UNITED
STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549 FORM
10-Q x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
  THE SECURITIES EXCHANGE ACT OF 1934 For the
  Quarterly Period Ended September 30, 2006ORo
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
  THE SECURITIES EXCHANGE ACT OF 1934For the transition period from ____________________
  to _______________________ Commission File
Number: 000-15366 ALLIANCE
FINANCIAL CORPORATION(Exact name of Registrant as specified in its charter)  New
  York

16-1276885(State or Other Jurisdiction of Incorporation 
  or Organization)

(IRS Employer Identification Number)  120
  Madison Street,Syracuse, New York 13202(Address of Principal
  Executive Offices) (Zip Code)  (315)
  475-4478(Registrants Telephone
  Number including area code) 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. Yesx
Noo  Indicate by check mark whether the Registrant is a
large accelerated filer, an accelerated filer, or a non-accelerated file (as
defined in Rule 12b-2 of the Exchange Act).
 Large accelerated filer o Accelerated
filer x Non-accelerated filer o
 Indicate by check mark whether the Registrant is a
shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o      No x The number of shares outstanding of the Registrants
common stock on October 30, 2006: Common Stock, $1.00 Par Value  4,944,445
shares.    TABLE
OF CONTENTS

Part I.
FINANCIAL INFORMATIONItem 1.
Financial Statements (All Unaudited)Consolidated Balance SheetsConsolidated Statements of IncomeConsolidated Statement of Changes in
  Shareholders EquityConsolidated Statements of Cash FlowsNotes to Consolidated Financial
  StatementsItem 2.
Managements Discussion and Analysis
  of Financial Condition and Results of OperationsItem 3.
Quantitative and Qualitative
  Disclosures About Market RiskItem 4.
Controls and ProceduresPart II.
OTHER INFORMATIONItem 1.
Legal ProceedingsItem 1A.

Risk FactorsItem 2.
Unregistered Sales of Equity
  Securities and Use of ProceedsItem 3.
Defaults Upon Senior SecuritiesItem 4.
Submission of Matters to a Vote of
  Security HoldersItem 5.
Other InformationItem 6.
ExhibitsSignatures2

Alliance Financial Corporation and
  subsidiaryConsolidated Balance Sheets
  (Unaudited)(In thousands, except share data)September
  30, 2006


December
  31, 2005AssetsCash and due
from banks

$
30,341

$
17,972Federal funds
sold





4,906Total cash and
cash equivalents


30,341


22,878Securities
available-for-sale


239,514


261,368Federal Home
Loan Bank of New York (FHLB) stock


5,407


6,126Loans and
leases


745,188


664,955Unearned
income


(19,274
)

(10,869
)Loans and
leases, net of unearned income


725,914


654,086Allowance for
loan and lease losses


(5,402
)

(4,960
)Net loans and
leases


720,512


649,126Bank premises,
furniture, and equipment, net


12,398


13,032Accrued
interest receivable


4,280


3,915Intangible
asset, net


9,293


9,671Other
assets


15,861


14,305Total
assets

$
1,037,606

$
980,421LiabilitiesNon-interest-bearing deposits

$
98,781

$
91,883Interest-bearing deposits


683,777


647,235Total
deposits


782,558


739,118Borrowings


144,606


150,429Junior
subordinated obligations issued to unconsolidated subsidiary
  trusts


25,774


10,310Accrued
interest payable


2,282


2,261Other
liabilities


8,892


8,732Total
liabilities

$
964,112

$
910,850Shareholders
equityPreferred
stock (par value $1.00) 1,000,000 shares authorized, none
  issued.





Common stock
(par value $1.00) 10,000,000 shares authorized, 4,012,410
  and 3,978,601 shares issued; and 3,583,454 and 3,565,012 shares outstanding,
  respectively issued;


4,012


3,979Surplus


10,953


11,185Unamortized
value of restricted stock





(1,453
)Undivided
profits


69,630


66,740Accumulated
other comprehensive income


(1,425
)

(1,700
)Treasury
stock, at cost; 428,956 and 413,589 shares, respectively


(9,676
)

(
  (9,180
)Total
shareholders equity


73,494


69,571Total
liabilities & shareholders equity

$
1,037,606

$
980,421The accompanying notes are an
integral part of the consolidated financial statements.
3

Alliance Financial Corporation and
  subsidiaryConsolidated Statements of Income (Unaudited)(Dollars in thousands, except per share data)Three months ended
  September 30,

Nine months ended 
  September 30,2006

2005

2006

2005Interest income:Loans and
leases, including fees

$
11,498

$
9,211

$
32,267

$
25,237Investment
securities


2,564


2,724


7,952


8,495Federal funds
sold


4


62


121


109Total interest
income


14,066


11,997


40,340


33,841Interest expense:Deposits


5,600


3,632


15,315


9,411Borrowings


1,756


1,464


4,744


3721Junior
subordinated obligations issued to unconsolidated subsidiary
  trusts


248


169


644


461Total interest
expense


7,604


5,265


20,703


13,593Net interest
income


6,462


6,732


19,637


20,248Provision for loan and
  lease losses


550


125


1,967


(34
)Net interest
income after provision for loan and lease losses


5,912


6,607


17,670


20,282Trust & brokerage
  income


2,157


2,262


6,637


5,617Service charges on deposit
  accounts


1,001


693


2,938


2,044Bank-owned life insurance


102


102


300


301Gain on the sale of loans


24


16


70


127Card-related fees


293


234


851


670Rental income from
  operating leases


185


212


601


984Loss on securities
  available-for-sale











(22
)Other non-interest income


408


205


845


536Total
non-interest income


4,170


3,724


12,242


10,257Total
operating income


10,082


10,331


29,912


30,539Salaries and employee
  benefits


3,903


4,331


11,722


12,508Building, occupancy, and
  equipment


1,495


1,295


4,528


4,341Communication expense


146


154


407


475Stationery and supplies
  expense


125


131


336


350Marketing expense


124


202


638


537Amortization of intangible
  asset


126


126


378


292Professional fees


697


557


2,083


1,568Other operating expenses


1,072


938


3,142


2,912Total
non-interest expense


7,688


7,734


23,234


22,983Income before income tax
  expense


2,394


2,597


6,678


7,556Income tax expense


575


615


1,447


1,812Net
income

$
1,819

$
1,982

$
5,231

$
5,744Net Income per common share
   basic

$
0.52

$
0.55

$
1.50

$
1.60Net Income per common share
   diluted

$
0.51

$
0.54

$
1.47

$
1.57The accompanying notes are an integral part of the consolidated
financial statements.

4

Alliance Financial Corporation and
  subsidiaryConsolidated Statements of Changes in Shareholders Equity(Unaudited) (Dollars in thousands)Issued
        andOutstandingCommonShares
    
    CommonStock
    
    Surplus
    
    UnamortizedValue
        ofRestrictedStock
    
    UndividedProfits
    
    AccumulatedOtherComprehensiveIncome
    
    TreasuryStock
    
    TotalBalance
        at December 31, 2004
    
    
    3,571,872
    
    $
    3,947
    
    $
    10,298
    
    $
    (1,047
    )
    $
    62,235
    
    $
    1,418
    
    $
    (7,955
    )
    $
    68,896Comprehensive
        incomeNet
        Income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,744
    
    
    
    
    
    
    
    
    5,744Other
        comprehensive income, net of taxes:Change
        in unrealized appreciation in available for sale securities, net of reclassification
        adjustment (net of tax)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,474
    )
    
    
    
    
    (1,474
    )Comprehensive
        income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,270Issuance
        of restricted stock
    
    
    24,500
    
    
    24
    
    
    754
    
    
    (778
    )
    
    
    
    
    
    
    
    
    
    
    Forfeiture
        of restricted stock
    
    
    (3,432
    )
    
    (3
    )
    
    (103
    )
    
    98
    
    
    
    
    
    
    
    
    
    
    
    8Amortization
        of restricted stock
    
    
    
    
    
    
    
    
    
    
    
    205
    
    
    
    
    
    
    
    
    
    
    
    205Tax
        benefit of restricted stock plan
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    11
    
    
    
    
    
    
    
    
    11Stock
        options exercised
    
    
    4,818
    
    
    5
    
    
    108
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    113Tax
        benefit of stock-based compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Cash
        dividend, $.63 per share
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,266
    )
    
    
    
    
    
    
    
    (2,266
    )Balance
        at September 30, 2005
    
    
    3,597,758
    
    $
    3,973
    
    $
    11,057
    
    $
    (1,522
    )
    $
    65,724
    
    $
    (56
    )
    $
    (7,955
    )
    $
    71,221Balance
        at December 31, 2005
    
    
    3,565,012
    
    $
    3,979
    
    $
    11,185
    
    $
    (1,453
    )
    $
    66,740
    
    $
    (1,700
    )
    $
    (9,180
    )
    $
    69,571Comprehensive
        incomeNet
        Income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,231
    
    
    
    
    
    
    
    
    5,231Other
        comprehensive income, net of taxes:Change
        in unrealized appreciation in available-for-sale securities (net of tax)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    349
    
    
    
    
    
    349Change
        in minimum pension liability
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (74
    )
    
    
    
    
    (74
    )Comprehensive
        income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,506Issuance
        of restricted stock
    
    
    24,000
    
    
    24
    
    
    712
    
    
    (736
    )
    
    
    
    
    
    
    
    
    
    
    Forfeiture
        of restricted stock
    
    
    (16,495
    )
    
    (17
    )
    
    (490
    )
    
    432
    
    
    
    
    
    
    
    
    
    
    
    (75
    )Amortization
        of restricted stock
    
    
    
    
    
    
    
    
    
    
    
    252
    
    
    
    
    
    
    
    
    
    
    
    252Tax
        benefit of restricted stock plan
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    16
    
    
    
    
    
    
    
    
    16Stock
        options exercised
    
    
    26,304
    
    
    26
    
    
    565
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    591Tax
        benefit of stock-based compensation
    
    
    
    
    
    
    
    
    486
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    486Cash
        dividend, $.66 per share
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,357
    )
    
    
    
    
    
    
    
    (2,357
    )Treasury
        stock purchased
    
    
    (15,367
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (496
    )
    
    (496
    )Reclassification of unearned restricted stock awards to surplus in accordance
        with SFAS No. 123R (68,375 shares)
    
    
    
    
    
    
    
    
    (1,505
    )
    
    1,505
    
    
    
    
    
    
    
    
    
    
    
    Balance
        at September 30, 2006
    
    
    3,583,454
    
    $
    4,012
    
    $
    10,953
    
    
    
    
    $
    69,630
    
    $
    (1,425
    )
    $
    (9,676
    )
    $
    73,4945
Alliance Financial Corporation and
  SubsidiaryCondensed Consolidated Statements of Cash Flow (Unaudited)(In thousands)Nine
  months ended September 30,2006

2005Net cash provided by
operating activities

$
7,582

$
8,709Lending and investing
activities:Proceeds from
maturities, redemptions, calls and principal repayments
  of  securities available-for-sale


45,364


77,491Proceeds from
maturities, redemptions, calls and principal repayments
  of  securities held-to-maturity





7,742Purchase of
securities available-for-sale


(22,762
)

(43,141
)Purchase of
securities held-to-maturity





(9,931
)Proceeds from
sales of securities available-for-sale





2,928Purchases of
FHLB stock


(8,299
)

(8,569
)Redemptions of
FHLB stock


9,019


9,255Net increase
in loans and leases


(73,353
)

(107,893
)Purchase of
premises and equipment


(1,808
)

(915
)Acquisition
purchases





(10,089
)Proceeds from
the sale of premises and equipment


364


107Net cash used
in lending and investing activities


(51,475
)

(83,015
)Deposit and financing
activities:Net increase
in deposits


43,440


121,103Net decrease
in borrowings


(5,823
)

(38,050
)Net increase
in junior subordinated obligations issued to unconsolidated  subsidiary trusts


15,464


Cash
dividends


(2,322
)

(2,260
)Purchase of
treasury stock


(496
)

Proceeds from
the exercise of stock options


591


113Tax benefit
from share-based payments


502


Net cash
provided by deposit and financing activities


51,356


80,906Increase in
cash and cash equivalents


7,463


6,600Cash and cash
equivalents at beginning of year


22,878


21,258Cash and cash
equivalents at end of period

$
30,341

$
27,858Supplemental disclosures of
cash flow information:Cash paid
during the period for:Interest on
deposits and borrowings

$
20,682

$
12,938Income
taxes


1,650


1,800Non-cash
investing activities:Net unrealized
gain (loss) on securities available-for-sale


596


(2,464
)Transfer of
loans to other real estate owned


20


Non-cash
financing activities:Dividends
declared and unpaid


788


756The accompanying notes are an
integral part of the consolidated financial statements.

6



Alliance Financial Corporation and
  subsidiary
  Notes to consolidated financial statementsA.
Basis of PresentationThe accompanying unaudited consolidated financial
statements include the accounts of Alliance Financial Corporation (the
Company or Alliance), its wholly-owned subsidiary Alliance Bank N.A. (the
Bank) and the Banks wholly-owned subsidiaries. All significant intercompany
accounts and transactions have been eliminated in consolidation. The
accompanying unaudited consolidated financial statements were prepared in
accordance with the instructions for Form 10-Q and Regulation S-X and,
therefore, do not include information for footnotes necessary for a complete
presentation of financial condition, results of operations, and cash flows in
conformity with generally accepted accounting principles. The following
material under the heading Managements Discussion and Analysis of Financial
Condition and Results of Operations is written with the presumption that the
users of the interim financial statements have read, or have access to, the
latest audited financial statements and notes thereto of the Company, together
with Managements Discussion and Analysis of Financial Condition and Results of
Operations as of December 31, 2005 and for the three-year period then ended,
included in the Companys Annual Report on Form 10-K for the year ended
December 31, 2005. Accordingly, only material changes in the results of
operations and financial condition are discussed in the remainder of Part I. Certain
amounts from prior year periods are reclassified, when necessary, to conform to
the current period presentation.

All adjustments that in the opinion of management are
necessary for a fair presentation of the financial statements have been
included in the results of operations for the nine months ended September 30,
2006 and 2005.

B.
Subsequent EventOn October 6, 2006, Alliance completed its acquisition
of Bridge Street Financial, Inc. (Bridge Street), and its wholly-owned
subsidiaries, Oswego County National Bank (OCNB) and Ladds Agency Inc.
(Ladds), an insurance agency. In connection with the acquisition, Alliance
issued approximately 1.3 million shares of common stock valued at $41.5 million
based on the closing price of Alliance common stock on October 6, and paid cash
of $13.2 million for total merger consideration of $54.7 million. After giving
effect to the issuance of shares in the merger, Alliance now has approximately
4.9 million shares of common stock outstanding. At the time of the acquisition,
Bridge Street had $219.3 million in assets, $148.3 million in gross loans, and
$169.2 million in deposits. In the acquisition, Bridge Street was merged into
Alliance, Ladds became a wholly-owned subsidiary of Alliance, and Oswego County
National Bank was merged into Alliance Bank.

C.
Earnings Per ShareBasic and diluted net income per common share
calculations are as follows:

For three months ended
  September 30

For nine months ended
  September 30(Dollars
  in thousands, except share and per share amounts)2006

2005

2006

2005Basic:Net income

$
1,819

$
1,982

$
5,231

$
5,744Weighted average
  common shares outstanding


3,503,851


3,597,758


3,496,132


3,594,298Net income per
  common share  basic

$
0.52

$
0.55

$
1.50

$
1.60Diluted:Net income

$
1,819

$
1,982

$
5,231

$
5,744Weighted average
  common shares outstanding


3,503,851


3,597,758


3,496,132


3,594,298Incremental
  shares from assumed conversion of stock options and restricted stock


81,353


71,661


73,194


72,046Weighted average
  common shares outstanding  diluted


3,585,204


3,669,419


3,569,326


3,666,344Net income per
  common share  diluted

$
0.51

$
0.54

$
1.47

$
1.577



Alliance Financial Corporation and
  subsidiary
  Notes to consolidated financial statementsBasic earnings per share are computed by dividing net
income by the weighted average number of common shares outstanding throughout
each year. Diluted earnings per share gives the effect to weighted average
shares which would be outstanding assuming the exercise of options and
issuances of unearned restricted stock using the treasury stock method.

D.
Allowance for Loan and Lease LossesThe allowance for loan and lease losses represents
managements best estimate of probable loan and lease losses in the Companys
loan portfolio. Managements quarterly evaluation of the allowance for loan and
lease losses is a comprehensive analysis that builds a total reserve by
evaluating the risks within each loan and lease type, or pool, of similar loans
and leases. The Company uses a general allocation methodology for all
residential and consumer loan pools. This methodology estimates a reserve for
each pool based on the average loss rate for the time period that includes the
current year and two full prior years. The average loss rate is adjusted to
reflect the expected impact that current trends regarding loan growth,
delinquency, actual losses, economic conditions, loan concentrations, policy
changes, experience and ability of lending personnel, and current interest rates
are likely to have. For commercial loan and lease pools, the Company
establishes a specific reserve allocation for all loans and leases classified
as being impaired in excess of $150,000, which have been risk rated under the
Companys risk rating system as substandard, doubtful, or loss. For all other
commercial loans and leases, the Company uses the general allocation
methodology that establishes a reserve for each risk-rating category. The
general allocation methodology for commercial loans and leases considers the
same factors that are considered when evaluating residential mortgage and
consumer loan pools. The combination of using both the general and specific
allocation methodologies reflects managements best estimate of the probable
loan and lease losses in the Companys loan and lease portfolio.

A loan or lease is considered impaired, based on
current information and events, if it is probable that the Company will be
unable to collect the scheduled payments of principal or interest when due
accord­ing to the contractual terms of the loan or lease agreement. The
measurement of impaired loans and leases is generally discounted­ at the
historical effective interest rate, except­­ that all collateral-dependent
loans and leases are measured­ for impairment based on fair value of the
collateral.

Loans are charged off when they are considered a loss
regardless of the delinquency status. From a delinquency standpoint, the policy
of the Company is to charge off loans when they are 120 days past due unless
extenuating circumstances are documented that attest to the ability to collect
the loan. Special circumstances to include fraudulent loans and loans in
bankruptcy will be charged off no later than 90 days of discovery or within 120
days delinquent, whichever is shorter. In lieu of charging off the entire loan
balance, loans with collateral may be written down to the value of the
collateral, less cost to sell, if foreclosure or repossession of collateral is
assured and in process.

E.
Stock Options and Other Share-Based
  CompensationEffective January 1, 2006, the Company adopted
provisions of Financial Accounting Standards Board (FASB) Statement No. 123R
Share-Based Payment, (FAS 123R) for its share-based compensation plans. The
Company previously accounted for these plans under the recognition and
measurement principles of Accounting Principles Board (APB) No. 25, Accounting
for Stock Issued to Employees, (APB 25) and related interpretations and
disclosure requirements established by FAS 123, Accounting for Stock-Based
Compensation. Under APB 25, because the exercise price of the Companys
employee stock options equaled the market price of the underlying stock on the
date of the grant, no compensation expense was recorded. The pro forma effects
on income for stock options were instead disclosed in a footnote to the
financial statements. Expense was recorded in the income statement for
restricted stock units.

8

Alliance Financial Corporation and
  subsidiary
  Notes to consolidated financial statementsUnder FAS 123R, all share-based compensation cost is
measured at the grant date, based on the fair value of the award, and is
recognized as an expense in the income statement over the vesting period. The
Company adopted FAS 123R using the modified prospective method. Under this
transition method, compensation cost recognized in the three months and nine
months ended September 30, 2006 includes the cost for all share-based payments
granted prior to, but not yet vested as of January 1, 2006. This cost was based
on grant-date fair value estimated in accordance with the original provisions
of FAS 123. The cost for all share-based awards granted subsequent to January
1, 2006 represented the grant-date fair value that was estimated in accordance
with the provisions of FAS 123R.

Pro forma disclosures for the three months and nine
months ended September 30, 2005, utilizing the estimated fair value of the
options and restricted stock granted are as follows (dollars in thousands,
except per share data):

Three months
  ended
  September 30, 2005






Nine months
  ended
  September 30, 2005Net income as reported


$
1,982



$
5,744Less: total
  stock-based employee compensation
  expense determined under Black-Scholes
  option pricing model, net of tax effect



(9
)



(26
)Pro forma net
  income


$
1,973



$
5,718Pro forma net
  income per share:Basic  as
  reported


$
0.55



$
1.60Basic  pro
  forma



0.55




1.59Diluted  as
  reported



0.54




1.57Diluted  pro
  forma



0.54




1.56Compensation expense charged against income in the
three months and nine months ended September 30, 2006 for stock options was
$11,000 and $34,000, respectively. The options were issued with a 10-year term
and become exercisable upon the Company achieving specified stock prices. At
September 30, 2006, 29,319 options with an average weighted exercise price of
$24.75 were unvested, and total remaining unrecognized compensation expense to
be recognized over the next two years was $60,000. Cash received from option
exercises during the nine months ended September 30, 2006, was $591,000.

During the third quarter of 2006, the Company did not
issue shares of restricted stock. Compensation expense charged against income
for restricted stock units during the quarter was $8,000, compared with $70,000
charged against income in the 2005 third quarter. During the third quarter of
2006, 7,500 shares of unearned restricted stock, with a weighted average grant
price of $30.55, were forfeited. This resulted in the reversal of previously
recorded compensation expense of $72,000. At September 30, 2006, the Company
had 68,375 unearned restricted stock units outstanding with a weighted average
grant price of $30.98. None of the restricted stock units outstanding at
September 30, 2006 were vested. Unrecognized compensation expense to be
recognized over the remainder of the vesting period associated with restricted
stock awards at September 30, 2006 was $1.5 million. The Companys restricted
stock awards vest over a seven year term, however 50% of awards vest if, on the
date at least three years following the award date, the Companys closing stock
price has been 160% of the award price for 15 consecutive days.

Additional disclosure requirements of SFAS 123R have
been omitted due to immateriality.

9

Alliance Financial Corporation and
  subsidiary
  Notes to consolidated financial statementsF.
Post-Retirement BenefitsThe Company provides post-retirement medical and life
insurance benefits through an unfunded plan to qualifying employees. Benefits
are available to full-time employees who have worked 15 years and attained age
55. Retirees and certain active employees with more than 20 years of service to
the Company continue to receive benefits in accordance with plans that existed
at First National Bank of Cortland and Oneida Valley National Bank, prior to
the merger of the banks in 1999. The Company does not have a defined benefit
pension plan.

The components of the Post-retirement plans net
periodic cost for the periods indicated are as follows:

Three months ended
  September 30,

Nine months ended
  September 30,2006

2005

2006

2005Service cost

$
31

$
34

$
91

$
95Interest cost


71


72


212


203Amortization of unrecognized prior service cost


20


21


59


60Net periodic benefit cost

$
122

$
127

$
362

$
35810

Item 2.
Managements Discussion and
  Analysis of Financial Condition and Results of OperationsGeneral

Throughout this analysis, the term the Company
refers to the consolidated entity of Alliance Financial Corporation, its
wholly-owned banking subsidiary, Alliance Bank, N.A. (the Bank), and the
Banks subsidiaries, Alliance Preferred Funding Corp. and Alliance Leasing,
Inc. The Company is a New York corporation which was formed in November 1998 as
a result of the merger of Cortland First Financial Corporation and Oneida
Valley Bancshares, Inc.

The following discussion presents an analysis of
material changes in the Companys results of operations and financial condition
during the three months and nine months ended September 30, 2006, which are not
otherwise apparent from the consolidated financial statements included in this
report.

This discussion and analysis contains certain
forward-looking statements (within the meaning of the Private Securities
Litigation Reform Act of 1995) with respect to the financial condition, results
of operations and business of the Company. These forward-looking statements
involve certain risks and uncertainties. Factors that may cause actual results
to differ materially from those contemplated by such forward-looking statements
include, among others, the following possibilities:


we may fail to realize the anticipated benefits of
  the merger with Bridge Street Financial, Inc.;
changes in key management personnel may adversely impact
  our operations;
an increase in competitive pressures in the banking
  industry;
changes in the interest rate environment that reduce
  margins;
changes in the regulatory environment;
general economic conditions, either nationally or
  regionally, that are less favorable than expected, resulting in, among other
  things, a deterioration in credit quality;
changes in business conditions and inflation;
changes in the securities markets;
changes in technology used in the banking business;
our ability to maintain and increase market share
  and control expenses;
the possibility that the Companys trust business
  will fail to perform as currently anticipated;
the continued success of our earnings improvement
  initiative; and
other factors detailed from time to time in the
  Companys SEC filings.Operating results for the three months and nine months
ended September 30, 2006 are not necessarily indicative of the results that may
be expected for the year ending December 31, 2006.

11

Results
of Operations For The Three Months and Nine Months Ended September 30, 2006

Earnings
Summary and Executive Overview

Net income was $1.82 million, or $0.51 per diluted
share, in the third quarter of 2006, a decrease of $163,000, or 8.2% (5.6% per diluted share), compared
to net income of $1.98 million or $0.54 per diluted share for the same period
in 2005. The return on average assets and return on average shareholders
equity were 0.72% and 10.27%, respectively, for the three months ended
September 30, 2006, compared with 0.82% and 11.23%, respectively, for the third
quarter of 2005.

The decrease in net income for the third quarter of
2006 compared with the year ago quarter resulted primarily from a decrease of
$270,000 in net interest income and a $425,000 increase in the provision for
loan losses offsetting a $446,000 increase in non-interest income.

The decrease in net interest income resulted from a
decline in our net interest margin of 25 basis points in the third quarter of
2006 compared with the same period in 2005, which offset a $43.8 million
increase in average earning assets during the same period. The higher loan loss
provision was due primarily to one commercial relationship that went into
nonperforming status during the quarter, while the growth in non-interest
income resulted largely from higher service charges on deposit accounts.

Net income was $5.23 million, or $1.47 per diluted
share for the nine months ended September 30, 2006, a decrease of $513,000, or
8.9% (6.4% per diluted share), compared with $5.74 million or $1.57 per diluted share for the nine months
ended September 30, 2005. A $2.0 million increase in the provision for loan
losses in the first nine months of 2006 compared with the year ago period was
the largest factor contributing to the lower earnings, and resulted in large
part from a $1.45
million increase in net charge-offs in the nine months ended September 30, 2006
compared with the year-ago period. Also impacting earnings in the nine months
ended September 30, 2006 compared with the year ago period was a decrease in
net interest income of $611,000 due in large part to a 31 basis point decrease
in our net interest margin, partially offset by a $41.7 million increase in
average earning assets, and an increase in noninterest expense of $251,000.
Noninterest income increased $2.0 million due primarily to the contribution of our
February 2005 acquisition of $560 million of trust assets under management from
HSBC Bank, USA, N.A., and higher service charges on deposit accounts.

Analysis
of Net Interest Income and the Net Interest Margin

Net interest income was $6.5 million in the third
quarter of 2006, a decrease of $270,000, or 4.0%, from the third quarter of 2005.
Total interest income increased $2.1 million, to $14.1 million in the third
quarter of 2006, compared with $12.0 million in the third quarter of 2005. This
increase was offset by an increase in interest expense of $2.3 million, to $7.6
million in the third quarter of 2006 compared with $5.3 million in the year ago
quarter.

An increase in average earning assets of $43.8 million
for the three months ended September 30, 2006 compared with the year ago period
partially offset the impact of a decrease in our net interest margin over this
time period. Higher short-term interest rates over the past year and the
persistently flat or inverted yield curve, along with highly competitive
deposit pricing, have caused our cost of funds to increase more than our asset
yields. The tax-equivalent yield on earning assets increased 62 basis points in
the three months ended September 30, 2006, compared with the same period in
2005. Our average cost of funds increased 105 basis points over this same time
period.

The growth in average earning assets resulted from an
$89.5 million increase in average loans and leases as of the third quarter of
2006 compared with the same period in 2005, partially offset by a $38.9 million
decrease in the securities portfolio. Commercial leases accounted for 58.9% of
the growth in average total loans and leases during the third quarter of 2006,
followed by increases of 24.7% for indirect loans and 18.3% for residential
mortgages, respectively. Average leases increased $52.8 million in the three
months ended September 30, 2006 compared with the year-ago quarter, reflecting
the success of our efforts to expand this business line. We originate leases
through reputable, well-established middle market leasing companies, and
through vendor and direct customer relationships,

12

with an emphasis on the medical and university
sectors. The leases are underwritten using our regular commercial credit
standards, and the collateral securing the leases is generally readily
marketable.

The change in our average earning asset mix reflects
our decision to fund a portion of the loan and lease growth with cash flows
from our securities portfolio due to the limited opportunity to profitably
invest in securities in the current interest rate environment.

Average indirect loans increased $22.1 million in the
three months ended September 30, 2006 compared with the same quarter in 2005.
During the second quarter of 2006 we increased our indirect loan rates in an
effort to manage the rate of growth in these loans, as highly competitive
pricing and higher funding costs have negatively impacted the profitability of
indirect lending. As a result,the rate of growth in
average indirect loans on a linked-quarter basis slowed in the third quarter of
2006 to $3.6 million compared with $6.3 million in the second quarter of 2006.

Highly competitive lending conditions and ample
availability of commercial financing in our market area has contributed to
slower growth in our commercial loan portfolio in recent quarters. During the
third quarter of 2006, average commercial loans decreased $861,000 compared
with the year ago quarter. Average commercial loans have decreased $2.7 in the
first nine months of 2006 compared with the same period in 2005. Commercial
lending continues to be an important part of our growth strategy, however, we
expect this highly competitive lending environment will continue to negatively
affect the rate of growth in this portfolio for the foreseeable future. As a
result, our leasing initiative will likely result in growth in that portfolio
exceeding that of our traditional commercial loan portfolio in the coming
quarters.

Average investment securities decreased $30.8 million
in the three months ended September 30, 2006 compared with the third quarter of
2005, as we used cash flow from our securities portfolio, along with deposit growth,
to fund our loan originations and payoff a portion of borrowings that matured
during the period.

Average deposits increased $38.0 million in the three
months September 30, 2006 compared with the same period in 2005. Increases in
demand deposits and time accounts offset a decline in savings and money market
accounts, and as a result, we continue to experience a change in our deposit
mix, as depositors continue to favor short-term, higher rate time accounts over
lower rate savings and money market accounts. Average time accounts represented
40.1% of average deposits in the third quarter of 2006, compared with 35.8% in
the year ago quarter. Average savings and money market accounts were 23.1% of
average deposits in the third quarter, down from 26.7% in the third quarter of
2005. Average demand deposits were 19.7% of average deposits in the third
quarter of 2006, up from 18.3% in the third quarter of 2005, as we experienced
gains in both retail and commercial accounts. The growth in deposits reflects
the impacts of our expanded branch presence, its business development
efforts and pricing strategies. Deposit growth was used to fund loan growth and
to reduce borrowings, which decreased $12.8 million in the third quarter of
2006 compared with the year ago quarter.

Our tax-equivalent net interest margin was 2.91% in
the quarter ended September 30, 2006, down 25 basis points from 3.16% in the
year ago period.

We expect the highly competitive deposit pricing in
our markets, along with continued migration of savings and money market
deposits to higher rate short-term time accounts will continue for the
foreseeable future. These conditions, along with the flat and inverted yield
curve, will continue to pressure our net interest margin in coming quarters.

Net interest income was $19.6 million for the nine
months ended September 30, 2006, a decrease of $611,000 or 3.0% compared with
the nine months ended September 30, 2005. Total interest income increased $6.5
million to $40.3 million in the nine months ended September 30, 2006 compared
with $33.8 million in the same period in 2005. This increase was offset by an
increase in interest expense of $7.1 million, to $20.7 million in the nine
months ended September 30, 2006 compared with the year ago period.

The increase in average earning assets of $69.8 million
for the nine months ended September 30, 2006 compared with the year ago period
partially offset the impact of a decrease in our net interest margin over this
time period. As discussed in the analysis of the third quarter of 2006 compared
with the third quarter of 2005, competitive deposit pricing pressures, higher
short-term interest rates and the flat and inverted yield curve resulted in our
cost of funds increasing more than our asset yields. The tax-equivalent yield
on earning assets increased 54 basis points in the

13

nine months ended September
30, 2006 compared with the same period in 2005. The average cost of funds
increased 102 basis points in the same time period.


Average earning asset growth for the nine months ended
September 30, 2006 compared with the year ago period showed trends similar to
those for the third quarter of 2006 compared with the third quarter of 2005,
except for the commercial loan portfolio. Average leases and indirect loans increased
$50.8 million and $39.4 million, respectively, in the nine months ended
September 30, 2006 compared with the same period in 2005. Average commercial
loans increased $2.7 million in the nine months ended September 30, 2006
compared with the year ago period, reflecting stronger portfolio growth in the
first half of 2006.

Average deposits increased $75.0 million in the nine
months ended September 30, 2006 compared with the same period in 2005, with
trends similar to those discussed in the analysis of the third quarter of 2006
versus the prior year period. Average time accounts represented 47.0% of
average deposits in the nine months ended September 30, 2006, compared with
41.6% in the year ago period, while average savings and money market accounts
decreased to 29.6% of average deposits, from 35.3% in the first nine months of
2005. Average demand deposits remained relatively steady as a percentage of
average deposits, and were 23.4% of average deposits in the first nine months
of 2006, compared with 23.0% in the same period in 2005.

Average borrowings decreased $12.6 million in the
first nine months of 2006 compared with the year ago period, as a
portion of borrowings that matured during the 2006 period were paid off.

Our tax-equivalent net interest margin was 3.00% in
the nine months ended September 30, 2006, down 31 basis points from 3.31% in
the year ago period.

14

Average Balance Sheet and Non-interest
Analysis

The following
table sets forth information concerning average interest-earning assets and
interest-bearing liabilities and the average yields and rates thereon for the
periods indicated. Interest income and yield information is adjusted for items
exempt from federal income taxes and assumes a 34% tax rate. Non-accrual loans
have been included in the average balances. Securities are shown at average
amortized cost.

Three months ended September 30,2006

2005AverageBalance

InterestEarned/Paid

Yield/Rate

AverageBalance

InterestEarned/Paid

Yield/Rate(Dollars in thousands)Assets:Interest earning
assets:Federal funds
sold

$
179

$
4


8.92
%
$
6,978

$
63


3.61
%Taxable
investment securities


177,285


1,839


4.15
%

213,671


1,966


3.68
%Nontaxable
investment securities


70,987


1,097


6.18
%

73,525


1,148


6.25
%Real estate
loans


195,084


2,978


6.11
%

178,726


2,710


6.07
%Commercial
loans


156,863


3,097


7.90
%

157,613


2,775


7.04
%Nontaxable
commercial loans


7,160


121


6.77
%

7,271


112


6.17
%Taxable
leases, net of unearned discount


80,369


1,490


7.42
%

36,051


532


5.90
%Nontaxable
leases, net of unearned discount


18,144


265


5.85
%

9,698


148


6.10
%Indirect
loans


183,301


2,374


5.18
%

161,162


1,920


4.77
%Consumer
loans


67,122


1,305


7.78
%

68,001


1,101


6.48
%Total interest-earning
assets


956,494


14,570


6.09
%

912,696


12,475


5.47
%Non-interest earning
assets:Other
assets


61,155








63,708Allowance for
loan losses


(5,270
)







(5,321
)Net unrealized (loss) gain on
securities available-for-sale


(4,235
)







217Total
assets

$
1,008,144







$
971,300Liabilities and
shareholders equity:Interest bearing
liabilities:Demand
deposits

$
86,010

$
135


0.63
%
$
79,527

$
57


0.29
%Savings
deposits


54,025


74


0.55
%

58,725


76


0.52
%MMDA
deposits


160,121


1,188


2.97
%

179,157


1,007


2.25
%Time
deposits


371,922


4,203


4.52
%

318,683


2,492


3.13
%Borrowings


159,204


2,004


5.04
%

170,288


1,633


3.84
%Total interest-bearing
liabilities


831,282


7,604


3.66
%

806,380


5,265


2.61
%Non-interest bearing
liabilities:Demand
deposits


96,332








83,269Other
liabilities


9,684








11,066Shareholders equity


70,846








70,585Total
liabilities and shareholders equity

$
1,008,144







$
971,300Net interest income
(FTE)




$
6,966







$
7,210Net interest margin








2.91
%







3.16
%Net interest rate
spread








2.43
%







2.86
%Federal tax exemption on
non-taxable investment securities included in
  interest income




$
504







$
47815



Nine months ended September 30,2006

2005AverageBalance

InterestEarned/Paid

YieldRate

AverageBalance

InterestEarned/Paid

YieldRate(Dollars in thousands)Assets:Interest
earning assets:Federal funds
sold

$
2,965

$
121


5.44
%
$
4,812

$
109


3.02
%Taxable
investment securities


185,164


5,729


4.12
%

222,371


6,221


3.73
%Nontaxable
investment securities


72,150


3,368


6.22
%

72,688


3,445


6.32
%Real estate
loans


190,522


8,652


6.05
%

176,718


8,011


6.04
%Commercial
loans


156,177


9,149


7.81
%

153,336


7,734


6.72
%Nontaxable
commercial loans


6,886


345


6.69
%

7,052


302


5.70
%Taxable leases
net of unearned discount


62,662


3,196


6.80
%

22,952


1,151


6.68
%Nontaxable
leases net of unearned discount


17,654


767


5.79
%

6,551


320


6.51
%Indirect
loans


178,813


6,697


4.99
%

139,412


4,874


4.66
%Consumer
loans


67,732


3,839


7.56
%

65,072


3,057


6.26
%Total interest-earning
assets

$
940,725

$
41,863


5.93
%
$
870,964

$
35,224


5.39
%Non-interest earning
assets:Other
assets


60,726








62,612Allowance for loan
losses


(5,128
)







(5,234
)Net unrealized (loss) gain on
securities available-for-sale


(3,600
)







486Total
assets

$
992,723







$
928,828Liabilities and
shareholders equity:Interest bearing
liabilities:Demand
deposits

$
84,971

$
336


0.53
%
$
80,177

$
171


0.28
%Savings
deposits


55,069


225


0.54
%

61,231


233


0.51
%MMDA
deposits


170,833


3,624


2.83
%

181,783


2,774


2.03
%Time
deposits


358,448


11,130


4.14
%

286,298


6,233


2.90
%Borrowings


149,923


5,388


4.79
%

161,910


4,182


3.44
%Total
interest-bearing liabilities

$
819,244

$
20,703


3.37
%
$
771,399

$
13,593


2.35
%Non-interest bearing
liabilities:Demand
deposits


93,438








78,276Other
liabilities


9,704








9,610Shareholders equity


70,337








69,543Total
liabilities and shareholders equity

$
992,723







$
928,828Net interest income
(FTE)




$
21,160







$
21,631Net interest margin








3.00
%







3.31
%Net interest rate
spread








2.56
%







3.04
%Federal tax exemption on
non-taxable investment securities included in
  interest income




$
1,523







$
1,38316

The following
table sets forth the dollar volume of increase (decrease) in interest income
and interest expense resulting from changes in the volume of earning assets and
interest-bearing liabilities, and from changes in rates for the periods
indicated. Volume changes are computed by multiplying the volume difference by
the prior periods rate. Rate changes are computed by multiplying the rate
difference by the prior periods balance. The change in interest income and
expense due to both rate and volume has been allocated equally between the
volume and rate variances.

Three
  months ended September 30, 2006
  compared to 2005

Nine months
  ended September 30, 2006
  compared to 2005Increase
  (decrease) due to

Increase (decrease)
  due toVolume

Rate

Net
  Change

Volume

Rate

Net
  Change(Dollars
in thousands)Federal funds sold


$
(106
)


$
47



$
(59
)


$
(58
)


$
70



$
12Taxable investment
securities



(356
)



229




(127
)



(1,096
)



604




(492
)Non-taxable investment
securities



(40
)



(11
)



(51
)



(25
)



(52
)



(77
)Real estate loans



249




19




268




626




15




641Commercial loans



(14
)



336




322




155




1,260




1,415Non-taxable commercial
loans



(2
)



11




9




(8
)



51




43Taxable leases, net of unearned
discount



738




220




958




2,008




37




2,045Non-taxable leases, net of
unearned discount



126




(9
)



117




513




(66
)



447Indirect loans



275




179




454




1,425




398




1,823Consumer loans



(16
)



220




204




138




644




782Total
interest-earning assets


$
854



$
1,241



$
2,095



$
3,678



$
2,961



$
6,639Interest-bearing demand
deposits



7




71




78




15




150




165Savings deposits



(6
)



4




(2
)



(24
)



16




(8
)MMDA deposits



(124
)



305




181




(199
)



1,049




850Time deposits



509




1,202




1,711




1,905




2,992




4,897Borrowings



(134
)



426




292




(370
)



1,393




1,023Junior subordinated obligations
issued to unconsolidated subsidiary
  trusts



32




47




79




30




153




183Total interest-bearing
liabilities


$
284



$
2,055



$
2,339



$
1,357



$
5,753



$
7,110Net interest
income (FTE)


$
570



$
(814
)


$
(244
)


$
2,321



$
(2,792
)


$
(471
)17



Analysis of Asset Quality and the Provision
and Allowance for Loan and Lease Losses

We establish
provisions for loan and lease losses, which are charged or credited to
operations, in order to maintain the allowance for loan and lease losses at a
level management considers necessary to absorb probable credit losses in the
current loan and lease portfolio. The amount of the allowance is based on
estimates and the ultimate losses may vary from such estimates as more
information becomes available or later events occur. Management assesses the
allowance for loan and lease losses on a quarterly basis and makes provisions
for loan and lease losses in order to adjust the allowance, when necessary.

Nonperforming
assets increased $262,000 in the third quarter of 2006, and were $1.1 million
or 0.11% of total assets, compared with $848,000 or 0.09% at June 30, 2006, but
were down from $1.6 million or 0.17% at December 31, 2005. The increase in the
third quarter resulted primarily from one commercial relationship in the amount
of $217,000 (net of a $257,000 charge-off recorded during the third quarter)
being added to non-performing status. The remaining balance of this loan was
paid off in October 2006 without further loss.

In
addition to the nonperforming loans discussed above, the Company has also
identified approximately $5.7 million in potential problem loans at September
30, 2006 as compared to $7.1 million at June 30, 2006 and $9.8 million at
December 31, 2005. The decrease in potential problem loans during the periods
indicated resulted from a combination of chargeoffs and paydowns on classified
commercial loans as well as a general decrease in loans classified as
substandard and worse. Potential problem loans are loans that are currently
performing, but where known information about possible credit problems of the
related borrowers causes management to have concerns as to the ability of such
borrowers to comply with the present loan repayment terms and which may result
in disclosure of such loans as nonperforming at some time in the future. At the
Company, potential problem loans are typically loans that are performing but
are classified by the Companys loan rating system as substandard. At
September 30, 2006, potential problem loans primarily consisted of commercial
real estate and commercial loans. Management cannot predict the extent to which
economic conditions may worsen or other factors which may impact borrowers and
the potential problem loans. Accordingly, there can be no assurance that other
loans will not become 90 days or more past due, be placed on non-accrual,
become restructured, or require increased allowance coverage and provision for
loan losses.

The provision
for loan and lease losses was $550,000 in the third quarter of 2006, compared
with $125,000 in the year-ago quarter. Net charge-offs were $318,000 in the
three months ended September 30, 2006, compared with $105,000 in the year-ago
quarter, the increase resulting primarily from the write-down of the one
commercial relationship mentioned above. The allowance for loan and
lease losses was $5.4 million at September 30, 2006, compared with $5.0 million
at December 31, 2005. The ratio of the allowance for loan and lease losses to
nonperforming loans and leases was 495.8% at September 30, 2006, compared with
304.7% at December 31, 2005, reflecting the decrease in nonperforming loans and
leases during this period.

The provision
for loan and lease losses was $2.0 million for the nine months ended September
30, 2006, compared with a recovery of loan and lease provisions of $34,000 in
the same period in 2005. The increase in the provision for loan and lease
losses is due primarily to a $1.5 million increase in net chargeoffs recorded
in 2006 compared with 2005. Approximately 52.7% of the chargeoffs recorded in
2006 occurred in the first quarter, due primarily to losses incurred with one
commercial customer that was negatively impacted by the dramatic
increase in energy costs at that time. The recovery of loan and lease
provisions in the nine months ended September 30, 2005 resulted primarily from
a very low level of net chargeoffs during the period, and to overall strong
asset quality.

18

The following
tables present a summary of non-performing assets for the periods indicated and
a summary of the changes in the allowance for loan and lease losses arising
from loans and leases charged off and recoveries on loans and leases previously
charged off and additions to the allowance, which have been charged to expense
for the periods indicated.

September
  30, 2006

June 30,
  2006

December
  31, 2005Non-accruing Loans and
Leases:Residential
real estate loans

$
9

$
10

$
11Commercial
loans


619


345


1,104Leases


99


99


Indirect
loans


70


76


74Other consumer
loans


64


55


169Total
non-accruing loans and leases


861


585


1,358Accruing loans and leases
delinquent 90 days or more


229


244


270Total
non-performing loans and leases


1,090


829


1,628Other real estate and
repossessed assets


20


19


6Total
non-performing assets

$
1,110

$
848

$
1,634Three
  months ended
  September 30,

Nine months
  ended
  September 30,2006

2005

2006

2005Allowance for loan and lease
losses, beginning of period

$
5,170

$
5,141

$
4,960

$
5,267Loans and leases
charged-off


(519
)

(237
)

(2,030
)

(588
)Recoveries of loans and leases
previously charged-off


201


132


505


516Net loans and leases
charged-off


(318
)

(105
)

(1,525
)

(72
)Provision for loan and lease
losses


550


125


1,967


(34
)Allowance for loan and lease
losses, end of period

$
5,402

$
5,161

$
5,402

$
5,161The following
table presents certain asset quality ratios for the periods indicated:

Three
  months ended
  September 30,

Nine months
  ended
  September 30,2006

2005

2006

2005Net loans and leases
charged-off to average loans and leases,
  annualized


0.18
%

0.07
%

0.30
%

0.02
%Provision for loan and lease
losses to average loans and leases,
  annualized


0.31
%

0.08
%

0.39
%

(0.01
%)Allowance for loan and lease
losses to period-end loans and leases


0.74
%

0.82
%

0.74
%

0.82
%Allowance for loan and lease
losses to non-performing loans and leases


495.80
%

252.89
%

495.80
%

252.89
%Non-performing loans and leases
to period-end loans and leases


0.15
%

0.32
%

0.15
%

0.32
%Non-performing assets to
period-end assets


0.11
%

0.21
%

0.11
%

0.21
%19

Non-interest
Income

The following table sets forth certain information on
non-interest income for the periods indicated, (dollars in thousands):

Three
  months ended September 30,

Nine
  months ended September 30,2006

2005

Change

2006

2005

ChangeTrust & brokerage
  income

$
2,157

$
2,262

$
(105
)
(4.64
)%
$
6,637

$
5,617

$
1,020

18.16
%Service charges on deposit
  accounts


1,001


693


308

44.44
%

2,938


2,044


894

43.74
%Loss on sale of securities
  available-for-sale










0.00
%




(22
)

22

100.00
%Bank-owned life
insurance


102


102




0.00
%

300


301


(1
)
(0.33
)%Gain on the sale of
loans


24


16


8

50.00
%

70


127


(57
)
(44.88
)%Card-related fees


293


234


59

25.21
%

851


670


181

27.01
%Rental income from
  operating leases


185


212


(27
)
(12.74
)%

601


984


(383
)
(38.92
)%Other non-interest
income


408


205


203

99.02
%

845


536


309

57.65
%Total non-interest
income

$
4,170

$
3,724

$
446

11.98
%
$
12,242

$
10,257

$
1,985

19.35
%The increase in non-interest income for the three
months and nine months ended September 30, 2006 compared with the year-ago
periods resulted primarily from increases in trust and brokerage revenue,
service charges on deposit accounts and card-related fees partially offset by
lower rental income from operating leases.

The decline in trust revenue for the three months
ended September 30, 2006 compared with the year-ago period is due primarily to
a higher level of client estate related transactions in the third quarter of
2005. Trust revenue increased by $1.0 million or 18.2% for the nine months
ended September 30, 2006 compared with the same period in 2005, reflecting the
impact of our February 2005 acquisition of $560 million of trust assets under
management from HSBC Bank, USA, N.A. Average trust assets under management for
the three months and nine months ended September 30, 2006 totaled $887.3
million and $878.5 million, respectively, compared with $858.8 million and
$784.1 million, respectively in the prior year periods.

Service charges on deposit accounts increased in both
the three months and nine months ended September 30, 2006 compared with the
prior year periods primarily from an increase in the fee we charge for
overdrafts to an amount that reflects current market conditions. Also
contributing to the increase in service charges is growth in our customer base
over the past year.

The volume of mortgage loans sold to the secondary
market, on which servicing is retained, increased during the third quarter of
2006 due to higher origination volume compared with the year-ago quarter,
resulting in an increase in gains on sale of loans when compared to the third
quarter of 2005. However, overall year to date loan sale volume is lower than
the same period in 2005 resulting in lower gain on sale of loans for the nine
months ended September 30, 2006 compared with the same period in 2005.

Card-related fees increased in both the three months
and nine months ended September 30, 2006 compared with the year-ago period due
primarily to an increase in customer debit card utilization and growth in
customer accounts.

Rental income from leases decreased in the quarterly
period ended September 30, 2006 compared with the year ago period due to the
declining balances in our operating lease portfolio. We ceased originating
operating leases in early 2004, and as a result, rental income will continue to
decline in the remainder of 2006, during which time substantially all of the
remaining rental income from these leases will be recognized.

Other
non-interest income increased in both the three month and nine months ended
September 30, 2006 compared with the prior year periods due primarily to the
disposal of fixed assets which resulted in gains of $54,000 in the third
quarter of 2006 compared to net losses of $71,000 during the same period in
2005. Non-interest income (excluding losses on sales of securities)
comprised 39.2% and 38.4%, respectively, of revenue in the three months and
nine months ended September 30, 2006 compared with 35.6% and 33.7%,
respectively, in the year-ago periods.

20



Operating
Expenses

The following table sets forth certain information on
operating expenses for the periods indicated, (dollars in thousands):

Three
  months ended September 30,

Nine months
  ended September 30,2006

2005

Change

2006

2005

ChangeSalaries and employee
benefits

$
3,903

$
4,331

$
(428
)
(9.88
)%
$
11,722

$
12,508

$
(786
)
(6.28
)%Building, occupancy, and
equipment


1,495


1,295


200

15.44
%

4,528


4,341


187

4.31
%Communication expense


146


154


(8
)
(5.19
)%

407


475


(68
)
(14.32
%Stationery and
supplies


125


131


(6
)
(4.58
)%

336


350


(14
)
(4.00
)Marketing


124


202


(78
)
(38.61
)%

638


537


101

18.81Amortization of intangible
assets


126


126




0
%

378


292


86

29.45
%Professional fees


697


557


140

25.13
%

2,083


1,568


515

32.84
%Other operating
expenses


1,072


938


134

14.29
%

3,142


2,912


230

7.90
%Total non-interest
expenses

$
7,688

$
7,734

$
(46
)
(0.59
)%
$
23,234

$
22,983

$
251

1.09
%Non-interest expenses were $7.7 million in the quarter
ended September 30, 2006, which was a decrease of $46,000 or 0.59% compared to
$7.7 million in the third quarter of 2005.

Salaries and employee benefits decreased $428,000 or
9.9% in the third quarter of 2006 compared with the year-ago quarter, primarily
due to efficiencies gained through the implementation of a new staffing model
in the first quarter of 2006. Total full-time equivalent employees were 253 at
September 30, 2006, compared with 309 at September 30, 2005.

Building, occupancy and equipment expense increased
$200,000 or 15.4% due to a $139,000 increase in depreciation of assets under
operating leases resulting from lower estimates of the assets residual values.
The remaining book value of assets under operating leases was $305,000 at
September 30, 2006, and will be substantially depreciated to the assets
estimated residual values by December 31, 2006. Also contributing to the
increase in occupancy and equipment is the timing of branch maintenance and
improvement projects and the added cost of operating a new branch that opened
in the third quarter of 2005.

Other operating expense increased $134,000 or 14.3% in
the third quarter of 2006 compared with the same period in 2005 due primarily
to increased customer debit card activity resulting in higher transaction fees
for the Company, which is offset by the increase in card-related income
discussed above.

Non-interest expenses were $23.2 million for the nine
months ended September 30, 2006, which was an increase of $251,000 or 1.1%
compared with the year-ago period.

Salaries and benefits decreased $786,000 for the nine
months ended September 30, 2006 compared with the same period in 2005, due
primarily to efficiencies gained through the staffing model discussed above.

Building, occupancy and equipment expense increased
$187,000 for the nine months ended September 30, 2006, compared with the
year-ago period due to the same factors affecting the third quarter discussed
above.

Marketing expense increased $101,000 or 18.8% for the
nine months ended September 30, 2006 compared with the same period in 2005, due
primarily to an increased level of marketing and promotional activities in the
first half of 2006 in support of our business development initiatives.

Amortization of intangible asset expense increased
$86,000 or 29.5% in the first nine months of 2006 compared with the same period
in 2005, reflecting the full year impact in 2006 of amortization of the
intangible asset created in connection with the purchase of the trust business
in February 2005 as discussed previously in this Form 10-Q.

21

The increase in professional fees of $515,000 or 32.8%
for the first nine months of 2006 compared with the year-ago period primarily
reflects the final payment in the first quarter of 2006 of costs associated
with the companys earnings improvement initiative, which was commenced in the
fourth quarter of 2005 and resulted in increased fee income and lower salaries
and benefits expense as discussed herein. Also contributing to the increase in
professional fees were non-routine professional service engagements relating to
information technology and other operational projects during 2006.

Income
taxes

The Companys effective tax rate was 21.7% for the
nine months ended September 30, 2006, below the rate of 24.0% reported for the
nine months ended September 30, 2005. The lower tax rate in the current year
period was attributable to an increase in tax-exempt income as a percentage of
total income. The difference from the statutory rate is driven substantially by
tax-exempt income.

ANALYSIS
OF FINANCIAL CONDITION

Total assets increased $57.2 million to $1.0 billion
at September 30, 2006 compared to $980.4 million at December 31, 2005. Total
loans and leases (net of unearned income) increased $71.8 million in the first
nine months of 2006, while securities available-for-sale decreased $21.9
million.

Leases (net of unearned income) increased $47.3
million or 72.6% in the first nine months of 2006, as a result of the business
development initiatives undertaken during this time period. Net leases totaled
$112.5 million and represented 15.5% of total loans and leases at September 30,
2006, compared with $65.2 million or 10.0% of total loans and leases at
December 31, 2005. We expect leases to become an increasingly larger portion of
our total loan and lease portfolio over the remainder of 2006 as growth in this
portfolio is expected to exceed that of our other portfolios.

Indirect loans increased $12.6 million or 7.3% in the
first nine months of 2006. Indirect loans totaled $184.7 million and were 25.4%
of total loans and leases at September 30, 2006, compared with $172.1 million
or 26.3% of total loans and leases at December 31, 2005. As discussed
previously in this Form 10-Q, we increased our indirect loan rates during the
second quarter of 2006 with the intent of slowing the rate of growth in this
portfolio in coming quarters

The increase in loans and leases during the first nine
months of 2006 was funded primarily with deposit growth of $43.4 million during
the period.

Securities available-for-sale decreased $21.9 million
due primarily to maturities and amortization of securities. Cash flows from the
securities portfolio were used to pay down borrowings that matured during the
period and to fund loan and lease growth.

The following table sets forth the composition of the
Banks loan and lease portfolio at the dates indicated (dollars in thousands):

September
  30, 2006

Percent

December
  31, 2005

PercentCommercial loans

$
165,709


22.8
%
$
162,350


24.8
%Residential real
  estate loans


196,741


27.1
%

186,550


28.5
%Leases (net of
  unearned income)


112,471


15.5
%

65,172


10.0
%Indirect loans


184,745


25.4
%

172,113


26.3
%Other consumer
  loans


66,248


9.2
%

67,901


10.4
%Total loans
  & leases

$
725,914


100.0
%
$
654,086


100.0
%Allowance for
  loan & lease losses


(5,402
)




(4,960
)Net loans and
  leases

$
720,512




$
649,12622

The following table sets forth the amortized cost and
fair value for the Companys securities available-for-sale portfolio (dollars
in thousands):

September
  30, 2006

December
  31, 2005Amortized
  Cost

Fair
  Value

Amortized
  Cost

Fair
  ValueU.S. Treasury
obligations

$
6,771

$
6,298

$
6,574

$
6,105U.S. Government sponsored
corporations


66,632


65,714


66,456


65,302Mortgage-backed
securities


90,768


88,521


111,968


109,477Obligations of states and
political subdivisions


71,524


72,610


73,610


74,908FHLB and Federal Reserve Bank
stock


5,788


5,788


6,508


6,508Other equity
securities


5,596


5,990


5,132


5,194Total

$
247,079

$
244,921

$
270,248

$
267,494Net unrealized loss on
securities available-for-sale


(2,158
)




(2,754
)Total carrying value

$
244,921




$
267,494Deposits were $782.6 million at September 30, 2006, an
increase of $43.4 million, or 5.9% from December 31, 2005. Increases in the
time deposit and checking account categories offset decreases in money market
and savings accounts.

Time deposits increased $41.5 million or 12.4% in the
first nine months of 2006, with the growth occurring primarily in the retail
category as consumers continue to favor higher rate short-term time deposits
over money market and savings accounts. Offsetting some of this increase was a
slight decline in commercial time deposits. Time deposits as a percentage of
total deposits increased to 48.0% at September 30, 2006, up from 45.2% at
year-end 2005. We expect migration of retail money market and savings accounts
into short-term time accounts will continue in the current interest rate and
competitive environments, with the resulting higher cost of funds further
pressuring our net interest margin.

Total checking deposits increased $23.1 million or
13.4% during the first nine months of 2006 and total $195.5 million at
September 30, 2006 compared to $172.4 million at the end of 2005. Growth
occurred in the municipal and commercial lines with retail checking
experiencing a modest decline. Municipal checking balances grew by $13.5
million or 80.6% due primarily to municipalities shifting funds from money
market accounts to interest-bearing checking in order to meet their liquidity
needs. Commercial demand balances increased $9.8 million or 12.7% in the first
nine months of 2006 as commercial business initiatives undertaken to leverage
commercial lending relationships showed positive results. Total checking
deposits were 25.0% of total deposits at September 30, 2006, up from 23.4% at
December 31, 2005.

Partially offsetting the growth in time and checking
account balances was a decline in money market balances during the first half
of 2006. Money market accounts at September 30, 2006 totaled $158.9 million,
down $18.0 million or 10.2% from December 31, 2005. Retail and municipal money
market accounts decreased $11.6 million and $11.0 million, respectively. Retail
money market accounts continued to migrate to higher rate short-term time
deposits, while the decline in municipal money market balances was due
primarily to municipalities shifting funds to checking accounts as discussed
above. Money market accounts as a percentage of total deposits were 20.3% at
September 30, 2006, down from 23.9% of total deposits at December 31, 2005.

23



The following table sets forth the composition of the
Companys deposits by business line at the dates indicated:

September
  30, 2006

December
  31, 2005Retail

Commercial

Municipal

Total

Percent

Retail

Commercial

Municipal

Total

PercentNon-interest
  checking

$
15,638

$
78,751

$
4,392

$
98,781


12.6
%
$
18,217

$
68,674

$
4,992

$
91,883


12.5
%Interest checking


62,493


8,427


25,795


96,715


12.4
%

60,150


8,661


11,725


80,536


10.9
%Total checking


78,131


87,178


30,187


195,496


25.0
%

78,367


77,335


16,717


172,419


23.4
%Savings


45,682


4,516


1,854


52,052


6.7
%

49,501


3,979


1,734


55,214


7.5
%Money market


69,287


34,391


55,205


158,883


20.3
%

80,870


29,809


66,215


176,894


23.9
%Time deposits


300,740


22,121


53,266


376,127


48.0
%

260,247


22,462


51,882


334,591


45.2
%Total deposits

$
493,840

$
148,206

$
140,512

$
782,558


100.0
%
$
468,985

$
133,585

$
136,548

$
739,118


100.0
%Borrowings declined $5.8 million, or 3.9%, during the
first nine months of 2006, and the paydowns were funded primarily from cash
flows from our securities portfolio.

Liquidity

The Companys liquidity primarily reflects the Banks
ability to provide funds to meet loan and lease requests, to accommodate
possible outflows in deposits, to take advantage of market interest rate
opportunities, and to pay dividends to the company. Funding loan and lease
requests, providing for liability outflows, and managing of interest rate
fluctuations require continuous analysis in order to match the maturities of
specific categories of short-term loans and leases and investments with
specific types of deposits and borrowings. Liquidity is normally considered in
terms of the nature and mix of the Banks sources and uses of funds. The Asset
Liability Committee (ALCO) of the Bank is responsible for implementing the
policies and guidelines for the maintenance of prudent levels of liquidity.
Management believes, as of September 30, 2006, that liquidity as measured by
the Bank is in compliance with its policy guidelines.

The Banks principal sources of funds for operations
are cash flows generated from earnings, deposits, loan and lease repayments,
borrowings from the Federal Home Loan Bank of New York (FHLB), and securities
sold under repurchase agreements. During the nine months ended September 30,
2006, cash and cash equivalents increased by $7.5 million, as net cash provided
by operating, and deposit and financing activities of $59.0 million exceeded
the cash used by lending and investing activities of $51.5 million. Net cash
provided by deposit and financing activities primarily reflects net increases
in deposits and junior subordinated obligations issued to unconsolidated subsidiary
trusts of $43.4 million and $15.5 million, respectively, and a net decrease in
borrowings of $5.8 million. Net cash from operating activities was primarily
provided by net income in the amount of $5.2 million. Net cash used in lending
and investing activities reflects a net increase in loans and leases of $73.4
million and a net decrease in investment securities of $23.3 million.

As a member of the FHLB, the Bank is eligible to
borrow up to an established credit limit against certain residential mortgage
loans and investment securities that have been pledged as collateral. As of
September 30, 2006, the Banks credit limit with the FHLB was $154.8 million.
The total of the Banks outstanding borrowings from the FHLB on that date was
$85.0 million.

Capital
Resources

During the nine months ended September 30, 2006,
shareholders equity increased $3.9 million to $73.5 million, while book value
per share increased from $19.52 to $20.51. Shareholders equity was positively
impacted during the first nine months of the year by net income of $5.2
million, by transactions related to restricted stock and stock option exercises
aggregating $1.3 million, and by a $226,000 decrease (net of taxes) in the
unrealized losses on securities available-for-sale. These increases were
partially offset by dividends totaling $2.4 million and share repurchases
totaling $496,000.

In September 2006, the Company formed a wholly-owned
subsidiary, Alliance Financial Capital Trust II (the Trust), which completed the sale of $15,000,000 of trust
preferred securities on September 21, 2006 that qualify

24



as Tier 1 capital of the Company. The Trust issued the
trust preferred securities at an annual rate equal to the three month LIBOR
rate plus 1.65%. The trust preferred securities mature on September 15, 2036,
and can be called without penalty beginning on September 15, 2011. The Trust
simultaneously issued 464 shares of the Trusts common securities to the
Company for a purchase price of $464,000, which constitutes all of the issued
and outstanding common securities of the Trust. The Trust used proceeds from
the sale of the trust preferred securities and common securities to purchase
the Companys junior subordinated deferrable interest notes due 2036. Approximately $13.2
million of the net proceeds of the offering were used by the Company to fund the cash portion of
the Bridge Street acquisition.

On December 19, 2003, the Company formed a wholly
owned subsidiary, Alliance Financial Capital Trust I (AFCT), a Delaware
business trust. AFCT issued $10,000,000 of 30-year floating rate
Company-obligated pooled capital securities (trust preferred securities) that
qualify as Tier I capital of the Company.

On March 11, 2005, the Federal Reserve Board (FRB)
announced approval of its final rule that allows the continued inclusion of
outstanding and prospective issuances of trust preferred securities in the Tier
1 capital of bank holding companies. Under the final rule, bank holding
companies may continue to treat trust preferred securities as Tier 1 capital up
to the current 25% core capital limit until March 31, 2009. After March 31,
2009, the 25% limit will be calculated net of goodwill (net of any associated
deferred tax liability).

In accordance with the Financial Accounting Standards
Board (FASB) Interpretation No. 46 (FIN 46) Consolidation of Variable
Interest Entities, the Company does not consolidate the assets and liabilities
or income and expenses of Alliance Financial Capital Trust I and II (Variable Interest Entities) with the Companys
financial statements.

In October, 2006 the Companys board of directors
approved a six-month extension, through March 2007, of its stock repurchase program
approved in September 2005. Up to 126,312 additional shares may be repurchased under the
program. Purchases may be made from time to time at managements discretion,
in open market or in privately negotiated transactions. The extent to which
shares are repurchased will depend on a number of factors including market
trends and prices, economic conditions, internal and regulatory trading
blackout periods and alternative uses for capital.

The Company and its banking subsidiary are subject to
various regulatory capital requirements administered by the federal banking
agencies. Failure to meet minimum capital requirements can initiate certain
mandatory and possibly discretionary actions by regulators that, if undertaken,
could have a direct material effect on the Companys financial statements.
Under capital adequacy guidelines and the regulatory framework for prompt
corrective action, the Company must meet specific capital guidelines that
involve quantitative measures of the Companys assets, liabilities, and certain
off-balance-sheet items as calculated under regulatory accounting practices.
The Companys capital amounts and classifications are also subject to
qualitative judgments by the regulators about components, risk weightings, and
other factors. Quantitative measures established by regulation to ensure
capital adequacy require the Company and its subsidiary bank to maintain
minimum amounts and ratios (set forth in the tables below) of total and Tier 1
Capital (as defined in the regulations) to risk-weighted assets (as defined)
and of Tier 1 Capital (as defined) to average assets (as defined).

As of December 31, 2005, the most recent notification
from the Office of the Comptroller of the Currency categorized the Bank as
well-capital­ized, under the regulatory framework for prompt corrective
action. To be categorized as well-capitalized, the Bank must maintain total
risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the
tables below. Management believes that, as of September 30, 2006, the Company
and its subsidiary Bank met all capital adequacy requirements to which they
were subject.

25

The following table compares the Companys actual
capital amounts and ratios with those needed to qualify for the well
capitalized category, which is the highest capital category as defined in the
regulations.

Actual

To be Well
  Capitalized Under
  Prompt Corrective
  Action ProvisionsAmount


Ratio


Amount


Ratio(Dollars
  in thousands)As of September 30, 2006Total
  Capital (to Risk-Weighted Assets)

$
96,370


13.39
%
$
71,956


310.00
%Tier I
  Capital (to Risk-Weighted Assets)


89,609


12.45
%

43,174


36.00
%Tier I
  Capital (to Average Assets)


89,609


8.93
%

50,187


35.00
%As of December 31, 2005Total
  Capital (to Risk-Weighted Assets)

$
76,766


11.72
%
$
52,407


310.00
%Tier I
  Capital (to Risk-Weighted Assets)


71,604


10.93
%

26,204


36.00
%Tier I
  Capital (to Average Assets)


71,604


7.42
%

38,597


35.00
%Application
of Critical Accounting Estimates

The Companys consolidated financial statements are
prepared in accordance with accounting principles generally accepted in the
United States and follow practices within the banking industry. Application of
these principles requires management to make estimates, assumptions, and
judgments that affect the amounts reported in the financial statements and
accompanying notes. These estimates, assumptions, and judgments are based on
information available as of the date of the financial statements; accordingly,
as this information changes, the financial statements could reflect different
estimates, assumptions, and judgments. Certain policies inherently have a
greater reliance on the use of estimates, assumptions, and judgments and as
such have a greater possibility of producing results that could be materially
different than originally reported. Estimates, assumptions, and judgments are
necessary when assets and liabilities are required to be recorded at fair value
or when an asset or liability needs to be recorded contingent upon a future
event. Carrying assets and liabilities at fair value inherently results in more
financial statement volatility. The fair values and information used to record
valuation adjustments for certain assets and liabilities are based on quoted
market prices or are provided by other third-party sources, when available.
When third party information is not available, valuation adjustments are
estimated in good faith by management.

The most significant accounting policies followed by
the Company are presented in Note 1 to the consolidated financial statements
included in the 2005 Annual Report on Form 10-K (the Consolidated Financial
Statements). These policies, along with the disclosures presented in the other
financial statement notes and in this discussion, provide information on how
significant assets and liabilities are valued in the financial statements and
how those values are determined. Based on the valuation techniques used and the
sensitivity of financial statement amounts to the methods, assumptions, and
estimates underlying those amounts, management has identified the determination
of the allowance for loan and lease losses, accrued income taxes, and the fair
value analysis of the intangible asset to be the accounting areas that require
the most subjective and complex judgments, and as such could be the most
subject to revision as new information becomes available.

The allowance for loan and lease losses represents managements
estimate of probable loan and lease losses inherent in the loan and lease
portfolio. Determining the amount of the allowance for loan and lease losses is
considered a critical accounting estimate because it requires significant
judgment and the use of estimates related to the amount and timing of expected
future cash flows on impaired loans and leases, if the loan is not
collateraldependent and measured based on the fair value of the collateral. It
also requires estimates of losses on pools of homogeneous loans and leases
based on historical loss experience and consideration of current economic
trends and conditions, both of which may be susceptible to significant change.
The loan and lease portfolio also represents the largest asset type on the
consolidated balance sheet. Note C to the Consolidated Financial Statements in
this Quarterly Report on Form 10-Q describes the methodology used to determine
the allowance for loan and lease losses, and a discussion of the factors
driving changes in the amount of the allowance for loan and lease losses is
included in this report.

26

The Company estimates its tax expense based on the
amount it expects to owe the respective tax authorities. Accrued taxes
represent the net estimated amount due or to be received from taxing
authorities. In estimating accrued taxes, management assesses the relative
merits and risks of the appropriate tax treatment of transactions, taking into
account statutory, judicial and regulatory guidance in the context of the
Companys tax position. If the final resolution of taxes payable differs from
the Companys estimates due to regulatory determination or legislative or
judicial actions or any other reason, adjustments to tax expense may be
required.

The Company utilizes significance estimates and
assumptions in determining the fair value of its intangible asset for purposes
of impairment testing. The valuation requires the use of assumptions, including
among others, discount rates, rates of return on assets, account attrition and
costs of servicing.

Other
Information

In December of 1998, the Oneida Indian Nation (The
Nation) and the U.S. Justice Department filed a motion to amend a
long-standing land claim against the State of New York to include a class of
20,000 unnamed defendants who own real property in Madison County and Oneida
County. An additional motion sought to include the Company as a representative
of a class of landowners. On September 25, 2000, the United States
District Court of Northern New York rendered a decision denying the motion to
include the landowners as a group, and thus, excluding the Company and many of
its borrowers from the litigation. The State of New York, the County of Madison
and the County of Oneida remain as defendants in the litigation. This ruling
may be appealed by The Nation, and does not prevent The Nation from suing
landowners individually, in which case the litigation could involve assets of
the Company. On August 3, 2001, the Justice Department moved to amend its
complaint to drop landowners as defendants. A Wisconsin Oneida tribe has filed
lawsuits against individual landowners, and has publicly stated its intention
to continue to file other suits against landowners. Management believes that,
ultimately, the State of New York will be held responsible for these claims and
that this matter will be settled without adversely impacting the Company,
although to date efforts to settle this litigation have been unsuccessful.

New
Accounting Pronouncements

In September 2006, the FASB issued
SFAS No. 157, Fair Value Measurements. This Statement applies under other
accounting pronouncements that require or permit fair value measurements. This Statement
defines fair value, establishes methods for measuring fair value and expands disclosures
about fair value measurements. While this Statement does not require any new fair value
measurements, it is intended to increase consistency and comparability in fair value
measurements, and expand disclosures about fair value measurements among companies. This
Statement is effective for the Company beginning January 1, 2008. The Company is currently
evaluating the impact this will have on the Companys current practice of measuring
fair value and any additional disclosures required in our financial statements.

On September 29, 2006,
the Financial Accounting Standards Board FASB issued SFAS No. 158, Employers Accounting for Defined Benefit
Pension and
Other Postretirement Plans (SFAS 158), which amends SFAS 87 and
SFAS 106 to require recognition of the overfunded or underfunded status of
pension and other postretirement benefit plans on the balance sheet. Under SFAS
158, gains and losses, prior service costs and credits, and any remaining
transition amounts under SFAS 87 and SFAS 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.
SFAS 158 is effective for publicly-held companies for fiscal years ending after
December 15, 2006, except for the measurement date provisions, which are
effective for fiscal years ending after December 15, 2008. The Company is
currently analyzing the effects of SFAS 158 and the impact on the Companys
financial conditions or results of operations has not yet been determined.

On September 13, 2006,
the Securities and Exchange Commission SEC issued Staff Accounting Bulleting
No. 108 (SAB 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
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 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 is currently analyzing the
effects of SAB 108 and the impact on the Companys financial conditions or
results of operations has not yet been determined.

27

In June 2006, the FASB
issued Interpretation No. 48, Accounting
for Uncertainty in Income Taxesan interpretation of FASB Statement No. 109.
This Interpretation clarifies the accounting for uncertainty in income taxes
recognized in an enterprises financial statements in accordance with FASB
Statement No. 109, Accounting for Income
Taxes. This Interpretation prescribes a recognition threshold and
measurement attribute for the financial statement recognition and measurement
of a tax position taken or expected to be taken in a tax return. This
Interpretation also provides guidance on derecognition, classification,
interest and penalties, accounting in interim periods, disclosure, and
transition.

This Interpretation is effective for the Company as of
January 1, 2007. The Company is currently analyzing the effects of this
interpretation and the impact on the Companys financial conditions or
results of operations has not yet been determined.

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
FASB Statement No. 140, Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities, with respect to the accounting for
separately recognized servicing assets and servicing liabilities. This
Statement 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 in any of the following situations: i) a
transfer of the servicers financial assets that meets the requirements for
sale accounting; ii) a transfer of the servicers financial assets to a
qualifying special-purpose entity in a guaranteed mortgage securitization in
which the transferor retains all of the resulting securities and classifies
them as either available-for-sale securities or trading securities in
accordance with FASB Statement No. 115, Accounting
for Certain Investments in Debt and Equity Securities; and iii) an
acquisition or assumption of an obligation to service a financial asset that
does not relate to financial assets of the servicer or its consolidated
affiliates. This statement requires all separately recognized servicing assets
and servicing liabilities to be initially measured at fair value, if
practicable. Subsequent measurement for each class of separately recognized
servicing assets and servicing liabilities shall be based on either the
Amortization Method or Fair Value Measurement Method, as defined by this
statement.

This Statement is effective for the Company as of January
1, 2007, and the requirements for recognition and initial measurement of
servicing assets and servicing liabilities will be applied prospectively to all
transactions after the effective date of this Statement. The Company is
currently analyzing the effects of Statement 156 and the impact on the Companys
financial conditions or results of operations has not yet been determined.

Item 3.
Quantitative and Qualitative
  Disclosures About Market RiskMarket risk is the risk of loss in a financial instru­ment
arising from adverse changes in market rates or prices such as interest rates,
foreign currency exchange rates, commodity prices, and equity prices. The
Companys market risk arises principally from interest rate risk in its
lending, deposit and borrowing activities. Other types of market risks do not
arise in the normal course of the Companys business activities.

The Asset Liability Committee (ALCO) is responsible
for reviewing the interest rate sensitivity position and establishing policies
to monitor and limit exposure to interest rate risk. The policies and
guidelines established by ALCO are reviewed and approved by the Companys Board
of Directors.

Interest rate risk is monitored primarily through the
use of two complementary measures: earnings simulation modeling and net present
value estimation. Both measures are highly assumption-dependent and change
regularly as the balance sheet and business mix evolve; however, the Company
believes that taken together they represent a reasonably comprehensive view of
the magnitude of interest rate risk, the distribution of risk along the yield
curve, the level of risk through time, and the amount of exposure to changes in
certain interest rate relationships. The key assumptions employed by these
measures are analyzed regularly and reviewed by ALCO.

Earnings
Simulation Modeling

Net interest income is affected by changes in the
absolute level of interest rates and by changes in the shape of the yield
curve. In general, a flattening of the yield curve would result in a decline in
earnings due to the compression of earning asset yields and funding rates,
while a steepening of the yield curve would result in increased earnings as
investment margins widen. The model requires management to make assumptions
about how the Banks balance sheet is likely to evolve through time in
different interest rate environments. Loan and deposit growth rate assumptions
are derived from historical analysis and managements outlook, as are the
assumptions used to project yields and rates for new loans and deposits. Securities
portfolio maturities and prepayments are assumed to be reinvested in similar
instruments. Mortgage loan prepayment assumptions are developed from industry
median

28

estimates of prepayment speeds in conjunction with the
historical prepayment performance of the Banks own loans. Non-contractual deposit
growth rates and pricing are modeled on historical patterns. Interest rates of
the various assets and liabilities on the balance sheet are assumed to change
proportionally, based on their historic relationship to short-term rates. The
Banks guidelines for risk management call for preventative measures to be
taken if the simulation modeling demonstrates that an instantaneous 2% increase
or decrease in short-term rates over the next twelve months would adversely
affect net interest income over the same period by more than 15% when compared
to the stable rate scenario. At September 30, 2006, based on the results of the
Banks simulation model, and assuming that management does not take action to
alter the outcome, the Bank would expect net interest income to decline 9.9% if
short term interest rates increase by 2%, and to increase 10.7% if short term
interest rates decrease by 2%.

Net
Present Value Estimation

The Net Present Value of Equity (NPV) measure is used
for discerning levels of risk present in the balance sheet that might not be
taken into account in the earnings simulation model due to the shorter time
horizon used by that model. The NPV of the balance sheet, at a point in time,
is defined as the discounted present value of the asset cash flows minus the
discounted value of liability cash flows. Interest rate risk analysis using NPV
involves changing the interest rates used in determining the cash flows and in
discounting the cash flows. The Banks NPV analysis models both an
instantaneous 2% increasing and 2% decreasing interest rate scenario comparing
the NPV in each scenario to the NPV in the current rate scenario. The resulting
percentage change in NPV is an indication of the longer-term repricing risk and
options risk embedded in the balance sheet. The NPV measure assumes a static
balance sheet versus the growth assumptions that are incorporated into the
earnings simulation measure, and an unlimited time horizon instead of the
one-year horizon applied in the earnings simulation model. As with earnings
simulation modeling, assumptions about the timing and the variability of
balance sheet cash flows are critical in NPV analysis. Particularly important
are assumptions driving mortgage prepayments in both the loan and investment
portfolios, and changes in the noncontractual deposit portfolios. These
assumptions are applied consistently in both models. Based on the September 30,
2006 NPV estimation, a 2% instantaneous increase in interest rates was
estimated to decrease NPV by 1.88%. NPV was estimated to increase by 0.66% if
rates immediately declined by 2%. Policy guidelines limit the amount of the
estimated increase/decline to 25% in a 2% rate change scenario.

Item 4.
Controls and ProceduresThe management of the Company is responsible for
establishing and maintaining effective disclosure controls and procedures, as
defined under Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of
1934. As of September 30, 2006, an evaluation was performed under the
supervision of and with the participation of the Chief Executive Officer and
Chief Financial Officer, of the effectiveness of the design and operation of
the Companys disclosure controls and procedures. Based on that evaluation, the
CEO and the CFO concluded that the Companys disclosure controls and procedures
as of September 30, 2006 were effective.

There has been no change in the Companys internal
control over financial reporting that occurred during the most recent fiscal
quarter that materially affected, or is reasonably likely to materially affect,
the Companys internal control over financial reporting.

29

PART II.


OTHER INFORMATIONItem 1.
Legal ProceedingsNot applicable.Item 1A
Risk FactorsIn addition to the risk factors set forth in our
  Report on Form 10-K for the fiscal year ended December 31, 2005, the
  following risk factors should be considered:
We may fail to realize the anticipated benefits of
  the proposed merger with Bridge Street Financial, Inc.
Changes in key management personnel may adversely
  impact our operationsItem 2.
Unregistered Sales of Equity
  Securities and Use of Proceedsa)
Not applicableb)
Not applicablec)

The table below sets forth the information with
  respect to purchases made by the Company (as defined in Rule 10b-18(a) (3)
  under the Securities Exchange Act of 1934, as amended), of our common stock
  during the quarter ended September 30, 2006:Period

Total Number
  of Shares
  Purchased

Average Price
  Paid Per Share

Total Number of
  Shares Purchased
  as Part of Publicly
  Announced Plan

Maximum Number
  of Shares that May
  Yet be Purchased
  Under the Plan (1)7/1/06  7/31/06







126,3128/1/06  8/31/06







126,3129/1/06  9/30/06







126,312Total







126,312(1) On September 28, 2005 the Company announced that
its Board of Directors had authorized the repurchase of up to 5% of the Companys
outstanding common stock, or approximately 180,000 shares, over a 12-month
period commencing on October 1, 2005. On October 5, 2006 the Companys board of
directors approved a six-month extension of this repurchase program, through
March 2007.

Item 3.
Defaults Upon Senior SecuritiesNot applicable.Item 4.
Submission of Matters to a Vote of
  Security HoldersThe Company held a special meeting of shareholders
  on September 20, 2006 for the purpose of voting on the Agreement and Plan of
  Merger (the Agreement), dated as of April 23, 2006, between Alliance
  Financial Corporation and Bridge Street Financial, Inc. The Agreement was
  approved with 2,533,854 shares voting in favor. The votes cast at the meeting
  were as follows:Votes for

Votes against

Votes withheld2,533,854

47,706

23,191Item 5.
Other InformationNot applicable30

Item 6.
ExhibitsExhibits required by Item 601 of Regulation S-K:Ex. No.

Description3.1

Amended and Restated Certificate of Incorporation of
  the Company(1)3.2

Amended and Restated Bylaws of the Company(2)4.1

Indenture dated as of September 21, 2006, between
  Alliance Financial Corporation and Wilmington Trust Company, as trustee (7)10.1

Agreement and Plan of Merger by and between Alliance
  Financial Corporation and Bridge Street Financial, Inc. dated April 23,
  2006(3)10.2

Offer of Employment dated May 1, 2006 by and between
  the Company and J. Daniel Mohr(4)10.3

Change of Control Agreement dated May 3, 2006 by and
  between the Company and J. Daniel Mohr (5)10.4

Restricted Stock Agreement dated May 5, 2006 by and
  between the Company and J. Daniel Mohr(6)10.5

Amended and Restated Declaration of Trust dated as
  of September 21, 2006, among Alliance Financial Corporation, as sponsor,
  Wilmington Trust Company, as Delaware trustee, Wilmington Trust Company, as
  institutional trustee, and J. Daniel Mohr, John H. Watt, Jr. , and Jack H. Webb,
  as administrators(8)10.6

Guarantee Agreement dated as of September 21, 2006,
  between Alliance Financial Corporation, as guarantor, and Wilmington Trust
  Company, as guarantee trustee (9)31.1

Certification of Jack
  H. Webb, Chairman of the Board, President and Chief Executive Officer of the
  Registrant, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002(10)31.2

Certification of J.
  Daniel Mohr, Treasurer and Chief Financial Officer of the Registrant,
  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002(10)32.1

Certification of Jack
  H. Webb, Chairman of the Board, President and Chief Executive Officer of the
  Registrant, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
  Section 906 of the Sarbanes-Oxley Act of 2002(10)32.2

Certification of J.
  Daniel Mohr, Treasurer and Chief Financial Officer of the Registrant,
  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
  Sarbanes-Oxley Act of 2002(10)(1)
Incorporated herein by reference to the exhibit with
  the same number to the Registration Statement on Form S-4 (Registration No.
  333-62623) of the Company filed with the Securities and Exchange Commission
  on August 31, 1998.(2)
Incorporated herein by reference to exhibit number
  3-2 to the Current Report on Form 8-K of the Company (File No. 0-15366) filed
  with the Commission on September 3, 2004.(3)
Incorporated herein by reference to exhibit 10.1 to
  the Current Report on Form 8-K of the Company (File No. 0-15366) filed with
  the Commission on April 24, 2006.31

(4)
Incorporated herein by reference to exhibit 10.1 to
  the Current Report on Form 8-K of the Company (File No. 0-15366) filed with
  the Commission on May 5, 2006.(5)
Incorporated herein by reference to exhibit 10.2 to
  the Current Report on Form 8-K of the Company (File No. 0-15366) filed with
  the Commission on May 5, 2006.(6)
Incorporated herein by reference to exhibit 10.3 to
  the Current Report on Form 8-K of the Company (File No. 0-15366) filed with
  the Commission on May 5, 2006.(7)
Incorporated herein by reference to exhibit 4.1 to
  the Current Report on Form 8-K of the Company (File No. 0-15366) filed with
  the Commission on September 26, 2006.(8)
Incorporated herein by reference to exhibit 10.1 to
  the Current Report on Form 8-K of the Company (File No. 0-15366) filed with
  the Commission on September 26, 2006.(9)
Incorporated herein by reference to exhibit 10.1 to
  the Current Report on Form 8-K of the Company (File No. 0-15366) filed with
  the Commission on September 26, 2006.(10)
Filed herewith.SIGNATURES

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

ALLIANCE FINANCIAL CORPORATIONDATE: November 8, 2006


/s/ Jack H. WebbJack H. Webb, Chairman of the Board, President
                 and
  Chief Executive OfficerDATE: November 8, 2006


/s/ J. Daniel MohrJ. Daniel Mohr, Treasurer and Chief Financial
  Officer32