocations at December 31, 2006 and 2005 and the target investment mix guidelines, by asset category.



|                  |  |              |   |                  |      |  |     |  
|----------------- |  | ------------ | - | ---------------- | ---- |  | --- | -
|                  |  | December 31, |   | Targetallocation |     
|                  |  | 2006         |   |                  | 2005 | 
|Equity securities |  | 65           | % |                  | 61   |  | 70  | %
|Debt securities   |  | 35           |   |                  | 39   |  | 30  |  
|                  |  |              |   |                  |      |  |     |  
|Total securities  |  | 100          | % |                  | 100  |  | 100 | %
|                  |  |              |   |                  |      |  |     |  



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



The investment objectives of the Plan assets are designed to maintain full funding with respect to
the projected benefit obligation and to maximize returns in order to minimize contributions within reasonable and prudent levels of risk. The precise amount for which these obligations will be settled depends on future events, including the life
expectancy of the Plans members and salary inflation. The obligations are estimated using actuarial assumptions, based on the current economic environment. The Plans investment strategy balances the requirement to generate return, using
higher-returning assets, with the need to control risk less volatile assets. Risks include, but are not limited to, inflation, volatility in equity values, and changes in interest rates that could cause the Plan to become underfunded, thereby
increasing the Plans dependence on contributions from the Company.



Plan assets are managed by professional investment firms as well as by investment professionals that are employees of the Company as approved by the Board of Directors. The Compensation Committee of the Board of
Directors is responsible for maintaining the investment policy of the Plan, approving the appointment of the investment manager, and reviewing the performance of the Plan assets at least annually.



Investments within the Plan are diversified with the intent to minimize the
risk of large losses to the Plan. As such, the total portfolio is constructed and maintained to provide prudent diversification within each investment category, and the Company assumes that the volatility of the portfolio will be similar to the
market as a whole. The asset allocation ranges represent a long-term perspective. As such, rapid unanticipated market shifts may cause the asset mix to fall outside the policy range. Such divergences should be short-term in nature.



Market liquidity risks are tightly controlled, with investments in common
stocks are targeted toward stocks of institutional quality and ones that are actively traded on major exchanges with market capitalization in excess of $100 million. In addition to these direct investments in individual securities, mutual funds and
pooled asset portfolios may be utilized. Foreign equity securities may account for up to 10% of the values presented for equity securities above. Fixed income investments included within the portfolio stress high quality and diversification by
sector with no inherent preferences for government or corporate issues. Investments are restricted to marketable issues with a minimum Moodys or Standard and Poors rating of A. Foreign bonds are not allowed under the
Plans investment policy. Additionally, the Companys investment policy for the Plan prohibits investments in real estate, commodity or commodity contracts, private placements, nonmarketable securities, and derivatives. Lending of
securities, margin transactions, short selling, or writing of options are also prohibited.



Expected Contributions. Contributions to Plan assets totaled $1.2 million during fiscal year 2006, and the Companys third party actuary estimates contributions during fiscal year 2007 will not fluctuate
significantly from 2006 levels.



Expected Benefit Payments. The
following table summarizes the benefits expected to be paid during the periods indicated (in thousands).



|                         |  |   |      
|------------------------ |  | - | -----
|Year ending December 31,
|2007                     |  | $ | 463  
|2008                     |  |   | 474  
|2009                     |  |   | 626  
|2010                     |  |   | 673  
|2011                     |  |   | 741  
|2012 - 2016              |  |   | 3,876
|                         |  |   |      
|                         |  | $ | 6,853
|                         |  |   |      



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



The expected benefits to be paid are based on the same assumptions used to measure the Companys
benefit obligation at December 31, 2006 and include estimated future employee service.



Stock Option Plans



Since 1987, the Company has adopted several plans pursuant to which the Companys Board of Directors may grant incentive and nonincentive stock options to certain key employees and directors of the Company. The Board determines the
option price and term of the options on the grant date. The option price must be at least 100% of fair market value as of the grant date, and the term of the options shall not be greater than 10 years. Because the Companys common stock is not
traded on an established market, the fair market value may be determined by an annual independent valuation. The only stock option plan currently in effect is the Palmetto Bancshares, Inc. 1997 Stock Compensation Plan. This plan originally provided
for the issuance of 175,000 common shares, which were doubled in conjunction with the 2000 stock split.



During the 2003 Annual Meeting of Shareholders, the shareholders of the Company voted to amend the Palmetto Bancshares, Inc. 1997 Stock Compensation Plan
to increase the number of shares of common stock of the Company subject to the 1997 Stock Compensation Plan by 100,000 shares. As of December 31, 2006, 449,200 options, net of cancellations, had been granted that expire at various dates through
December 31, 2015. Of these, 251,670 remained outstanding at December 31, 2006 at prices ranging from $8.75 to $27.30. These options are not granted in lieu of otherwise payable cash compensation. All options granted have a vesting term of
five years and an exercise period of ten years. At December 31, 2006 and 2005, there were 800 and 35,800 remaining options, respectively, available for grant under this plan.



Adoption of SFAS No. 123(R). Prior to January 1, 2006, the Company accounted for its 1997 Stock Compensation Plan
under the recognition and measurement provisions of APB No. 25 as permitted by SFAS No. 123 and SFAS No. 148. Prior to 2006, no stock-based employee compensation cost was recognized in the Consolidated Statements of Income for
options granted as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. Effective January 1, 2006, the Company adopted the fair value recognition provisions
of SFAS No. 123(R) using the modified prospective transition method. Under that transition method, compensation cost recognized in fiscal year 2006 includes compensation cost for all share-based payments vesting during 2006 that were granted
prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the original provisions of SFAS No. 123, and compensation cost for all share-based payments vesting during 2006 that were
granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123(R). Results for prior periods have not been restated.



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



The following table summarizes the impact on net income and net income per share as if the fair value
recognition provisions of SFAS No. 123 had been applied to all outstanding and unvested awards for the periods indicated (in thousand, except common and per share data). For purposes of this pro forma disclosure, the value of the options is
estimated using a Black-Scholes option-pricing formula and amortized to expense over the options vesting periods (in thousands, except per share data).



|                                                                                                                                    |  |                                 |        |   |      |        |   |      |        |  
|----------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ---- | ------ | - | ---- | ------ | -
|                                                                                                                                    |  | For the years endedDecember 31, |       
|                                                                                                                                    |  | 2006                            |        |   | 2005 |        |   | 2004 |       
|Net income, as reported                                                                                                             |  | $                               | 15,241 |   |      | 13,780 |   |      | 12,111 |  
|Add: stock-based compensation expense included in reported net income, net of related tax effects                                   |  |                                 | 156    |   |      |       |   |      |       |  
|                                                                                                                                    |  |                                 |       
|Deduct: stock-based compensation expense determined under fair market value based method for all awards, net of related tax
effects |  |                                 | (156   | ) |      | (120   | ) |      | (124   | )
|                                                                                                                                    |  |                                 |        |   |      |        |   |      |        |  
|Pro forma net income including stock-based compensation expense based on fair market value method                                   |  | $                               | 15,241 |   |      | 13,660 |   |      | 11,987 |  
|                                                                                                                                    |  |                                 |        |   |      |        |   |      |        |  
|Per Share Data                                                                                                                      |  |                                 |        |   |      |        |   |      |        |  
|Net incomebasic, as reported                                                                                                       |  | $                               | 2.40   |   |      | 2.18   |   |      | 1.93   |  
|Net incomebasic, pro forma                                                                                                         |  |                                 | 2.40   |   |      | 2.16   |   |      | 1.91   |  
|                                                                                                                                    |  |                                 |       
|Net incomediluted, as reported                                                                                                     |  | $                               | 2.37   |   |      | 2.15   |   |      | 1.90   |  
|Net incomediluted, pro forma                                                                                                       |  |                                 | 2.37   |   |      | 2.13   |   |      | 1.88   |  



Determining Fair Value



Valuation and Amortization Method. The Company estimates the
fair value of stock options granted using the Black-Scholes option-pricing formula. This fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period.



Dividend Yields. The Company estimates the expected dividend based on
historical dividends declared per year, giving consideration for any anticipated changes and the estimated stock price over the expected term based on historical experience when using the Black-Scholes option-pricing formula to determine the fair
value of options granted.



Expected Volatility. As noted in the
Item 5. Market For Registrants Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities, there is no established public trading market for the Companys stock. The Companys Secretary facilitates
stock trades of the Companys common stock by matching willing buyers and sellers that contact her with their intent. However, trades can be and are made that are not facilitated through the Secretary between willing buyers and sellers of which
the Company may have no record. Additionally, many of these transactions do not constitute arms length transactions as many of the transactions are between buyers and sellers with relationships that may lead to a sale at a price other than
fair market value. The Company believes that many trades are between buyers and sellers that are family members, that are family members of Company employees, or that are members of the community who may be willing to pay a premium for the stock of
a company headquartered in their community. Because of these factors, the Company does not believe that the prices at which the trades recorded by its Secretary are transacted can be considered fair market value, and, as a result, annually, a third
party fair market valuation is performed by an external third party on a minority block of the outstanding common shares of Palmetto Bancshares, Inc. for use in conjunction with stock options. The Company uses this fair market valuation of the
common stock in determining an estimated volatility factor when using the Black-Scholes option-pricing formula to determine the fair value of options granted.



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



Risk-Free Interest Rate. The Company bases the risk-free interest rate used in the Black-Scholes
option pricing formula on the implied yield currently available on U.S. Treasury zero coupon issues with the same or substantially equivalent remaining term as the expected term of the option.



Expected Term. The expected term represents the period that the
Companys stock-based awards are expected to be outstanding. The Company bases the expected term of options on its historical share option exercise experience as it believes this results in the best estimate of future exercise patterns.



The following table summarizes the stock-based awards granted
by the Company, the fair market value of each award granted as estimated on the date of grant using the Black-Scholes option-pricing model, and the weighted average assumptions used for such grants for the grant dates indicated.



|                                |  |            |        |   |           |       |           |        |           |       
|------------------------------- |  | ---------- | ------ | - | --------- | ----- | --------- | ------ | --------- | ------
|Grant Date                      |  | 10/17/2006 |        |   | 6/20/2006 |       | 1/17/2006 |        | 1/18/2005
|Awards granted                  |  |            | 20,000 |   |           | 5,000 |           | 10,000 |           | 33,000
|Option price                    |  | $          | 27.30  |   |           | 27.30 |           | 27.30  |           | 26.60 
|Fair market value of each award |  | $          | 4.29   |   |           | 4.79  |           | 3.39   |           | 5.19  
|                                |  |            |        |  
|Expected dividend yields        |  |            | 2.7    | % |           | 2.7   |           | 2.7    |           | 2.4   
|Expected volatility             |  |            | 5      | % |           | 5     |           | 5      |           | 16    
|Risk-free interest rate         |  |            | 5      | % |           | 5     |           | 4      |           | 4     
|Expected term (years)           |  |            | 10     |   |           | 10    |           | 10     |           | 9     
|Vesting period (years)          |  |            | 5      |   |           | 5     |           | 5      |           | 5     



Stock Option
Compensation Expense



The compensation cost that was charged
against pretax net income during 2006 for stock options was $163 thousand. The total income tax benefit recognized in the Consolidated Statements of Income with regard to the deductible portion of this compensation cost was $6 thousand. Management
estimated that forfeitures would not be significant and is recognizing compensation costs for all equity awards.



At December 31, 2006, based on options outstanding at that time, the total compensation cost related to nonvested stock option awards granted under
the Companys stock option plans but not yet recognized was $316 thousand. Stock option compensation expense is recognized on a straight-line basis over the vesting period of the option. This cost is expected to be recognized over a remaining
period of four years.



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



Stock Option Activity



The following table summarizes stock option activity for the Palmetto Bancshares, Inc. 1997 Stock Compensation Plan for the
periods indicated.



|                                 |  |                          |   |  |                                |      
|-------------------------------- |  | ------------------------ | - |  | ------------------------------ | -----
|                                 |  | Stock optionsoutstanding |   |  | Weighted-averageexercise price
|Outstanding at December 31, 2003 |  | 261,510                  |   |  | $                              | 12.95
|                                 |  |                          |   |  |                                |      
|Granted                          |  | 34,000                   |   |  |                                | 23.30
|Forfeited                        |  | (3,600                   | ) |  |                                | 13.00
|Exercised                        |  | (34,075                  | ) |  |                                | 10.80
|                                 |  |                          |   |  |                                |      
|Outstanding at December 31, 2004 |  | 257,835                  |   |  |                                | 14.59
|                                 |  |                          |   |  |                                |      
|Granted                          |  | 33,000                   |   |  |                                | 26.60
|Forfeited                        |  | (4,000                   | ) |  |                                | 13.50
|Exercised                        |  | (34,050                  | ) |  |                                | 11.20
|                                 |  |                          |   |  |                                |      
|Outstanding at December 31, 2005 |  | 252,785                  |   |  |                                | 16.63
|                                 |  |                          |   |  |                                |      
|Granted                          |  | 35,000                   |   |  |                                | 27.30
|Forfeited                        |  |                         |   |  |                                |     
|Exercised                        |  | (36,115                  | ) |  |                                | 12.77
|                                 |  |                          |   |  |                                |      
|Outstanding at December 31, 2006 |  | 251,670                  |   |  | $                              | 18.67
|                                 |  |                          |   |  |                                |      



The following table
summarizes information regarding stock options outstanding and exercisable at December 31, 2006.



|                         |  |                                             |  |                                                  |  |                               |       |                                             |         |                               |   |       |  |  |  | 
|------------------------ |  | ------------------------------------------- |  | ------------------------------------------------ |  | ----------------------------- | ----- | ------------------------------------------- | ------- | ----------------------------- | - | ----- |  |  |  | 
|                         |  |                                             |  | Options outstanding                              |  | Options exercisable          
|Range of exercise prices |  | Number ofstockoptionsoutstandingat 12/31/06 |  | Weighted-averageremainingcontractuallife (years) |  | Weighted-averageexerciseprice |       | Number ofstockoptionsexercisableat 12/31/06 |         | Weighted-averageexerciseprice
|$  8.75 to $  8.75       |  | 36,535                                      |  | 1.00                                             |  | $                             | 8.75  |                                             | 36,535  |                               | $ | 8.75 
|13.00 to   13.00         |  | 24,800                                      |  | 3.00                                             |  |                               | 13.00 |                                             | 24,800  |                               |   | 13.00
|13.50 to   13.50         |  | 20,200                                      |  | 4.00                                             |  |                               | 13.50 |                                             | 20,200  |                               |   | 13.50
|15.00 to   15.00         |  | 36,000                                      |  | 5.00                                             |  |                               | 15.00 |                                             | 36,000  |                               |   | 15.00
|20.00 to   23.30         |  | 69,735                                      |  | 6.49                                             |  |                               | 21.61 |                                             | 47,335  |                               |   | 21.42
|26.60 to   27.30         |  | 64,400                                      |  | 8.54                                             |  |                               | 26.98 |                                             | 16,600  |                               |   | 26.90
|                         |  |                                             |  |                                                  |  |                               |       |                                             |         |                               |   |       |  |  |  | 
|Total                    |  | 251,670                                     |  | 5.59                                             |  | $                             | 18.67 |                                             | 181,470 |                               | $ | 16.06
|                         |  |                                             |  |                                                  |  |                               |       |                                             |         |                               |   |       |  |  |  | 



Cash received from
stock option exercises under the Companys stock option plan for the year ended December 31, 2006 and 2005 was $461 thousand and $381 thousand, respectively.



401(k) Retirement Plan



Employees are given the opportunity to participate in the Companys retirement plan designed to supplement an employees retirement income.
Under the program, the Company makes contributions to a trust fund that will pay the employee benefits at retirement. Employees are eligible to participate in this plan after completing one year of service and reaching age 21. Employees may withhold
from one percent to fifteen percent of compensation with certain limitations for deposit into the trust fund. Employees may terminate deferrals at any time. The Company makes matching contributions to each employee based on the employees
deferral in a percentage set by the Company prior to the end of each plan year. During the years ended December 31, 2006,



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



2005, and 2004, the Company made matching contributions to employee 401(k) retirement plans totaling $257 thousand, $269 thousand, and $267 thousand,
respectively.



14.    Net
Income per Common Share



Basic earnings per
share, which excludes dilution, is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur
if securities or other contracts to issue common stock, such as stock options, result in the issuance of common stock that share in the earnings of the Company.



The following table summarizes the Companys reconciliation of the numerators and denominators of the basic and diluted net income per common
share computations for the periods indicated.



|                                                                |  |                                 |           |      |           |      |          
|--------------------------------------------------------------- |  | ------------------------------- | --------- | ---- | --------- | ---- | ---------
|                                                                |  | For the year ended December 31,
|                                                                |  | 2006                            |           | 2005 |           | 2004
|Weighted average common shares outstandingbasic                |  |                                 | 6,353,752 |      | 6,317,110 |      | 6,272,594
|Dilutive impact resulting from potential common share issuances |  |                                 | 67,990    |      | 100,248   |      | 106,193  
|                                                                |  |                                 |           |      |           |      |          
|Weighted average common shares outstandingdiluted              |  |                                 | 6,421,742 |      | 6,417,358 |      | 6,378,787
|                                                                |  |                                 |           |      |           |      |          
|Common Share Data                                               |  |                                 |           |      |           |      |          
|Net incomebasic                                                |  | $                               | 2.40      |      | 2.18      |      | 1.93     
|Net incomediluted                                              |  |                                 | 2.37      |      | 2.15      |      | 1.90     



At December 31,
2006, there were no option shares excluded from the calculation of diluted net income per common share because the exercise price was greater than the average market price as determined by an independent valuation of common shares.



The Company paid cash dividends of $0.73, $0.66, and $0.58 per share for the
years ended December 31, 2006, 2005, and 2004, respectively.



15.    Commitments and Contingencies



Legal Proceedings



The Company is currently subject to various legal proceedings and claims that have arisen in the ordinary course of its business. In the opinion of
management, based on consultation with external legal counsel, any reasonably foreseeable outcome of such current litigation would not materially impact the Companys financial condition or results of operations.



Lease Agreements



At December 31, 2006, the Company occupied banking office space and
land under leases expiring on various dates through 2029. The following table summarizes minimum rental commitments under these noncancelable operating leases relative to the years ending after December 31, 2006 (in thousands).



|                                                                      |  |   |      
|--------------------------------------------------------------------- |  | - | -----
|2007                                                                  |  | $ | 743  
|2008                                                                  |  |   | 614  
|2009                                                                  |  |   | 467  
|2010                                                                  |  |   | 231  
|2011                                                                  |  |   | 114  
|Subsequent years                                                      |  |   | 31   
|                                                                      |  |   |      
|Total minimum rental obligations under noncancelable operating leases |  | $ | 2,200
|                                                                      |  |   |      



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



During 2006, the Company announced its plan to relocate its headquarters to downtown Greenville in
2008. As such, the real property operating lease obligations in the preceding table include the Companys obligations under its current lease with regard to its East North Street banking office. No real property operating lease obligations
related to the new corporate headquarters are included in the preceding table due to the fact that the Company is currently in negotiations with regards to such obligations.



Such leases often have options for extensions under substantially the same terms as in the original lease period with
certain rate escalations. The leases typically provide that the lessee pay property taxes, insurance, and maintenance costs. The above lease payments do not include option terms that the Company may elect not to exercise and, therefore, are not
deemed to be commitments by the Company.



During the third
quarter of 2005, the Company entered into a lease for real property and improvements in Spartanburg to which to move its current Blackstock Road banking office. The Company completed this move during December 2005. During the first quarter of 2006,
the Bank completed negotiations with a third party with regard to the sublease of its previous Blackstock Road banking office location. Also during the first quarter of 2006, the Bank entered into a one-year lease agreement with regard to the
banking office used temporarily during the construction of the new Boiling Springs banking office opened in 2006.



During January 2007, the Bank entered into a ground lease agreements for leased property at which the Company will house a new ATM. This ground lease is
located in a market area that the Company currently serves.



See Note 5 for further discussion regarding the Companys lease agreements related to its premises and equipment.



The Company enters into agreements with third parties with respect to the leasing, servicing, and maintenance of equipment. However, because the Company
believes that these agreements are immaterial when considered individually, or in the aggregate, with regard to the Companys Consolidated Financial Statements, the Company has not included such agreements in this analysis. As such, management
believes that noncompliance with terms of such agreements would not have a material impact on the Companys financial condition or results of operations. Furthermore, as most such commitments are entered into for a 12-month period with option
extensions, costs beyond 2007 cannot be reasonably estimated at this time.



Lending Commitments



In
the normal course of business, the Company makes contractual commitments to extend credit that are legally binding agreements to lend money to customers at predetermined interest rates for a specific period of time. The Company also provides standby
letters of credit. These lending commitments are provided to customers in the normal course of business, and the Companys credit policies and standards are applied when making these commitments. These instruments are not recorded until funds
are advanced under the commitments.



For commercial customers,
lending commitments typically take the form of revolving credit arrangements to finance customers working capital requirements. For retail customers, lending commitments are lines of credit secured by residential property. Generally, unused
lending commitments are at adjustable-rates that fluctuate with the prime rate or are at fixed-rates that approximate market rates.



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



The following table summarizes the Companys contractual commitments to extend credit, by
collateral type, at December 31, 2006 (in thousands).



|                                                     |  |   |        
|---------------------------------------------------- |  | - | -------
|Commercial and industrial                            |  | $ | 32,377 
|                                                     | 
|Real estate1 - 4 family                             |  |   | 81,571 
|Real estateconstruction                             |  |   | 9,232  
|Real estateother                                    |  |   | 83,850 
|                                                     |  |   |        
|Total contractual commitments secured by real estate |  |   | 174,653
|                                                     | 
|Bankcards                                            |  |   | 39,756 
|Others                                               |  |   | 19,025 
|                                                     |  |   |        
|Total contractual commitments                        |  | $ | 265,811
|                                                     |  |   |        



Guarantees



Standby letters of credit represent an obligation of the
Company to a third party contingent upon the failure of the Companys customer to perform under the terms of an underlying contract with the third party or an obligation of the Company to guarantee or stand as surety for the benefit of the
third party. The underlying contract may entail either financial or nonfinancial obligations and may involve such things as the customers delivery of merchandise, completion of a construction contract, release of a lien, or repayment of an
obligation. Under the terms of a standby letter of credit, generally, drafts will be drawn only when the underlying event fails to occur. The Company can seek recovery of the amounts paid from the borrower. However, standby letters of credit are
generally not collateralized. The Company has reflected in its policy regarding such commitments that collateral is encouraged with exceptions requiring approval. The Company applies the same credit standards used in the lending process when
extending these commitments and periodically reassesses the customers creditworthiness through ongoing credit reviews. Commitments under standby letters of credit are usually for one year or less. At December 31, 2006, the Company
recorded no liability for the current carrying amount of the obligation to perform as a guarantor, and no contingent liability was considered necessary as such amounts were not considered material. The maximum potential amount of undiscounted future
payments related to standby letters of credit at December 31, 2006 was $8.3 million compared with $2.2 million at December 31, 2005. Past experience indicates that these standby letters of credit will expire unused. However, through its
various sources of liquidity, the Company believes that it has the necessary resources available to meet these obligations should the need arise. Additionally, the Company does not believe that the current fair market value of such guarantees was
material at December 31, 2006.



Other Off-Balance Sheet
Arrangements



At December 31, 2006, the Company had
no interest in nonconsolidated special purpose entities nor was it involved in other off-balance sheet contractual relationships, unconsolidated related entities that have off-balance sheet arrangements, or transactions that could result in
liquidity needs (other than those discussed herein).



At
December 31, 2006, of its approximately $103 million available credit based on qualifying loans to serve as collateral against short-term or long-term borrowings from the FHLB, the Company employed $10.0 million in borrowings, all of which was
determined to be long-term when employed and employed $79.0 million in a letter of credit. FHLB letters of credit provide an attractive alternative to using traditional collateral for various transactions. Advantages of FHLB letters of credit
include enhancing member liquidity (substituting letter of credit for securities as collateralization of public unit deposits) and utilization of residential mortgage loans as



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



collateral for the letters of credit. However, the utilization of FHLB letters of credit reduces the Companys available credit based on qualifying
loans to serve as collateral. The Company uses the FHLB letter of credit for collateralization of public deposits.



16.Derivative Financial Instruments and Hedging Activities



At December 31, 2006, the Companys derivative instruments
consisted of forward sales commitments relating to the Companys commitments to originate certain residential loans held for sale.



The Company originates certain residential loans with the intention of selling these loans. Between the time that the Company enters into an interest rate
lock or a commitment to originate a fixed-rate residential loan with a potential borrower and the time the closed loan is sold, the Company is subject to variability in market prices. The Company believes that it is prudent to limit the variability
of expected proceeds from the sales through forward sales of loans.



Outstanding commitments on mortgage loans not yet closed (primarily single-family loan commitments) amounted to approximately $3.8 million at December 31, 2006. The fair market value of derivative assets related to commitments to
originate such residential loans held for sale and forward sales commitments was not significant at December 31, 2006.



Commitments to extend credit are agreements to lend to borrowers absent any violation of the conditions established by the commitment letter. Commitments
generally have fixed expiration dates or other termination clauses. The majority of commitments are funded within a 12-month period. The Company evaluates each customers creditworthiness on a case-by-case basis. The amount of collateral
obtained is based on managements credit evaluation of the borrower. Collateral held consists of residential properties.



See Note 1 for further discussion regarding the Companys significant accounting policies with regard to the Companys derivative instruments.



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



17.    Disclosures Regarding Fair Market Value of Financial
Instruments



The Company has used managements
best estimate of fair value based on the assumptions summarized in Note 1. Thus, the fair values presented may not be the amounts that could be realized in an immediate sale or settlement of the instrument. Additionally, changes in assumptions could
significantly impact the fair market values presented. Further, any income taxes or other expenses, which would be incurred in an actual sale or settlement, are not taken into consideration in the fair values presented. The following table
summarizes the estimated fair market value of the Companys financial instruments at the dates indicated (in thousands).



|                                         |  |                   |         |                           |         |                |         |                           |        
|---------------------------------------- |  | ----------------- | ------- | ------------------------- | ------- | -------------- | ------- | ------------------------- | -------
|                                         |  | December 31, 2006 |         | December 31, 2005        
|                                         |  | Carryingamount    |         | Estimatedfairmarket value |         | Carryingamount |         | Estimatedfairmarket value
|ASSETS                                   |  |                   |         |                           |         |                |         |                           |        
|Cash and cash equivalents                |  | $                 | 46,666  |                           | 46,666  |                | 37,976  |                           | 37,976 
|FHLB stock                               |  |                   | 2,599   |                           | 2,599   |                | 3,786   |                           | 3,786  
|Investment securities available for sale |  |                   | 116,567 |                           | 116,567 |                | 125,988 |                           | 125,988
|Loans (1)                                |  |                   | 947,588 |                           | 949,662 |                | 871,002 |                           | 867,594
|                                         |  |                   |         |                          
|LIABILITIES                              |  |                   |         |                           |         |                |         |                           |        
|Deposits                                 |  | $                 | 993,581 |                           | 997,883 |                | 903,383 |                           | 895,483
|Borrowings                               |  |                   |         |                           |         |                |         |                           |        
|Retail repurchase agreements             |  |                   | 14,427  |                           | 14,427  |                | 16,728  |                           | 16,728 
|Commercial paper                         |  |                   | 20,988  |                           | 20,988  |                | 17,915  |                           | 17,915 
|Federal funds purchased                  |  |                   | 6,000   |                           | 6,000   |                | 1,000   |                           | 1,000  
|FHLB borrowingsshortterm               |  |                   |        |                           |        |                | 16,900  |                           | 16,900 
|FHLB borrowingslongterm                |  |                   | 10,000  |                           | 10,044  |                | 23,000  |                           | 23,122 
|                                         |  |                   |         |                          
|OFF-BALANCE SHEET FINANCIAL INSTRUMENTS  |  |                   |         |                           |         |                |         |                           |        
|Commitments to extend credit             |  | $                 | 265,811 |                           | 265,811 |                | 197,777 |                           | 197,777
|Standby letters of credit                |  |                   | 8,341   |                           | 8,341   |                | 2,189   |                           | 2,189  

---

|(1) |  | Calculated using loans including mortgage loans held for sale, net of unearned income, excluding the allowance for loan losses
|--- |  | ------------------------------------------------------------------------------------------------------------------------------



18.    Holding Company Condensed Financial
Information



The holding companys principal
source of income consists of dividends from the Bank. South Carolina banking regulations restrict the amount of dividends that a subsidiary bank can pay to its holding company and may require prior approval before declaration and payment of any
excess dividend. The Banks total risk-based capital ratio at December 31, 2006 was 10.19%. See Note 19 for further discussion regarding regulatory capital requirements. At December 31, 2006, the Bank had approximately $1.9 million of
excess capital available for payment of dividends and still be considered well capitalized with regard to the total risk-based capital ratio.



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



The holding companys principal asset is its investment in its banking subsidiary. The following
tables summarize the holding companys financial condition, results of operations, and cash flows at and for the dates indicated (in thousands).



Condensed Balance Sheets



|                                           |  |              |         |      |        
|------------------------------------------ |  | ------------ | ------- | ---- | -------
|                                           |  | December 31,
|                                           |  | 2006         |         | 2005
|ASSETS                                     |  |              |         |      |        
|Cash and cash equivalents                  |  | $            | 118     |      | 875    
|Due from subsidiary                        |  |              | 20,988  |      | 17,915 
|Investment in subsidiary                   |  |              | 99,554  |      | 87,362 
|Goodwill                                   |  |              | 704     |      | 704    
|                                           |  |              |         |      |        
|Total assets                               |  | $            | 121,364 |      | 106,856
|                                           |  |              |         |      |        
|LIABILITIES AND SHAREHOLDERS EQUITY       |  |              |         |      |        
|Commercial paper (Master notes)            |  | $            | 20,988  |      | 17,915 
|Shareholders equity                       |  |              | 100,376 |      | 88,941 
|                                           |  |              |         |      |        
|Total liabilities and shareholders equity |  | $            | 121,364 |      | 106,856
|                                           |  |              |         |      |        



Condensed Statements
of Income



|                                                      |  |                                 |        |   |      |        |   |      |        |  
|----------------------------------------------------- |  | ------------------------------- | ------ | - | ---- | ------ | - | ---- | ------ | -
|                                                      |  | For the years endedDecember 31, |       
|                                                      |  | 2006                            |        |   | 2005 |        |   | 2004 |       
|Interest income from commercial paper (Master notes)  |  | $                               | 867    |   |      | 439    |   |      | 124    |  
|Dividends received from the Bank                      |  |                                 | 3,432  |   |      | 4,171  |   |      | 3,642  |  
|Equity in undistributed earnings of subsidiary        |  |                                 | 11,981 |   |      | 9,609  |   |      | 8,469  |  
|Interest expense on commercial paper (Master notes)   |  |                                 | (867   | ) |      | (439   | ) |      | (124   | )
|Other operating income                                |  |                                 | 43     |   |      |       |   |      |       |  
|Compensation expense related to stock options granted |  |                                 | (163   | ) |      |       |   |      |       |  
|Other operating expense                               |  |                                 | (52    | ) |      |       |   |      |       |  
|                                                      |  |                                 |        |   |      |        |   |      |        |  
|Net income                                            |  | $                               | 15,241 |   |      | 13,780 |   |      | 12,111 |  
|                                                      |  |                                 |        |   |      |        |   |      |        |  



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



Condensed Statements of Cash Flows



|                                                                                 |  |                                 |         |   |      |        |   |      |        |  
|-------------------------------------------------------------------------------- |  | ------------------------------- | ------- | - | ---- | ------ | - | ---- | ------ | -
|                                                                                 |  | For the years endedDecember 31, |        
|                                                                                 |  | 2006                            |         |   | 2005 |        |   | 2004 |       
|Cash flows from operating activities                                             |  |                                 |         |   |      |        |   |      |        |  
|Net income                                                                       |  | $                               | 15,241  |   |      | 13,780 |   |      | 12,111 |  
|Adjustments to reconcile net income to net cash provided by operating activities |  |                                 |         |   |      |        |   |      |        |  
|Increase in due from subsidiary                                                  |  |                                 | (3,073  | ) |      | (864   | ) |      | (881   | )
|Compensation expense related to stock options granted                            |  |                                 | 163     |   |      |       |   |      |       |  
|Increase in equity in undistributed earnings of subsidiary                       |  |                                 | (11,981 | ) |      | (9,609 | ) |      | (8,469 | )
|                                                                                 |  |                                 |         |   |      |        |   |      |        |  
|Net cash provided by operating activities                                        |  |                                 | 350     |   |      | 3,307  |   |      | 2,761  |  
|                                                                                 |  |                                 |        
|Cash flows from financing activities                                             |  |                                 |         |   |      |        |   |      |        |  
|Net increase in commercial paper                                                 |  |                                 | 3,073   |   |      | 864    |   |      | 881    |  
|Proceeds from stock option activity                                              |  |                                 | 461     |   |      | 381    |   |      | 368    |  
|Dividends paid                                                                   |  |                                 | (4,641  | ) |      | (4,171 | ) |      | (3,642 | )
|                                                                                 |  |                                 |         |   |      |        |   |      |        |  
|Net cash used in financing activities                                            |  |                                 | (1,107  | ) |      | (2,926 | ) |      | (2,393 | )
|                                                                                 |  |                                 |        
|Net increase (decrease) in cash and cash equivalents                             |  |                                 | (757    | ) |      | 381    |   |      | 368    |  
|Cash and cash equivalents, beginning of the year                                 |  |                                 | 875     |   |      | 494    |   |      | 126    |  
|                                                                                 |  |                                 |         |   |      |        |   |      |        |  
|Cash and cash equivalents, end of the year                                       |  | $                               | 118     |   |      | 875    |   |      | 494    |  
|                                                                                 |  |                                 |         |   |      |        |   |      |        |  



19.    Dividend Restrictions and Regulatory Capital Requirements



The ability of the holding company to pay cash dividends over the long-term is dependent upon receiving cash in the form of dividends from the Bank. South
Carolinas banking regulations restrict the amount of dividends that the Bank can pay. All dividends paid from the Bank are payable only from the net income of the current year unless prior regulatory approval is granted. Capital requirements
considerations could further limit the availability of dividends from the Bank.



The Federal Reserve has adopted risk-based capital guidelines for bank holding companies. Under these guidelines, the minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet
activities) is 8%. At least half of the total capital is required to be Tier 1 capital, principally consisting of common shareholders equity, noncumulative preferred stock, a limited amount of cumulative perpetual preferred stock, and minority
interests in the equity accounts of consolidated subsidiaries, less certain goodwill items. The remainder, known as Tier 2 capital, may consist of a limited amount of subordinated debt and intermediate term preferred stock, certain hybrid capital
instruments and other debt securities, perpetual preferred stock, and a limited amount of the general allowance for loan losses. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet items, are multiplied
by a risk-weight ranging from 0% to 100% based on the risk inherent in the type of asset. In addition to the risk-based capital guidelines, the Federal Reserve has adopted a minimum Tier 1 (leverage) capital ratio under which a bank holding
company must maintain a minimum level of Tier 1 capital (as determined under applicable rules) to average total consolidated assets of at least 3% in the case of bank holding companies that have the highest regulatory examination ratios and are not
contemplating significant growth or expansion. All other bank holding companies are required to maintain a Tier 1 (leverage) capital ratio of at least 4%.



122



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



The Bank is subject to capital requirements imposed by the Federal Deposit Insurance Corporation (the
FDIC). The FDIC requires state-chartered, nonmember banks to comply with risk-based capital standards substantially similar to those required by the Federal Reserve. The FDIC also requires state-chartered, nonmember banks to maintain a
minimum leverage ratio similar to that adopted by the Federal Reserve. Under the FDICs leverage capital requirement, state-chartered, nonmember banks that receive the highest rating during the examination process and are not anticipating or
experiencing any significant growth are required to maintain a minimum Tier 1 (leverage) capital ratio of 3%. All other banks are required to maintain an absolute minimum Tier 1 (leverage) capital ratio of not less than 4%.



Failure to meet minimum capital requirements can initiate certain mandatory
and discretionary actions by regulators that, if undertaken, could have a material impact on the Companys financial condition and results of operations. Under capital requirements guidelines and the regulatory framework for prompt corrective
regulatory action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of the assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The
Companys and the Banks capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk-weightings, and other factors.



At December 31, 2006, the most recent notification from federal banking agencies categorized the Company and the Bank
as well capitalized under the regulatory framework. To be categorized as well capitalized, minimum total risk-based capital, Tier 1 capital, and Tier 1 leverage ratios as set forth in the following table (dollars in thousands) must be
maintained. Since December 31, 2006, there have been no events or conditions that management believes would change these categories.



|                                       |  |        |         |       |                              |   |                                                               |        |       |      |        |         |       |      
|-------------------------------------- |  | ------ | ------- | ----- | ---------------------------- | - | ------------------------------------------------------------- | ------ | ----- | ---- | ------ | ------- | ----- | -----
|                                       |  | Actual |         |       | For capitaladequacy purposes |   | To be wellcapitalized underprompt corrective actionprovisions
|                                       |  | amount |         | ratio |                              |   | amount                                                        |        | ratio |      | amount |         | ratio
|At December 31, 2006                   |  |        |         |       |                              |   |                                                               |        |       |      |        |         |       |      
|Total capital to risk-weighted assets  |  |        |         |       |                              |   |                                                               |        |       |      |        |         |       |      
|Company                                |  | $      | 105,515 |       | 10.19                        | % |                                                               | 82,824 |       | 8.00 |        | n/a     |       | n/a  
|Bank                                   |  |        | 105,397 |       | 10.18                        |   |                                                               | 82,824 |       | 8.00 |        | 103,530 |       | 10.00
|Tier 1 capital to risk-weighted assets |  |        |         |       |                              |   |                                                               |        |       |      |        |         |       |      
|Company                                |  |        | 96,988  |       | 9.37                         |   |                                                               | 41,412 |       | 4.00 |        | n/a     |       | n/a  
|Bank                                   |  |        | 96,870  |       | 9.36                         |   |                                                               | 41,412 |       | 4.00 |        | 62,118  |       | 6.00 
|Tier 1 capital to average assets       |  |        |         |       |                              |   |                                                               |        |       |      |        |         |       |      
|Company                                |  |        | 96,988  |       | 8.59                         |   |                                                               | 45,166 |       | 4.00 |        | n/a     |       | n/a  
|Bank                                   |  |        | 96,870  |       | 8.58                         |   |                                                               | 45,166 |       | 4.00 |        | 56,458  |       | 5.00 
|                                       |  |        |         |       |                              |  
|At December 31, 2005                   |  |        |         |       |                              |   |                                                               |        |       |      |        |         |       |      
|Total capital to risk-weighted assets  |  |        |         |       |                              |   |                                                               |        |       |      |        |         |       |      
|Company                                |  | $      | 94,149  |       | 10.28                        | % |                                                               | 73,297 |       | 8.00 |        | n/a     |       | n/a  
|Bank                                   |  |        | 93,272  |       | 10.18                        |   |                                                               | 73,297 |       | 8.00 |        | 91,621  |       | 10.00
|Tier 1 capital to risk-weighted assets |  |        |         |       |                              |   |                                                               |        |       |      |        |         |       |      
|Company                                |  |        | 85,718  |       | 9.36                         |   |                                                               | 36,648 |       | 4.00 |        | n/a     |       | n/a  
|Bank                                   |  |        | 84,841  |       | 9.26                         |   |                                                               | 36,648 |       | 4.00 |        | 54,972  |       | 6.00 
|Tier 1 capital to average assets       |  |        |         |       |                              |   |                                                               |        |       |      |        |         |       |      
|Company                                |  |        | 85,718  |       | 8.08                         |   |                                                               | 42,422 |       | 4.00 |        | n/a     |       | n/a  
|Bank                                   |  |        | 84,841  |       | 7.99                         |   |                                                               | 42,450 |       | 4.00 |        | 53,063  |       | 5.00 



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



The Company has risk management policies and systems which attempt to monitor and limit exposure to
interest rate risk. Specifically, the Company manages its exposure to fluctuations in interest rates through policies established by its Asset / Liability Committee and approved by its Board of Directors. The primary goal of the Asset / Liability
Committee is to monitor and limit exposure to interest rate risk through implementation of various strategies. While the Asset / Liability Committee considers these strategies to ultimately position the balance sheet to minimize fluctuations in
income associated with interest rate risk, it also monitors the Companys liquidity and capital positions to ensure that its strategies result in adequate capital positions. The Companys primary source of capital has been the retention of
net income. In order to ensure adequate levels of capital, an ongoing assessment is conducted of projected sources and uses of capital in conjunction with projected increases in assets and the level of risk. Management believes it has adequate
capital to meet its needs without entering capital markets.



20.Quarterly Financial Data (Unaudited)



The following tables summarize selected financial data regarding results of operations for the periods indicated (in thousands, except common share data).



|                                                    |  |                                      |        |               |        |              |        |               |        |       |       
|--------------------------------------------------- |  | ------------------------------------ | ------ | ------------- | ------ | ------------ | ------ | ------------- | ------ | ----- | ------
|                                                    |  | For the year ended December 31, 2006
|                                                    |  | Firstquarter                         |        | Secondquarter |        | Thirdquarter |        | Fourthquarter |        | Total
|Interest income                                     |  | $                                    | 17,948 |               | 18,769 |              | 19,577 |               | 20,152 |       | 76,446
|Interest expense                                    |  |                                      | 5,853  |               | 6,601  |              | 7,242  |               | 7,601  |       | 27,297
|                                                    |  |                                      |        |               |        |              |        |               |        |       |       
|Net interest income                                 |  |                                      | 12,095 |               | 12,168 |              | 12,335 |               | 12,551 |       | 49,149
|Provision for loan losses                           |  |                                      | 525    |               | 525    |              | 275    |               | 300    |       | 1,625 
|                                                    |  |                                      |        |               |        |              |        |               |        |       |       
|Net interest income after provision for loan losses |  |                                      | 11,570 |               | 11,643 |              | 12,060 |               | 12,251 |       | 47,524
|                                                    |  |                                      |        |               |        |              |        |               |        |       |       
|Investment secuities gains                          |  |                                      | 2      |               | 1      |              |       |               | 31     |       | 34    
|Other noninterest income                            |  |                                      | 3,901  |               | 3,975  |              | 3,805  |               | 4,799  |       | 16,480
|Noninterest expense                                 |  |                                      | 10,066 |               | 10,085 |              | 10,026 |               | 10,658 |       | 40,835
|                                                    |  |                                      |        |               |        |              |        |               |        |       |       
|Net income before provision for income taxes        |  |                                      | 5,407  |               | 5,534  |              | 5,839  |               | 6,423  |       | 23,203
|Provision for income taxes                          |  |                                      | 1,757  |               | 1,803  |              | 2,038  |               | 2,364  |       | 7,962 
|                                                    |  |                                      |        |               |        |              |        |               |        |       |       
|Net income                                          |  | $                                    | 3,650  |               | 3,731  |              | 3,801  |               | 4,059  |       | 15,241
|                                                    |  |                                      |        |               |        |              |        |               |        |       |       
|Per Share Data                                      |  |                                      |        |               |        |              |        |               |        |       |       
|Net incomebasic                                    |  | $                                    | 0.58   |               | 0.59   |              | 0.60   |               | 0.63   |       | 2.40  
|                                                    |  |                                      |        |               |        |              |        |               |        |       |       
|Net incomediluted                                  |  | $                                    | 0.57   |               | 0.58   |              | 0.59   |               | 0.63   |       | 2.37  
|                                                    |  |                                      |        |               |        |              |        |               |        |       |       



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



|                                                    |  |                                      |        |               |        |              |        |               |        |       |       
|--------------------------------------------------- |  | ------------------------------------ | ------ | ------------- | ------ | ------------ | ------ | ------------- | ------ | ----- | ------
|                                                    |  | For the year ended December 31, 2005
|                                                    |  | Firstquarter                         |        | Secondquarter |        | Thirdquarter |        | Fourthquarter |        | Total
|Interest income                                     |  | $                                    | 14,289 |               | 15,497 |              | 16,255 |               | 16,742 |       | 62,783
|Interest expense                                    |  |                                      | 3,476  |               | 3,943  |              | 4,789  |               | 5,071  |       | 17,279
|                                                    |  |                                      |        |               |        |              |        |               |        |       |       
|Net interest income                                 |  |                                      | 10,813 |               | 11,554 |              | 11,466 |               | 11,671 |       | 45,504
|Provision for loan losses                           |  |                                      | 600    |               | 600    |              | 600    |               | 600    |       | 2,400 
|                                                    |  |                                      |        |               |        |              |        |               |        |       |       
|Net interest income after provision for loan losses |  |                                      | 10,213 |               | 10,954 |              | 10,866 |               | 11,071 |       | 43,104
|                                                    |  |                                      |        |               |        |              |        |               |        |       |       
|Investment secuities gains                          |  |                                      | 54     |               | 15     |              | 12     |               | 1      |       | 82    
|Other noninterest income                            |  |                                      | 3,637  |               | 3,923  |              | 3,830  |               | 3,930  |       | 15,320
|Noninterest expense                                 |  |                                      | 8,776  |               | 9,557  |              | 9,712  |               | 9,739  |       | 37,784
|                                                    |  |                                      |        |               |        |              |        |               |        |       |       
|Net income before provision for income taxes        |  |                                      | 5,128  |               | 5,335  |              | 4,996  |               | 5,263  |       | 20,722
|Provision for income taxes                          |  |                                      | 1,717  |               | 1,788  |              | 1,673  |               | 1,764  |       | 6,942 
|                                                    |  |                                      |        |               |        |              |        |               |        |       |       
|Net income                                          |  | $                                    | 3,411  |               | 3,547  |              | 3,323  |               | 3,499  |       | 13,780
|                                                    |  |                                      |        |               |        |              |        |               |        |       |       
|Per Share Data                                      |  |                                      |        |               |        |              |        |               |        |       |       
|Net incomebasic                                    |  | $                                    | 0.54   |               | 0.56   |              | 0.53   |               | 0.55   |       | 2.18  
|                                                    |  |                                      |        |               |        |              |        |               |        |       |       
|Net incomediluted                                  |  | $                                    | 0.53   |               | 0.55   |              | 0.52   |               | 0.55   |       | 2.15  
|                                                    |  |                                      |        |               |        |              |        |               |        |       |       



21.Related Party Transactions



SFAS No. 57, Related Party Disclosures, provides guidance regarding transactions with related parties. Transactions between related parties commonly occur in the normal course of business and are
considered to be related party transactions even though they may not be given accounting recognition.



Generally accepted accounting principles require certain disclosures regarding material related party transactions. Financial statements must include
disclosures of material related party transactions, other than compensation arrangements, expense allowances, and other similar items in the ordinary course of business. Related party transactions deemed to be material and not in the ordinary course
of the Companys business are described below. Although determined to be in the normal course of business, extensions of credit to related parties are described below.



Intercompany Transactions



The Companys trust department manages the Companys employee benefit plans



The Company has determined that the Companys trust department is considered related with respect to SFAS
No. 57 disclosure requirements due to the fact that the department manages the assets of the Companys applicable employee benefit plans.



Transactions of Management and Others



The Bank is subject to certain restrictions on extensions of credit to certain of the Companys officers, directors, principal shareholders, or any
related interest of such persons of both the Company and the Bank. Extensions of credit to such persons must be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable
transactions with unaffiliated persons, and transactions must not involve more than the normal risk of repayment or present other unfavorable features. Aggregate



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PALMETTO BANCSHARES, INC. AND SUBSIDIARY



Notes To Consolidated Financial Statements(Continued)



limitations on extensions of credit also may apply. The Bank is also subject to certain lending limits and restrictions on overdrafts to such persons.



Although determined to be in the normal course of business,
certain of the Companys Directors and Named Executive Officers are also customers who, including their related interests, were indebted to the Company in the approximate amounts of $16.8 million at December 31, 2006. Directors and Named
Executive Officers at December 31, 2005 were indebted to the Company in the approximate amounts of $16.7 million at December 31, 2005. Such indebtedness does not include bankcard balances, as these balances are deemed to be immaterial, nor
is it adjusted for joint guarantor relationships. From January 1, 2006 through December 31, 2006, these Directors and Named Executive Officers and their related interests were given credit extensions and received disbursements on existing
borrowings totaling $1.3 million and repaid $1.2 million. A portion of these new and repaid loans may have been the result of refinancing activity during the year.



Certain Business Relationships



From time to time the Company makes payments to related parties as defined above for property or services. Required
disclosures relating to such relationships are set forth in the definitive Proxy Statement of the Company filed in connection with its 2007 Annual Meeting of the Shareholders, which is incorporated herein by reference.



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Item 9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosure



None.



Item 9A.Controls and Procedures



Evaluation of Disclosure Controls and Procedures



An evaluation of the Companys disclosure controls and procedures (as defined in Section 13(a)-14(c) of the Securities Exchange Act of 1934) was
carried out under the supervision and with the participation of the Companys Chief Executive Officer, the President and Chief Operating Officer (Chief Accounting Officer) and several other members of the Companys senior management as of
December 31, 2006, the last day of the period covered by this Annual Report. The Companys Chief Executive Officer and the President and Chief Operating Officer (Chief Accounting Officer) concluded that the Companys disclosure
controls and procedures were effective as of December 31, 2006 in ensuring that the information required to be disclosed by the Company in the reports it files or submits under the Securities Exchange Act of 1934 is (i) accumulated and
communicated to the Companys management (including the Chief Executive Officer and the President and Chief Operating Officer (Chief Accounting Officer)) in a timely manner, and is (ii) recorded, processed, summarized, and reported within
the time periods specified in the SECs rules and forms.



See Item 8. Financial Statements and Supplementary Data which include managements report on internal control over financial reporting and the attestation report thereon issued by Elliott Davis, LLC.



During the fourth quarter of 2006, the Company did not make any changes in
its internal controls over financial reporting that has materially affected is reasonably likely to materially affect those controls.



Item 9B.Other Information



None.



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Part III



Item 10.Directors, Executive Officers and Corporate Governance



The information required by this item is set forth in the definitive Proxy Statement of the Company filed in connection with its 2007 Annual Meeting of
the Shareholders, which is incorporated herein by reference.



Item 11.Executive Compensation



The information required by this item is set forth in the definitive Proxy Statement of the Company filed in connection with its 2007 Annual Meeting of
the Shareholders, which is incorporated herein by reference.



Item 12.Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters



A portion of the information required by this item is set forth in Item 5 of this Annual Report on Form 10-K.
Additional information required by this item is set forth in the definitive Proxy Statement of the Company filed in connection with its 2007 Annual Meeting of Shareholders, which is incorporated herein by reference.



Item 13.Certain Relationships and Related Transactions, and Director Independence



The information required by these items is set forth in the definitive Proxy Statement of the Company filed in connection with its 2007 Annual Meeting of
the Shareholders, which is incorporated herein by reference.



Item 14.Principal Accounting Fees and Services



The information required by these items is set forth in the definitive Proxy Statement of the Company filed in connection with its 2007 Annual Meeting of
the Shareholders, which is incorporated herein by reference.



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Part IV



|Item 15.Exhibits, | Financial Statement Schedules
|----------------- | -----------------------------



(a)    (1) All Financial Statements



See Item 8.



(2) Financial Statement Schedules



All schedules to the Consolidated Financial Statements required by Article 9 of Regulation S-X and all other schedules to the financial statements of the
Company required by Article 5 of Regulation S-X are not required under the related instructions or are inapplicable and, therefore, have been omitted, or the required information is contained in the Consolidated Financial Statements or the notes
thereto, which are included in Item 8 hereof.



(3) Listing of
Exhibits



|            |  |                                                                                                                                                                                                                                                                                                             
|----------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                                                                                                                                                 
|3.1.1       |  | Articles of Incorporation filed on May 13, 1982 in the office of the Secretary of State of South Carolina: Incorporated by reference to Exhibit 3 to the Companys Registration Statement
on Form S-4, Commission File No. 33-19367, filed with the Securities and Exchange Commission on December 30, 1987 
|            | 
|3.1.2       |  | Articles of Amendment filed on May 5, 1988 in the office of the Secretary of State of South Carolina: Incorporated by reference to Exhibit 4.1.2 to the Companys Registration Statement
on Form S-8, Commission File No. 33-51212 filed with the Securities and Exchange Commission on August 20, 1992     
|            | 
|3.1.3       |  | Articles of Amendment filed on January 26, 1989 in the office of the Secretary of State of South Carolina: Incorporated by reference to Exhibit 4.1.3 to the Companys Registration
Statement on Form S-8, Commission File No. 33-51212 filed with the Securities and Exchange Commission on August 20, 1992
|            | 
|3.1.4       |  | Articles of Amendment filed on April 23, 1990 in the office of the Secretary of State of South Carolina: Incorporated by reference to Exhibit 4.1.4 to the Companys Registration
Statement on Form S-8, Commission File No. 33-51212 filed with the Securities and Exchange Commission on August 20, 1992  
|            | 
|3.1.5       |  | Articles of Amendment filed on October 16, 1996 in the office of the Secretary of State of South Carolina: Incorporated by reference to Exhibit 3.1.5 to the Companys Quarterly Report on
Form 10-Q for the fiscal quarter ended September 30, 1996                                                        
|            | 
|3.1.6       |  | Articles of Amendment filed on May 17, 1999 in the office of the Secretary of State of South Carolina: incorporated by reference to Exhibit 3.1.6 of the Companys quarterly report on
Form 10-Q for the fiscal quarter ended June 30, 1999                                                                 
|            | 
|3.2.1       |  | By-Laws adopted April 10, 1990. Incorporated by reference to Exhibit 3.2.1 to the Companys 1996 Annual Report on Form 10-K, filed with the Securities and Exchange Commission on
March 30, 1997                                                                                                            
|            | 
|3.2.2       |  | Amendment to By-Laws dated April 12, 1994. Incorporated by reference to Exhibit 3.2.2 to the Companys 1996 Annual Report on Form 10-K, filed with the Securities and Exchange Commission
on March 30, 1997                                                                                                 
|            | 
|3.2.3       |  | Amendment to By-Laws dated January 19, 1999. Incorporated by reference to Exhibit 3.2.3 to the Companys 1998 Annual Report on Form 10-K, filed with the Securities and Exchange
Commission on March 19, 1999                                                                                               
|            | 
|4.1.1       |  | Articles of Incorporation of the Registrant: Included in Exhibits 3.1.1 - .5                                                                                                                                                                                                                                
|            | 
|4.2         |  | Bylaws of the Registrant: Included in Exhibit 3.2.1 - .3                                                                                                                                                                                                                                                    



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|            |  |                                                                                                                                                                                                                                                                                                                                                                                                    
|----------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                                                                                                                                                                                                                                        
|4.3         |  | Specimen Certificate for Common Stock: Incorporated by reference to Exhibit 4.3 to the Companys Registration Statement on Form S-8, Commission File No. 33-51212, filed with the
Securities and Exchange Commission on August 20, 1992                                                                                                                                                            
|            | 
|4.4         |  | Palmetto Bancshares, Inc. 1997 Stock Compensation Plan, as amended to date. Incorporated by reference to the Companys 1997 Annual Report on Form 10-K, filed with the Securities and
Exchange Commission on March 23, 1998                                                                                                                                                                        
|            | 
|10.1*       |  | Palmetto Bancshares, Inc. Stock Option Plan: Incorporated by reference to Exhibit 10 (a) to the Companys Registration Statement on Form S-4, Commission File No. 33-19367, filed with the
Securities and Exchange Commission on May 2, 1988                                                                                                                                                       
|            | 
|10.2*       |  | The Palmetto Bank Pension Plan and Trust Agreement: Incorporated by reference to Exhibit 10 (c) to the Companys Registration Statement on Form S-4, Commission File No. 33-19367, filed
with the Securities and Exchange Commission on May 2, 1988                                                                                                                                                
|            | 
|10.3*       |  | The Palmetto Bank Officer Incentive Compensation Plan                                                                                                                                                                                                                                                                                                                                              
|            | 
|10.4*       |  | Palmetto Bancshares, Inc. 1997 Stock Compensation Plan, as amended to date: incorporated by reference to Exhibit 10.1 to the Companys 1997 Annual Report on Form 10-K, filed with the
Securities and Exchange Commission on March 23, 1998.                                                                                                                                                       
|            | 
|10.4.1*     |  | Amendment to the Palmetto Bancshares, Inc.s 1997 Stock Compensation Plan. Approved by the Companys Board of Directors on January 21, 2003 and by the Companys shareholders on
April 15, 2003 and incorporated by reference to Exhibit 10.4.1 to the Companys 2003 Annual Report on Form 10-K, filed with the Securities and Exchange Commission on March 15, 2004 as amended on March 29, 2004.
|            | 
|21.1^       |  | List of Subsidiaries of the Registrant                                                                                                                                                                                                                                                                                                                                                             
|            | 
|23.1^       |  | Consent of Elliott Davis, LLC                                                                                                                                                                                                                                                                                                                                                                      
|            | 
|31.1^       |  | L. Leon Pattersons Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                                                                        
|            | 
|31.2^       |  | Paul W. Stringers Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                                                                         
|            | 
|32^         |  | Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                                                                                           

---

|* |  | Management contract or compensatory plan or arrangement
|- |  | -------------------------------------------------------

|^ |  | Filed with this Annual Report on Form 10-K
|- |  | ------------------------------------------



Copies of exhibits are available upon written request to Lauren S. Greer, The Palmetto Bank, Post Office Box 49, Laurens, South Carolina 29360.



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SIGNATURES



Pursuant to the
requirements of Section 13 or 15(d) 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.



PALMETTO BANCSHARES, INC.By:

/s/    L. LEON
PATTERSONL. Leon Patterson Chairman and Chief Executive Officer, Palmetto Bancshares, Inc.




/s/    PAUL W.
STRINGERPaul W. Stringer President and Chief Operating Officer, Palmetto Bancshares, Inc. Chief Accounting Officer




Date: March 16, 2007



Pursuant to the
requirements of the Securities Exchange Act of 1934, this report has been signed below and on the dates by the following persons on behalf of the registrant and in the capacities indicated.



|                                                |  |                                                                                               |  |               
|----------------------------------------------- |  | --------------------------------------------------------------------------------------------- |  | --------------
|Signature                                       |  | Title                                                                                         |  | Date          
|                                                |  |                                                                                              
|/s/    L. LEON
PATTERSONL. Leon
Patterson       |  | Director Chairman Chief Executive Officer Palmetto Bancshares, Inc.                           |  | March 16, 2007
|                                                |  |                                                                                              
|/s/    PAUL W.
STRINGERPaul W.
Stringer         |  | Director President Chief Operating Officer Palmetto Bancshares, Inc. Chief Accounting Officer |  | March 16, 2007
|                                                |  |                                                                                              
|/s/    W. FRED DAVIS,
JR.W. Fred Davis,
Jr.     |  | Director                                                                                      |  | March 16, 2007
|                                                |  |                                                                                              
|/s/    DAVID P. GEORGE,
JR.David P. George,
Jr. |  | Director                                                                                      |  | March 16, 2007
|                                                |  |                                                                                              
|/s/    MICHAEL D.
GLENNMichael D.
Glenn         |  | Director                                                                                      |  | March 16, 2007
|                                                |  |                                                                                              
|/s/    JOHN T. GRAMLING,
IIJohn T. Gramling, II |  | Director                                                                                      |  | March 16, 2007
|                                                |  |                                                                                              
|/s/    JOHN D. HOPKINS,
JR.John D. Hopkins,
Jr. |  | Director                                                                                      |  | March 16, 2007



131



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|                                                      |  |          |  |               
|----------------------------------------------------- |  | -------- |  | --------------
|Signature                                             |  | Title    |  | Date          
|                                                      |  |         
|/s/     SAM B. PHILLIPS,
JR.Sam B. Phillips, Jr.      |  | Director |  | March 16, 2007
|                                                      |  |         
|/s/    ALBERT V. SMITHAlbert V. Smith                 |  | Director |  | March 16, 2007
|                                                      |  |         
|/s/    ANN B. SMITHAnn B. Smith                       |  | Director |  | March 16, 2007
|                                                      |  |         
|/s/    EDWARD KEITH SNEAD,
IIIEdward Keith Snead, III |  | Director |  | March 16, 2007
|                                                      |  |         
|/s/    JANE S. SOSEBEEJane S. Sosebee                 |  | Director |  | March 16, 2007
|                                                      |  |         
|/s/    L. STEWART
SPINKSL. Stewart
Spinks             |  | Director |  | March 16, 2007
|                                                      |  |         
|/s/     J. DAVID WASSON,
JR.J. David Wasson,
Jr.      |  | Director |  | March 16, 2007



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EXHIBIT INDEX



|            |  |                                                                                            
|----------- |  | -------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                
|            | 
|21.1        |  | List of Subsidiaries of the Registrant                                                     
|            | 
|23.1        |  | Consent of Elliott Davis, LLC                                                              
|            | 
|31.1        |  | L. Leon Pattersons Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
|            | 
|31.2        |  | Paul W. Stringers Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 
|            | 
|32          |  | Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                   



133