SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                    FORM 10-K

                  Annual Report Pursuant to Section 13 or 15(d)
                     of the Securities Exchange Act of 1934


For the Fiscal Year ended:                                 Commission File
    DECEMBER 31, 1998                                     Number:  430893107


                           HIGHLANDS BANKSHARES, INC.
             (Exact name of registrant as specified in its charter)


VIRGINIA                                                   54-1796693
(State or other jurisdiction                             (I.R.S. Employer
of incorporation or organization)                      Identification Number)

340 WEST MAIN STREET
ABINGDON, VIRGINIA                                        24210-1128
(Address of principal                                     (Zip Code)
executive offices)

Registrant's telephone number, including area code:              (540)628-9181


           Securities registered pursuant to Section 12(b) of the Act:
                                 NOT APPLICABLE

           Securities registered pursuant to Section 12(g) of the Act:
                          COMMON STOCK, $2.50 PAR VALUE
                                (Title of Class)


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 and (2) has been subject to such filing requirements for
the past 90 days.
Yes [ X ]   No  [   ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K (Section 229.405 of this chapter) is not contained herein, and
will not be contained, to the best of registrant's knowledge, in definitive
proxy or information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K.
[   ]

As of December 31, 1998, there were 1,246,548 shares of Common Stock
outstanding.

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<PAGE>

                       DOCUMENTS INCORPORATED BY REFERENCE

List hereunder the following documents if incorporated by reference and the Part
of Form 10-K into which the documents are incorporated:

(1) Part II incorporates information by reference from the registrant's Annual
    Report to Stockholders for the fiscal year ended December 31, 1998.

(2) Part III incorporates by reference from the registrant's proxy statement for
    its Annual Meeting of Stockholders scheduled for May 12, 1999.

(3) Part IV incorporates by reference from: (i) the registrant's Annual Report
    to Stockholders for the fiscal year ended December 31, 1998, and (ii) the
    registrant's proxy statement for its Annual Meeting of Stockholders
    scheduled for May 12, 1999.

The exhibit index is located on page 26.

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<PAGE>


PART I.

ITEM I.  BUSINESS

                                     GENERAL

        Highlands Bankshares Inc. (the "Corporation") was incorporated in
Virginia in 1995 to serve as the holding company for Highlands Union Bank, (the
"Bank"). The stockholders of the Bank approved the Plan of Reorganization at the
Annual Meeting on December 13, 1995, and the reorganization was consummated on
December 29, 1995 with the Bank becoming a wholly-owned subsidiary of the
Corporation. The Bank is a state charted bank with principal offices in
Abingdon, Virginia. The Bank was incorporated in 1985.

        At December 31, 1998, the Corporation had total assets of $307,764,000,
deposits of $272,341,000, and net worth of $18,279,000.

        The Corporation's principal business activities, which are conducted
through the Bank, are attracting checking and savings deposits from the general
public through its retail banking offices and originating and servicing loans
secured by first mortgage liens on single-family dwellings, including
condominium units. All of the retail banking offices are located in Virginia.
The Corporation also lends funds to retail banking customers by means of home
equity and installment loans, and originates residential constructions loans and
loans secured by commercial property, multi-family dwellings and manufactured
housing units. The Corporation opened an indirect lending department in 1997.
The majority of indirect lending originates through new and used car
dealerships. The indirect lending portfolio comprises a significant portion of
the total consumer loan portfolio. The Corporation invests in certain U.S.
Government and agency obligations and other investments permitted by applicable
laws and regulations. The operating results of the Corporation are highly
dependent on net interest income, the difference between interest income earned
on loans and investments and the cost of checking and savings deposits and
borrowed funds.

        The Bank is a member of the Federal Deposit Insurance Corporation
("FDIC"), and its deposit accounts are insured up to $100,000 as applied by FDIC
guidelines. The Bank is also a member of the Federal Reserve System, as such,
the Bank and the Corporation are subject to the supervision, regulation and
examination of the Federal Reserve. As a Virginia state chartered bank the Bank
is also subject to supervision, regulation and examination by the Virginia State
Corporation Commission.

        The Corporation has two direct subsidiaries as of December 31, 1998. The
Bank which was formed in 1985 and Highlands Capital Trust I, a statutory
business trust (the "Trust") which was created by the Corporation on January 21,
1998. The Corporation's material assets as of December 31, 1998 include:
building and land, approximately $1.4 million; investment securities,
approximately $4.2 million; and its investment in subsidiaries, approximately
$19.8 million. The Corporation's only material liability is the note payable on
the trust preferred debentures issued in January of 1998, $7.5 million.

        The Corporation operates six full service and one express facility
throughout Washington County, Virginia, the City of Bristol, Virginia, Marion,
Virginia., and Glade Spring, Virginia. The Corporation also operates fifteen
off-site ATM's throughout the service areas listed above as well as Russell
County and Wythe County, Virginia.

        The results of operations for the fiscal years ended December 31, 1998,
1997, and 1996 ("fiscal year 1998", "fiscal year 1997" and "fiscal year 1996",
respectively) reflect the Corporation's strategies of expanding its community
banking operations.

        See "Management's Discussion and Analysis" of operations and financial
condition, included as part of the Annual Report to Stockholders, for a detailed
discussion of certain aspects of the Corporation's business.

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<PAGE>



                               LENDING ACTIVITIES

RESIDENTIAL MORTGAGE LENDING

        The Corporation's lending policy is generally to lend up to 80% of the
appraised value of residential property. The Corporation lends up to 95% of the
appraised value with the normal requirement of insurance from private mortgage
insurance companies. This insurance normally covers amounts in excess of 80%
loan to value up to 95%.
        The in-house residential mortgages are comprised of primarily one, three
and five year adjustable rate mortgages and 15 year fixed rate mortgages.
Adjustable rate mortgages are indexed to 275 basis points over the average yield
on United States Treasury securities adjusted to a constant maturity of one,
three or five years. An adjustment limitation (increase or decrease) of 2% per
annum applies to the one year adjustable product. A 4% lifetime cap over the
life of the loan is included in the one, three and five year adjustable rate
mortgages.
        The corporation's existing loan contracts generally provide for
repayment of residential mortgage loans over periods ranging from 15 to 30
years. However, such loans normally have remained outstanding for much shorter
periods of time as borrowers refinance or prepay their loans through the sale of
their homes.
        Most of the Corporation's residential mortgage loans have "due on sale"
clauses which allows the creditor the right to declare a loan immediately due
and payable in the event the borrower sells or otherwise disposes of the real
property. Most of the Corporation's residential mortgage loans are not
assumable.
        Mortgage loans exceeding $450,000 but less than $750,000 must be
approved by the loan committee of the Board of Directors. Mortgage loans in
excess of $750,000 must be approved by the Board of Directors.
        All of the Corporation's mortgage lending is subject to loan origination
procedures established by the Board of Directors. Most originations require a
property valuation by state licensed appraisers, for a fee, approved by the
Board of Directors. Loan applications are obtained to determine the borrowers
ability to repay. Significant items are verified through the use of credit
reports, financial statements, etc.
        It is generally the Corporation's policy to require title insurance on
first mortgage loans in excess of $100,000 (lower where deemed necessary). It is
also the Bank's general policy to require an attorney's opinion statement on all
first mortgage deeds of trust. Fire and casualty insurance (extended coverage)
is generally required on all property serving as security for these loans.
Hazard insurance and flood insurance (where required) is generally provided by
customer prior to closing of the loan. The borrower is generally responsible for
paying insurance premiums and real estate taxes.
        Federal regulations allow the Corporation to originate loans on real
estate within the State of Virginia, and within limits, to originate and
purchase loans or loan participations secured by real estate located in any part
of the United States. During fiscal year 1998 the Corporation's primary lending
area was Washington County, Virginia , the City of Bristol, Virginia, and Smyth
County, Virginia.
        Residential loan originations come from many sources. Some of these
sources include existing customers, walk-in applications, referrals from real
estate brokers and others.
        Federal regulation limits loans to one borrower to a maximum of 15% of
unimpaired capital and unimpaired surplus of the Bank.
        The Corporation receives fees in addition to interest in connection with
real estate loan originations, loan modifications, late payments, etc. Income
from these activities varies from period to period depending on the volume and
type of loan made. Although not a significant portion of the Corporation's
income, late charges are received when monthly payments are delinquent but are
later paid.
        The Corporation also offers secondary market fixed rate mortgages with
terms up to 30 years and up to 95% loan to value. These loans and servicing
rights are generally sold immediately into the secondary market and fees
received booked into income. These loans must meet certain criteria generally
set by the secondary market and are not a significant portion of the Bank's
residential mortgage activity.
        Residential mortgages, including equity lines of credit, made up
approximately 36.99% of the loan portfolio as of December 31, 1998.

CONSTRUCTION AND COMMERCIAL REAL ESTATE LENDING

        The Corporation generally makes construction loans for periods up to one
year on residential and commercial real estate property. These loans are for
interim financing and are either paid off or converted to permanent financing
when completed. At December 31, 1998 outstanding construction loans (net of
undisbursed funds) totaled $2,156,000. These loans are generally made at 80% or
less of appraised value at

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<PAGE>
completion. Funds are advanced as the project is completed after an inspection
by a staff inspector or the appraiser as deemed appropriate. These loans are
made based on established corporate underwriting standards. Most of these
construction loans are one to four family dwellings. The Corporation generally
charges a 1% origination fee on these construction loans in addition to
applicable interest.
        Loans on commercial properties, multi-family dwellings, and apartment
buildings are typically made at 75% to 80% of the appraised value. These loans
totaled $46,097,000 or 19.75% of total loans held for investment at December 31,
1998.
        Commercial and construction loans, by nature, entail additional risk as
compared to residential mortgage lending. They are generally more complex and
involve larger balances than typical residential mortgages. Payments are
typically dependent upon successful operation of a related real estate project
or business as compared to individual earnings on most residential mortgages.
Therefore, the market risk is somewhat greater. Construction delays, cost
overruns or the inability of the contractor to sell the finished product add an
element of risk to such lending.

CONSUMER LENDING

        The Corporation offers other types of loans in addition to real estate
mortgage and construction loans. Consumer loans of many types are offered by the
Corporation. Some of these loans are loans to purchase automobiles, boats,
recreational vehicles and manufactured housing, as well as other secured and
unsecured consumer loans. The Corporation further makes loans secured by savings
accounts at 2% above the rate of the savings instrument. The terms generally do
not exceed ten years for manufactured housing loans and five years on other
consumer loans. Outstanding consumer loans at December 31, 1998 were
$70,137,000.

COMMERCIAL AND AGRICULTURE NON-REAL ESTATE LOANS

        The Corporation also makes commercial (including agriculture) non-real
estate loans. These loans in general have higher risk associated with them than
real estate loans. They are generally secured by inventory, equipment, accounts
receivable, etc., or unsecured in some cases backed by appropriate financial
condition as per the underwriting standards of the Corporation. Agriculture
loans are generally secured by machinery, equipment, other miscellaneous assets
or unsecured in keeping with the underwriting standards of the Corporation. The
timely pay back is dependent upon the successful operation of the business or
farm. The outstanding balance of non-real estate commercial loans was
$24,240,000 at December 31, 1998 and the outstanding balance of non-real estate
agriculture loans was $2,821,000 at December 31, 1998.

                                   INVESTMENTS

INVESTMENT SECURITIES

        The Corporation invests in mortgage-backed securities, agency notes and
bonds, collateralized mortgage obligations (CMO's), municipal bonds, equity
securities and United States Treasury Notes.

        A substantial portion of the mortgage-backed security portfolio consists
of securities that are either insured or guaranteed by FHLMC, FNMA or GNMA.
Guaranteed securities are more liquid than individual mortgage loans. At
December 31, 1998 the Corporation's mortgage-backed securities portfolio had a
carrying value of $37,918,000 or 12.32% of total assets compared to $36,424,000
or 14.10% of total assets at December 31, 1997. Amortized costs of
mortgage-backed securities were $38,077,000 at December 31, 1998 and $36,299,000
for the comparable 1997 period. Due to repayments and prepayments of the
underlying loans, the actual maturities of mortgage-backed securities are
expected to be substantially less than the scheduled maturities.

        The Corporation also holds investments in CMO's with a market value at
December 31, 1998 of $7,873,000 and amortized cost of $7,886,000 compared to a
market value of $480,000 and amortized cost of $476,000 at December 31, 1997.

        The Corporation had $0 and $1,503,000 invested in United States Treasury
Notes at December 31, 1998 and 1997 respectively. These investments represented
approximately 0.00% and 0.58% of total assets at those dates.

                                       5

<PAGE>

        The Corporation had $2,765,000 and $1,486,000 in United States
Government-sponsored Agency Obligations at December 31, 1998 and 1997
respectively. These investments represent approximately 0.90% and 0.57% of total
assets at those dates.

        The Corporation holds the following equity investments: Federal Reserve
Bank Stock of $295,400 and $248,150 as of December 31, 1998 and 1997
respectively; Federal Home Loan Bank Stock of $950,900 and $781,000 for the same
dates as above; and Community Bankers' Bank Stock of $54,750 and $54,750 for the
same dates as above.

        The Corporation also holds investments in municipal bonds of $759,000
and $972,000 as of December 31, 1998 and 1997 respectively. These investments
represented approximately 0.25% and 0.38% of total assets at those dates.

INVESTMENT ACTIVITIES

        Under Federal Reserve regulations, the Bank is required to maintain
certain liquidity ratios and does so by investing in certain obligations and
other securities which qualify as liquid assets under Federal Reserve
regulations. See "Regulation". As a state chartered bank, the Bank's investment
authority is limited by federal law which permits investment in, among other
things, certain certificates of deposit issued by commercial bank, banker's
acceptances, loans to commercial banks for Federal Funds, United States
government and agency obligations of state governments, and corporate bonds.

        The Corporation's investment committee, which meets monthly, follows
Federal Reserve guidelines with respect to portfolio investment and accounting.
Such Federal Reserve guidelines state that insured institutions must account for
securities held for investment, sale and/or trading in accordance with generally
accepted accounting principles. The Corporation maintains a written investment
policy to set forth investment portfolio composition and investment strategy.
The investment portfolio composition policy considers, among other factors, the
financial condition of the institution, the types of securities, amounts of
investments in those securities and safety and soundness considerations
pertaining to the institution. The investment strategy considers, among other
factors, interest rate risk, anticipated maturity of each type of investment and
the intent of the institution with respect to each investment.

                                SOURCES OF FUNDS

GENERAL

        Deposit accounts have traditionally been the principal source of the
Corporation's funds for use in lending and for other general business purposes.
In addition to deposits, the Corporation derives funds from loan repayments,
repayments from securities, FHLB advances and loan participation sales.
Borrowings may be used on a short-term basis to compensate for seasonal or other
reductions in deposits or inflows at less than projected levels, as well as on a
longer term basis to support expanded lending activities.

DEPOSIT ACTIVITIES

        The Corporation, in its continuing effort to remain a competitive force
in its markets, offers a wide variety of deposit services, with varied
maturities, minimum-balance requirements and market-sensitive interest rates
that are attractive to all types of depositors. The Corporation's deposit
products include checking accounts, statement savings accounts, money market
deposit accounts, negotiable orders of withdrawal accounts, individual
retirement accounts and certificates of deposit accounts. The Corporation is
able to offer a broad array of products that are consistent with current Federal
Reserve regulations, and as a major result, the Corporation's deposit portfolio
is, for the most part, sensitive to general market fluctuations.

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<PAGE>
The following table sets forth the various types of accounts offered by the
Corporation at December 31, 1998:

<TABLE>
<CAPTION>
                            Weighted
                            Average               Minimum       Amount
                            Interest              Balance       In                % of
Type of Account             Rate        Term      Deposit       Thousands         Total
---------------             ----        ----      -------       ---------         -----
<S>                        <C>          <C>       <C>           <C>               <C>

Checking Account            0.00%       none     $ 100.00       $  36,187        13.29%
Interest Checking           3.51        none       100.00          14,888         5.47
Passbook Accounts           4.00        none        25.00          35,640        13.09
Money Market
    Deposit Accounts        3.78        none       500.00           7,048         2.59
Christmas Club Accts        4.04        none         5.00              36         0.00
Individual Retirement
    Accounts                6.53        various    500.00          25,217         9.26
Certificates of Deposit
    Accounts                5.82        various    500.00         153,325        56.30
                                                                ---------      -------

Totals                                                           $272,341       100.00%
                                                                 --------       -------
</TABLE>

        The variety of deposit accounts offered by the Corporation and the
competitive rates paid on these deposit accounts has increased the Corporation's
ability to retain deposits and has allowed it to be more competitive in
obtaining new funds, reducing the threat of disintermediation (the flow of funds
away from deposit institutions into direct investment vehicles such as
government and corporate securities). As customers have become more rate
conscious and willing to move funds to higher yielding accounts, the ability of
the Corporation to attract and maintain deposits and the Corporation's cost of
funds have been, and will continue to be, significantly affected by money market
conditions.

        The following table sets forth information relating to the Corporation's
deposits flows during the years indicated.
<TABLE>
<CAPTION>

                                            Years Ended December 31
(In Thousands)                             1998      1997      1996
--------------                             -----     ----      ----
<S>                                      <C>        <C>        <C>
Increase (decrease) in deposits before
   interest credited back to accounts    $ 28,880   $ 41,924   $ 38,054
Interest credited back to accounts          6,815      5,251      4,090
                                         --------   --------   --------
Net increase in deposits                   35,695     47,175     42,144
                                         --------   --------   --------
Total deposits at year end               $272,341   $236,646   $189,471
                                         --------   --------   --------
</TABLE>


BORROWINGS

        The Corporation may obtain advances from the FHLB upon the security of
the capital stock it owns in the bank and certain of its home mortgage loans
provided certain standards related to creditworthiness have been met. Such
advances may be made pursuant to several different credit programs. Each credit
program has its own interest rate and range of maturities and the FHLB
prescribes the acceptable uses to which the advances pursuant to each program
may be used, as well as limitations on the

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<PAGE>

size of such advances. Depending on the program, such limitations are based
either on a fixed percentage of the Corporation's net worth or on the FHLB's
assessment of the Corporation's creditworthiness. The FHLB is required to review
its credit limitations and standards at least once every six months. FHLB
advances have from time been available to meet seasonal and other withdrawals of
savings accounts and to expand lending.

        The Bank also has established credit arrangements with several of it's
correspondent banks. At December 31, 1998 the Bank had approximately $52,592,000
of unused lines of credit, including FHLB unused lines of credit, to fund any
necessary cash requirements.

        The following table sets forth certain information as to the
Corporation's advances and other borrowings at the dates indicated. See Notes 8,
9 and 14 to the Consolidated Financial Statements, included as part of the
Annual Report to Stockholders, for information as to rates, maturities, average
balances and maximum amounts outstanding.

<TABLE>
<CAPTION>
                                                 December 31
(In Thousands)                         1998      1997      1996
--------------                         ----      ----      ----
<S>                                   <C>       <C>       <C>
Advances from FHLB                    $ 6,643   $ 1,786   $ 1,929
Guaranteed preferred beneficial
  interests in corporation's junior
  subordinated debt securities          7,500       -0-       -0-
Other borrowings                          120       828       -0-
                                      -------   -------   -------
          Total borrowings            $14,263   $ 2,614   $ 1,929
</TABLE>

                                    EMPLOYEES

        The Corporation at December 31, 1998, had 143 full time employees. None
of these employees are represented by a collective agent, and the Corporation
believes its employee relations are excellent.

                                   COMPETITION

        The Corporation encounters competition for both deposits and loans. For
deposits, competition comes from other commercial banks, savings and loan
associations and/or savings banks, mutual money market funds, credit unions and
various other corporate and financial institutions. Competition also comes from
interest paying obligations issued by various levels of government and from a
variety of securities paying dividends or interest. Competition for loans comes
primarily from other commercial banks, savings and loan associations and/or
savings banks, insurance companies, mortgage companies and other lending
institutions.

                                  SUBSIDIARIES

        The Corporation was incorporated in Virginia in 1995 to serve as the
holding company for the Bank. The Bank is a state chartered bank with principal
offices in Abingdon, Virginia. The Bank was incorporated in 1985 under the laws
of the Commonwealth of Virginia. The Corporation formed a statutory business
trust, Highlands Capital Trust I, in January of 1998 to issue trust preferred
securities in order to raise additional capital.

                          FEDERAL HOME LOAN BANK SYSTEM

        The Bank is a member of the Federal Home Loan Bank System, which
consists of 12 regional Federal Home Loan Banks. The Federal Home Loan Bank
System is regulated by the Federal Housing Finance Board ("FHFB"). The FHFB is
composed of five members, including the Secretary of Housing and Urban
Development and four private citizens appointed by the President with the advice
and consent of the Senate for terms of seven years. At least one director must
be chosen from organizations with more than a two-year history of representing
consumer or community interests on banking services, credit needs, housing or
financial consumer protections.

        The Bank, as a member of the FHLB of Atlanta, is required to purchase
and maintain stock in its bank in an amount as if 30 percent of the member's
assets were home mortgage loans.

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<PAGE>

        The FHFB is required to adopt regulations establishing standards of
community investment or service for members of the Federal Home Loan Banks as a
condition for continued access to advances. The regulations are to take into
account the record of performance of the institution under the Community
Reinvestment Act of 1977 and its record of lending to first time home buyers.

        In addition, new collateral requirements for advances are to be
established which will be designed to insure credit quality and marketability of
the collateral.


                                   REGULATION
GENERAL

        The Corporation and it's subsidiary are subject to the supervision,
regulation and examination of the Federal Reserve Board, the Federal Deposit
Insurance Corporation and the state regulators of the Commonwealth of Virginia
which has jurisdiction over financial institutions and has obtained regulatory
approval for it's various activities to the extent required.

FEDERAL AND STATE LAWS AND REGULATIONS

        Bank holding companies and banks are extensively regulated under federal
and state law. To the extent that the following information describes statutory
and regulatory provisions, it is qualified in its entirety by reference to such
statutes and regulations. Any change in applicable law or regulation may have a
material effect on the business of the Corporation and it's subsidiary.

BANK HOLDING COMPANY REGULATION

        The Corporation is registered as a "bank holding company" with the Board
of Governors of the Federal Reserve System ("Federal Reserve"), and is subject
to supervision by the Federal Reserve under the Bank Holding Corporation Act
("BHC Act"). The Corporation is required to file with the Federal Reserve
periodic reports and such additional information as the Federal Reserve may
require pursuant to the BHC Act. The Federal Reserve examines the Corporation
and the subsidiary bank.

        The BHC Act requires prior Federal Reserve approval for, among other
things, the acquisition by a bank holding company of direct or indirect
ownership or control of more than 5% of the voting shares or substantially all
of the assets of any bank, or for a merger or consolidation of a bank holding
company with another bank holding company. With certain exceptions, the BHC Act
prohibits a bank holding company from acquiring direct or indirect ownership or
control of the voting shares of any company which is not a bank or bank holding
company and from engaging directly or indirectly in any activity other than
banking or managing or controlling banks or performing services for it's
authorized subsidiaries. A bank holding company may, however, engage in or
acquire an interest in a company that engages in activities which the Federal
Reserve has determined by regulation or order to be so closely related to
banking or managing or controlling banks as to be a proper incident thereto.

BANK REGULATION

        The Bank, as a state chartered member of the Federal Reserve Systems, is
subject to regulation and examination by the Virginia State Corporation
Commission and the Federal Reserve Board. In addition, the Bank is subject to
the rules and regulations of the Federal Deposit Insurance Corporation, which
currently insures the deposits of each member bank to a maximum of $100,000 per
depositor.

        The commercial banking business is affected by the monetary policies
adopted by the Federal Reserve Board. Changes in the discount rate on member
bank borrowings, availability of borrowing at the "discount window", open market
operations, the imposition of any changes in reserve requirements against member
banks' deposits and certain borrowings by banks and their affiliates, and the
limitation of interest rates which member banks may pay on deposits are some of
the instruments of monetary policy available

                                       9

<PAGE>

to the Federal Reserve Board. Taken together, these controls give the Board a
significant influence over the growth and profitability of all banks. Management
of the Bank is unable to predict how the Board's monetary policies (or the
fiscal policies or economic controls imposed by Federal or state governments)
will affect the business and earnings of the Bank or the Corporation, or what
those policies or controls will be.

        The references in this section to various aspects of supervision and
regulation are brief summaries which do not purport to be complete and which are
qualified in their entirety by reference to applicable laws, rules and
regulations.

FEDERAL DEPOSIT INSURANCE CORPORATION IMPROVEMENT ACT

        The difficulties encountered nationwide by financial institutions during
1990 and 1991 prompted federal legislation designed to reform the banking
industry and to promote the viability of the industry and of the deposit
insurance system. The Federal Deposit Insurance Corporation Improvement Act of
1991 ("FDICIA"), which became effective on December 19, 1991, bolsters the
deposit insurance fund, tightens bank and thrift regulation and trims the scope
of federal deposit insurance as summarized below.

        FDICIA requires each federal banking regulatory agency to prescribe, by
regulation, standards for all insured depository institutions and depository
institution holding companies relating to (i) internal controls, information
systems and audit systems; (ii) loan documentation; (iii) credit underwriting;
(iv) interest rate exposure; (v) asset growth; (vi) compensation, fees and
benefits; and (vii) such other operational and managerial standards as the
agency determines to be appropriate. The compensation standards would prohibit
employment contracts, compensation or benefit arrangements, stock option plans,
fee arrangements or other compensatory arrangements that provide excessive
compensation, fees or benefits or could lead to material financial loss. In
addition, each federal banking regulatory agency must prescribe by regulation
standards specifying (i) a maximum ratio of classified assets to capital; (ii)
minimum earnings sufficient to absorb losses without impairing capital; (iii) to
the extent feasible, a minimum ratio of market value to book value for publicly
traded shares of depository institutions and depository institution holding
companies; and (iv) such other standards relating to asset quality, earnings and
valuation as the agency determines to be appropriate. If an insured institution
fails to meet any of the standards promulgated by regulation, then such
institution will be required to submit a plan to its federal regulatory agency
specifying the steps it will take to correct the deficiency.

        Prompt corrective action measures adopted in FDICIA and which became
effective on December 19, 1992, impose significant new restrictions and
requirements on depository institutions that fail to meet their minimum capital
requirements. Under new Section 38 of the Federal Deposit Insurance Act ("FDI
Act"), the federal banking regulatory agencies have developed a classification
system pursuant to which all depository institutions are placed into one of five
categories based on their capital levels and other supervisory criteria: well
capitalized, adequately capitalized; undercapitalized; significantly
undercapitalized; and critically undercapitalized.

        The Bank met the requirements at December 31, 1998 to be classified as
"adequately capitalized". This classification is determined solely for the
purposes of applying the prompt corrective action regulations and may not
constitute an accurate representation of the Corporation's overall financial
condition.

        An undercapitalized depository institution is required to submit a
capital restoration plan to its principal federal regulator. The federal banking
agencies may not accept a capital plan without determining, among other things,
that the plan is based on realistic assumptions and is likely to succeed in
restoring the depository institution's capital and is guaranteed by the parent
holding company. If a depository institution fails to submit an acceptable plan,
it will be treated as if it were significantly undercapitalized.

        Unless its principal federal regulator has accepted its capital plan, an
undercapitalized bank may not increase its average total assets in any calendar
quarter. If an undercapitalized institution's capital plan has been accepted,
asset growth will be permissible only if the growth is consistent with the plan
and the institution's ratio of tangible equity to assets increases during the
quarter at a rate sufficient to enable the institutions to become adequately
capitalized within a reasonable time.

                                       10

<PAGE>

        An institution that is undercapitalized may not solicit deposits by
offering rates of interest that are significantly higher than the prevailing
rates on insured deposits in the institution's normal market areas or in the
market area in which the deposits would otherwise be accepted.

        An undercapitalized may not branch, acquire an interest in another
business or institution or enter a new line of business unless its capital plan
has been accepted and its principal federal regulator approves the proposed
action.

        An insured depository institution may not pay management fees to any
person having control of the institution nor may an institution, except under
certain circumstances and with prior regulatory approval, make any capital
distribution if, after making such payment or distribution, the institution
would be undercapitalized.

        Significantly undercapitalized depository institutions may be subject to
a number of requirements and restrictions, including orders to sell sufficient
voting stock to become adequately capitalized, requirements to reduce total
assets and cessation of receipt of deposits from correspondent banks. Critically
undercapitalized institutions are subject to appointment of a receiver or
conservator.

        If its principal federal regulator determines that an adequately
capitalized institution is in an unsafe or unsound condition or is engaging in
an unsafe or unsound practice, it may require the institution to submit a
corrective action plan, restrict its asset growth and prohibit branching, new
acquisitions and new lines of business. An institution's principal federal
regulator may deem it to be engaging in an unsafe or unsound practices if it
receives a less than satisfactory rating for asset quality, management, earnings
or liquidity in its most recent examination.

        In addition, regulators were required to draft a new set of non-capital
measures of bank safety, such as loan underwriting standards and minimum
earnings levels, effective December 1, 1993. The legislation also requires
regulators to perform annual on-site bank examinations, place limits on real
estate lending by banks and tightens auditing requirements.

                           FEDERAL AND STATE TAXATION

GENERAL

        The following discussion of federal taxation is a summary of certain
pertinent federal income tax matters as they pertain to the Corporation. With
some exceptions, including particularly the reserve for bad debts discussed
below, the Corporation is subject to federal income tax under the Internal
Revenue Code of 1986 (the "Code") in the same general manner as other
corporations.

BAD DEBT RESERVES

        Commercial banks such as the Bank, which meet certain definitional tests
primarily relating to their assets and the nature of their businesses, are
permitted to establish a reserve for bad debts and to make annual additions to
the reserve. These additions, may within specified formula limits, be deducted
in arriving at the Bank's taxable income. For purposes of computing the
deductible addition to its bad debt reserve, the Bank utilizes the experience
method.

        Under the experience method, the deductible annual addition is the
amount necessary to increase the balance of the reserve at the close of the
taxable year to the greater of (1) the amount which bears the same ratio to
loans outstanding at the close of the taxable year as the total net bad debts
sustained during the current and five preceding taxable years to bear to the sum
of the loans outstanding at the close of those six years or (2) the lower of (a)
the balance in the reserve account at the close of the last taxable year prior
to the most recent adoption of the experience method (the base year is the last
taxable year beginning before 1988), or (b) if the amount of loans outstanding
at the close of the taxable year is less than the amount of loans outstanding at
the close of the base year, the amount which bears the same ratio to loans
outstanding at the close of the taxable year as the balance of the reserve at
the close of the base year bears to the amount of loans outstanding at the close
of the base year.


MINIMUM TAX

                                       11
<PAGE>


        A 20% corporate alternative minimum tax generally will apply to a base
of regular taxable income plus certain tax preferences ("alternative minimum
taxable income" or "AMTI") and will be payable to the extent such AMTI is in
excess of an exemption amount. The Code provides that an item of tax preference
is the excess of the bad debt deduction over the amount allowable under the
experience method. The other items of tax preference that constitute AMTI
include (a) tax-exempt interest on newly-issued (generally, issued on or after
August 8, 1986) private activity bonds other than certain qualified bonds and
(b) 75% of the excess (if any) of (i) 75% of adjusted current earnings as
defined in the Code, over (ii) AMTI (determined without regard to this
preference and prior to reduction by net operating losses).

OTHER

        For federal income tax purposes, the Corporation reports its income and
expenses on the accrual basis method of accounting and uses a year ending
December 31 for filing its income tax returns. The Corporation may generally
carry back net operating losses to the preceding two taxable years and forward
to the succeeding twenty taxable years.

        The Commonwealth of Virginia imposes an income tax on corporations
domiciled in the state. The Virginia taxable income is based on the federal
taxable income with certain adjustments for interest and dividend income on
obligations of securities of the United States and states other than Virginia.
The tax rate is 6% of taxable income.

        See Note 6 to the Consolidated Financial Statements, included as part of
the Annual Report to Stockholders, for additional information regarding the
income taxes of the Company.

DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY; INTEREST RATES AND
INTEREST DIFFERENTIAL


<TABLE>
<CAPTION>

                                                                  Year Ended December 31,
                                       1998                                1997                          1996
                                                                (Dollars in Thousands)

                           AVERAGE                YEILD/     AVERAGE                YIELD/  AVERAGE                YIELD/
                           BALANCE    INTEREST    RATE       BALANCE     INTEREST   RATE    BALANCE     INTEREST   RATE
                           -------    --------    ----       -------     --------   ----    -------     --------   ----
<S>                            <C>        <C>       <C>        <C>          <C>       <C>     <C>         <C>       <C>
     ASSETS
Interest earning assets
 (taxable-equivalent
  basis (1) :

Loans (net of un-
  earned discount) (2)     $213,069   $ 19,618      9.21%    $175,542     $16,249     9.26%   $131,449   $ 12,326     9.38%
Securities (3)               56,757      3,057      5.39       38,158       2,363     6.19      34,350      2,082     6.06
Federal funds sold            4,250        222      5.22        3,244         169     5.20       3,822        204     5.33
                           --------   --------    ------     --------    --------   ------    --------   --------   ------


Total interest-earning
  assets                   $274,076   $ 22,897      8.35%    $216,944    $ 18,781     8.66%   $169,621   $ 14,612     8.61%
                           --------   --------    ------     --------    --------   ------    --------   --------   ------

     LIABILITIES
Interest-bearing
  liabilities :

Savings & time dep.        $226,142   $ 12,336      5.46%    $181,846    $ 10,099     5.55%   $142,331   $  7,714     5.42%
Other interest-bearing
  liabilities                13,933      1,065      7.64        3,366         222     6.59       1,803        108     5.99
                           --------   --------    ------     --------    --------   ------    --------   --------   ------


Total interest-bearing
  liabilities              $240,075   $ 13,401      5.58%    $185,212    $ 10,321     5.57%   $144,134   $  7,822     5.43%
                           --------   --------    ------     --------    --------   ------    --------   --------   ------

Net interest income                   $  9,496                           $  8,460                        $  6,790
Net margin on int.
  earning assets on a
  tax equivalent basis                              3.46%                             3.90%                           4.00%
Average interest
  spread                                            2.77%                             3.09%                           3.18%

</TABLE>

                                       12

<PAGE>

(1) Tax equivalent adjustments (using 34% federal tax rates) have been made in
    calculating yields on tax-free loans and investments. Virginia banks are
    exempt from state income tax.
(2) For the purposes of these computations, non-accruing loans are included in
    the daily average loan amounts outstanding.
(3) The yield on securities classified as available for sale is computed based
    on the average balance of the historical amortized cost balance without the
    effects of the fair value adjustment required by FAS115
        As the largest component of income, net interest income represents the
amount that interest and fees earned on loans and investments exceeds the
interest costs of funds used to support these earning assets. Net interest
income is determined by the relative levels, rates and mix of earning assets and
interest-bearing liabilities. The following table attributes changes in net
interest income either to changes in average volume or to changes in interest
due to both rate and volume has been allocated to volume and rate changes in
proportion to the relationship of the absolute dollar amounts of the change in
each.

<TABLE>
<CAPTION>
                                                       1998 Compared to 1997                     1997 Compared to 1996

                                        INCREASE         INCREASE                         INCREASE        INCREASE
                                     (DECREASE) DUE   (DECREASE) DUE                   (DECREASE) DUE  (DECREASE) DUE
                                      TO CHANGE IN     TO CHANGE IN     NET INCREASE    TO CHANGE IN    TO CHANGE IN    NET INCREASE
Increase (Decrease) in                   VOLUME            RATE          (DECREASE)       VOLUME            RATE         (DECREASE)
----------------------                   ------            ----          ----------       ------            ----         ----------
<S>                                      <C>             <C>              <C>             <C>              <C>              <C>
INTEREST INCOME
Securities .........................     $ 1,148         $  (454)         $   694         $   278          $     3          $   281
Federal funds sold .................          52               1               53             (36)               1              (35)
Loans ..............................       3,474            (105)           3,369           4,135             (212)           3,923
                                         -------         -------          -------         -------          -------          -------

Total Income Change ................     $ 4,674         $  (558)         $ 4,116         $ 4,377          $  (208)         $ 4,169
                                         -------         -------          -------         -------          -------          -------


INTEREST EXPENSE
Savings and time
   deposits ........................     $ 2,441         $  (204)         $ 2,237         $ 2,377          $     8          $ 2,385
Other interest-bearing
   liabilities .....................         697             146              843             113                1              114
                                         -------         -------          -------         -------          -------          -------

Total Expense Change ...............     $ 3,138         $   (58)         $ 3,080         $ 2,490          $     9          $ 2,499
                                         -------         -------          -------         -------          -------          -------

Increase (Decrease) in
   Net Interest Income .............     $ 1,536         $  (500)         $ 1,036         $ 1,887          $  (217)         $ 1,670
                                         -------         -------          -------         -------          -------          -------
</TABLE>

INVESTMENT PORTFOLIO

        The following table presents the maturity distribution, market value,
book value and approximate tax equivalent yield (assuming a 34% federal income
tax rate) of the investment portfolio at December 31, 1998.

                             (Dollars in Thousands)
<TABLE>
<CAPTION>

                                          One Year        Five Years
                          Within One      Through          Through        After Ten                     Total Book        Market
                             Year        Five Years       Ten Years         Years         Yield           Value            Value
                             ----        ----------       ---------         -----         -----           -----            -----
<S>                        <C>             <C>             <C>            <C>           <C>              <C>              <C>

U.S.T.N.'s ........         $     0         $     0         $     0         $     0            0%         $     0         $     0
U.S. Gov Agency ...             282           4,665           4,513          39,809         5.37           49,425          49,269
State & Muni's ....               0               0             305             454         6.85              754             759
Other .............               0               0               0           1,327         6.44            1,327           1,327
                            -------         -------         -------         -------         ----          -------         -------
  TOTAL ...........         $   282         $ 4,665         $ 4,818         $41,590         5.39          $51,506         $51,355
                            -------         -------         -------         -------         ----          -------         -------
</TABLE>


                                       13

<PAGE>

LOAN PORTFOLIO

        The table below classifies loans, net of unearned income, by major
category and percentage distribution at December 31, 1998 for each of the past
three years:

                                  December 31,
                             (Dollars in thousands)
<TABLE>
<CAPTION>
                               1998                           1997                             1996

  Description        Amount         Percentage       Amount        Percentage         Amount        Percentage
  -----------        ------        ----------        ------        ----------         ------        ----------
    <S>             <C>              <C>             <C>              <C>             <C>              <C>

Commercial          $ 24,235          10.38%         $ 24,395          12.71%         $ 20,365          13.14%
Real Estate          136,184          58.37           104,818          54.59           101,491          65.50
Consumer              70,132          30.05            59,653          31.07            30,128          19.44
Other                  2,821           1.20             3,139           1.63             2,967           1.92
                    --------         ------          --------         ------          --------         ------
  Total             $233,372         100.00%         $192,005         100.00%         $154,951         100.00%
                    --------         ------          --------         ------          --------         ------
</TABLE>



        The following table shows the maturity of loans outstanding, inclusive
of contractual amortization as of December 31, 1998. Loans are classified based
upon the period in which the final payment is due.

                                December 31, 1998
                             (Dollars in Thousands)
<TABLE>
<CAPTION>


                                Within One               After One But              After Five
                                  Year                 Within Five Years              Years
                                  ----                 -----------------              -----
                          Fixed        Floating       Fixed      Floating       Fixed        Floating
                          Rate           Rate         Rate         Rate          Rate          Rate           Total
                          ----           ----         ----         ----          ----          ----           -----
<S>                    <C>            <C>           <C>          <C>            <C>           <C>           <C>
Commercial              $  6,054      $  5,418      $ 10,917      $    804      $  1,006      $     36      $ 24,235
Real Estate               16,884         4,101        45,953         6,856        17,395        44,995       136,184
Consumer                  20,911           797        46,617            18         1,739            50        70,132
Other                      1,227           973           503           118             0             0         2,821
                        --------      --------      --------      --------      --------      --------      --------
Total                   $ 45,076      $ 11,289      $103,990      $  7,796      $ 20,140      $ 45,081      $233,372
                        --------      --------      --------      --------      --------      --------      --------
</TABLE>

NON-PERFORMING LOANS

        The loan portfolio of the Bank is reviewed regularly by senior officers
to evaluate loan performance. The frequency of the review is based on a rating
of credit worthiness of the borrower utilizing various factors such as net
worth, credit history, customer relationship, etc. The evaluations emphasize
different factors depending upon the type of loan involved. The commercial and
real estate type loans are reviewed on the basis of estimated net realizable
value through an evaluation of collateral and the financial strength of the
borrower. Installment loans are evaluated largely on the basis of delinquency
data because of the large number of such loans and relatively small size of each
individual loan.

        Management review of commercial and other loans may result in a
determination that a loan should be placed on a non-accrual of interest basis.
It is the policy of the Bank to discontinue the accrual of interest on any loan
on which full collectability of principal and / or interest is doubtful.
Subsequent collection of interest is recognized as income on a cash basis upon
receipt. Placing a loan on non-accrual status for the purpose of income
recognition is not in itself a reliable indication of potential loss of
principal. Other factors, such as the value of the collateral securing the loan
and the financial condition of the borrower, serve as more reliable indications
of potential loss of principal.

        The policy of the Bank is that non-performing loans consist of loans
accounted for on a non-accrual basis and loans which are contractually past due
90 days or more in regards to interest and/ or principal payments. As of the
three periods ended December 31, 1998, 1997 and 1996, non-accrual loans amounted
to $1,396,000, $888,000 and $96,000, respectively. Interest income lost on
non-accruing loans was approximately $146,000, $71,000, and $6,000 for December
31, 1998, 1997, and 1996 respectively.

                                       14
<PAGE>

SUMMARY OF LOAN LOSS EXPERIENCE

        The allowance for loan losses is increased by the provision for loan
losses and reduced by loans charged off net of recoveries. The allowance for
loan losses is established and maintained at a level judged by management to be
adequate to cover any anticipated loan losses to be incurred in the collection
of outstanding loans. In determining the adequate level of the allowance for
loan losses, management considers the following factors: (a) loan loss
experience; (b) problem loans, including loans judged to exhibit potential
charge-off characteristics, loans on which interest is no longer being accrued,
loans which are past due and loans which have been classified in the most recent
regulatory examination; and (c) anticipated economic conditions and the
potential impact these conditions may have on individual classifications of
borrowers.

        The following table presents the Corporation's loan loss experience for
the past three years:


                            Years Ended December 31,
                             (Dollars in Thousands)

<TABLE>
<CAPTION>
                                                   1998           1997           1996
                                                   ----           ----           ----
<S>                                              <C>            <C>             <C>

Allowance for loan losses at
   beginning of year                              $  1,636       $  1,072       $    908

Loans charged off:
    Commercial                                         270             42            170
    Real Estate                                          0              0              0
    Consumer                                           786            470             85
    Other                                                0              0              0
                                                  --------       --------       --------
    Total                                         $  1,056       $    512       $    255
                                                  --------       --------       --------

Recoveries of loans previously charged off:
    Commercial                                    $     41              6             32
    Real Estate                                          0              0              0
    Consumer                                           157             68             13
    Other                                                0              0              0
                                                  --------       --------       --------
    Total                                         $    198       $     74       $     45
                                                  --------       --------       --------
Net loans charged off                             $    858       $    438       $    210
Provision for loan losses                            1,230          1,002            374
                                                  --------       --------       --------
Allowance for loan losses end of year             $  2,008       $  1,636       $  1,072
                                                  --------       --------       --------
Average total loans (net of unearned income)      $213,069       $175,542       $131,449
Total loans (net of unearned                      
    income) at year-end                           $233,372       $192,005       $154,951

Ratio of net charge-offs to average loans            0.403%         0.249%         0.160%
Ratio of provision for loan losses to                
    average loans                                    0.577%         0.571%         0.285%
Ratio of provision for loan                        
    losses to net charge-off                       143.357%       228.770%       178.100%
Allowance for loan losses to                          
    year-end loans                                   0.860%         0.852%         0.690%
</TABLE>

                                       15
<PAGE>

ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES

        The following table provides an allocation of the allowance for loan
losses as of December 31, 1998


                          Year Ended December 31, 1998
                        Percent of Loans on each category

                             (Dollars in Thousands)

<TABLE>
<CAPTION>
                            Allowance for    Percentage of      Percentage of
                             Loan Loss      Total Loan Loss      Total Loans
                             ---------      ---------------      -----------
<S>                           <C>                <C>                <C>
Commercial                    $  503             25.05%             10.38%
Real Estate                      118              5.88              58.37%
Consumer                       1,384             68.92              30.05
Other                              3              0.15               1.20
                              ------            ------             ------
   Total                      $2,008            100.00%            100.00%
                              ------            ------             ------
</TABLE>



DEPOSITS

        The following table provides a breakdown of deposits at December 31 for
the years indicated is as follows:

<TABLE>
<CAPTION>
                                                      December 31,
                                                 (Dollars in Thousands)
                                             1998        1997         1996
                                             ----        ----         ----
<S>                                         <C>         <C>          <C>

Non-interest bearing demand deposits        $36,187     $30,930      $26,003
Interest bearing demand deposits             21,936      15,065       13,378
Savings deposits                             35,640      26,808       21,930
Time deposits                               178,578     163,843      128,160
                                            -------     -------      -------

   Total Deposits                           $272,341    $236,646     $189,471
                                            --------    --------     --------
</TABLE>


        The average daily amount of deposits and rates paid on such deposits is
summarized for the periods indicated in the following table:

<TABLE>
<CAPTION>
                                                        Year Ended December 31,
                                                        (Dollars in Thousands)

                                         1998                     1997                   1996
                                         ----                     ----                   ----
                                  Amount       Rate         Amount      Rate       Amount        Rate
                                 ------       ----         ------      ----       ------        ----
<S>                             <C>           <C>         <C>          <C>        <C>           <C>
Non-interest bearing
   demand deposits               $ 33,671      0.00%      $ 28,177      0.00%      $ 22,566      0.00%
Interest-bearing demand
   deposits                        18,239      3.60         14,029      3.58         12,566      3.60
Savings deposits                   32,681      4.00         24,600      4.00         20,516      4.01
Time deposits                     175,222      5.92        143,217      6.01        109,249      5.89
                                 --------     -----       --------      ----       --------      ----
   Total                         $259,813                 $210,023                 $164,897
                                 --------                 --------                 --------
</TABLE>


                                       16
<PAGE>


        The remaining maturities of time deposits at December 31, 1998 are as
follows (in thousands) :

<TABLE>
<CAPTION>


        Maturity
         <S>                                                 <C>

        3 months or less....................................$  37,373
        Over 3 through 12 months............................   87,916
        Over 12 months......................................   53,289
                                                             --------
             Total                                           $178,578
                                                             ========
</TABLE>


INTEREST RATE SENSITIVITY ANALYSIS

        The following table provides the maturities of investment securities,
loans, and deposits as of December 31, 1998, and measures the interest rate
sensitivity gap for each range of maturity indicated: The amounts below also
reflect various prepayment assumptions.

                                December 31, 1998
                             (Dollars in Thousands)
                                    Maturing


<TABLE>
<CAPTION>
                                        Within One     After One But    After Five
                                           Year      Within Five Years    Years         Total
                                           ----      -----------------    -----         -----
<S>                                    <C>             <C>              <C>           <C>
ASSETS
Interest-bearing
   Investment Securities                 $  28,882       $  13,004      $   9,469       $  51,355
   Fed Funds Sold                            1,670                                          1,670
      Loans                                 97,629         123,250         10,484         231,363
Noninterest-bearing
   Other Assets                             10,819               0         12,557          23,376
                                         ---------       ---------      ---------       ---------
Total Assets                             $ 139,000       $ 136,254      $  32,510       $ 307,764
                                         ---------       ---------      ---------       ---------

LIABILITIES AND SHARE-
   HOLDERS' EQUITY
Interest-bearing
   All Interest-bearing Deposits         $ 149,519       $  81,606      $   5,029       $ 236,154
   Other Interest-bearing Liab.                666             600         13,500          14,766
Noninterest-bearing
   Demand Deposit Non-Interest              24,754          11,433              0          36,187
   Other Liabilities                         2,015               0            363           2,378
   Shareholders' Equity                          0               0         18,279          18,279
                                         ---------       ---------      ---------       ---------
Total Liabilities and Shareholders'
   Equity                                $ 176,954       $  93,639      $  37,171       $ 307,764
                                         ---------       ---------      ---------       ---------
Interest Rate Sensitivity GAP            $ (37,954)      $  42,615      $  (4,661)      $       0
</TABLE>


                                       17

<PAGE>

RETURN ON EQUITY AND ASSETS

        The following table highlights certain ratios for the periods indicated:

<TABLE>
<CAPTION>

                                                        Year Ended December 31,
                                                              (Percentage)

                                                      1998        1997      1996
                                                      ----        ----      ----
<S>                                                   <C>        <C>        <C>
Net income to:
   Average total assets                                0.61       0.84       0.97
   Average shareholders' equity                       10.06      12.53      13.01

Dividend payout ratio (dividends declared per
   share divided by net income per share)              6.93       0.00       0.00

Average shareholders' equity to average total
   assets ratio                                        6.02       6.73       7.46
</TABLE>

ITEM 2. PROPERTIES

        The Corporation's and the Bank's main offices are located at 340 W. Main
Street, Abingdon, Virginia. The main office is a two story brick structure owned
by the Bank. The Bank utilizes the entire structure for its day to day
operations. Attached to the main office is a four lane drive thru facility
constructed in 1998. The new drive thru replaced an older unit which was
detached from the main office's structure. The main office opened for operations
in 1985. In addition, the Bank has three other branch locations within
Washington County, Virginia. The East Abingdon branch is a one story brick
facility located at 24412 Maringo Road which operates as a full service branch.
The branch was completed and opened for operation in 1993. The West Abingdon
location operates as an "express facility." This location contains four drive
thru lanes and a walk-up window. This is a limited service facility. The West
Abingdon Express branch was completed and opened for operations in 1994 and is
located at Exit 14, I-81, Jonesboro Road, Abingdon, Virginia. During 1998, the
Bank constructed and placed in service a two-story brick building located at 506
Maple Avenue, Glade Spring, Virginia. The Glade Spring Office is a full service
location with four drive thru lanes. The Bank also has two full service branch
locations within the City of Bristol, Virginia. The East Bristol office is
located at 999 Old Airport Road, Bristol, Virginia. This is a two story brick
building with interior customer loan and deposit areas as well as a four lane
drive thru unit. The office was completed and opened for operations in 1988. The
Commonwealth office is located at 821 Commonwealth Avenue, Bristol, Virginia.
This is a two story block building with full service customer service areas and
a four lane drive thru facility. The Bank also operates its dealer finance
division out of the Commonwealth office. This office was completed and opened
for operations in 1995. The Bank also has a full service branch at 1425 North
Main Street , Marion, Virginia. The branch was placed in service in December of
1997. It is a two story brick building and operates as a full service branch.
The Marion office has two drive thru lanes. There is also an ATM located
approximately 1/2 mile from the branch on North Main Street. The ATM resides on
property purchased by the Bank in 1997. All of the Bank's branch locations
except Marion have an on premises ATM. All branch properties are owned by the
Bank and are free of liens. In September 1998, the Bank acquired the adjacent
building to its Commonwealth office to facilitate future expansion. This is a
one story brick structure, located at 801-805 Commonwealth Avenue, Bristol,
Virginia and is currently leased. A note payable to the sellers was executed and
is secured by a first deed of trust. The balance on the note as of December 31,
1998 was approximately $120,000. Also during 1998, the Bank initiated an off
premises ATM program. Throughout 1998, 15 offsite ATMs were purchased and
installed throughout the Bank's market areas. Three machines were placed in
Bristol, Virginia; five were installed in Washington County, Virginia; one in
Russell County, Virginia; five in Smyth County, Virginia, and one in Wythe
County, Virginia. All machines are free of liens.

        The Corporation acquired a commercial building during 1997 which is
located at 266 West Plumb Alley, Abingdon, Virginia. The building is a two story
concrete structure which was originally constructed

                                       18
<PAGE>

by another bank for use as an operations center. The Corporation assumed
the lease of the building's current tenants. The second floor of the structure
is leased to third parties. During 1997, the Corporation entered into a leasing
arrangement with its subsidiary to lease the first floor to be used for its
operations center. Currently, the bookkeeping, proof, accounting, shareholder
services, human resources, internal audit and training departments are located
there. The West Plumb Alley property is free of liens. Also during 1998, the
Corporation purchased the adjacent property to the operations center. The
property purchased is a one story brick structure which is currently leased. It
is management's intention to utilize the property as growth continues. The
property is owned free and clear of all liens.

ITEM 3. LEGAL PROCEEDINGS

        The Corporation is not involved in any pending legal proceedings, other
than non-material legal proceedings undertaken in the ordinary course of
business.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

        There were no matters submitted to a vote of security holders during the
quarter ended December 31, 1998.

                                    PART II.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

        There is no established trading market for the stock of Highlands
Bankshares, Inc.. At December 31, 1998 the Corporation has approximately 994
stockholders of record. The Corporation acts as it's own registered Stock
Transfer Agent, without charging a transfer fee, ensuring that all applicable
federal guidelines relating to stock transfers are enforced. The Corporation
maintains a list of individuals who are interested in purchasing it's common
stock and connects these people with stockholders' who are interested in selling
their stock. These parties negotiate the per share price independent of the
Corporation. The stock transfer agent of the Corporation attempts to keep a
record of what the stock sales are trading at by asking the parties about the
trade price per share. Please refer to the table below entitled Common Stock
Performance for a breakdown of the trades for the four quarters of 1998. It is
the opinion of management that this range accurately reflects the market value
of the Corporations common stock at the present time.

                Common Stock Performance-December 31 1998

                             High                Low          Quarterly Average
                             ----                ---          -----------------
First Quarter               $32.00              $29.00              $30.53

Second Quarter              $31.67              $30.00              $30.56

Third Quarter               $30.00              $30.00              $30.00

Fourth Quarter              $32.00              $30.00              $31.00


        The Corporation's and the Bank's Board of Directors determines whether
to declare dividends and the amount of any dividends declared. Such
determinations by the Board take into account the Corporation's financial
condition, results of operations, and other relevant factors. The declaration,
amount and timing of future dividends will be determined by the Board of
Directors after a review of the Corporation's operations and will be dependent
upon, among other factors, the Corporation's income, operating costs, overall
financial condition and capital requirements and upon general business
conditions. The Corporation declared and paid cash dividends of $123,000 or
$0.10 per share during 1998.

        At December 31, 1998, there were approximately 994 holders of the
Corporation's common stock (based on the number of record holders as of that
date).

                                       19

<PAGE>

ITEM 6. SELECTED FINANCIAL DATA

        The following table sets forth certain selected consolidated financial
data for the past five years.

                            Years Ended December 31,
                  (Dollars in thousands, except per share data)



<TABLE>
<CAPTION>
                                           1998         1997          1996          1995         1994
                                           ----         ----          ----          ----         ----
<S>                                     <C>          <C>          <C>            <C>           <C>
Income Statement Amounts:
   Gross interest income                $ 22,897     $ 18,781     $  14,612      $  11,585     $ 8,425
   Gross interest expense                 13,401       10,321         7,822          6,161       3,985
   Net interest income                     9,496        8,460         6,790          5,424       4,440
   Provision for possible loan
     Losses                                1,230        1,002           374            143         120
   Net interest income after
     provision                             8,266        7,458         6,416          5,281       4,320
   Other operating income                  1,367          842           644            488         425
   Other operating expense                 6,962        5,382         4,439          3,541       3,004
   Income before income taxes
     and other items                       2,671        2,918         2,621          2,228       1,741
   Income taxes                              896          966           857            779         581
   Income before cumulative
     effect of change in
     accounting principles                 1,775        1,952         1,764          1,449       1,160
   Cumulative effect of change
     in accounting principles                -0-          -0-           -0-            -0-         -0-
   Net income                           $  1,775     $  1,952     $   1,764      $   1,449       1,160

Per Share Data (1):

   Net income per share                 $   1.44     $   1.59     $    1.45      $    1.19     $   0.96
   Cash dividends per share                  .10          -0-           -0-            -0-          -0-
   Book value (at year end)                14.66        13.64         11.97          10.52         8.43

Balance Sheet Amounts (at year-end):

   Total assets                         $307,764     $258,236     $ 207,739      $ 162,543     $128,749
   Total loans (net of unearned
     income)                             233,371      192,005       154,951        113,743       93,738
   Total deposits                        272,341      236,646       189,471        147,327      117,314
   Long-term debt                          6,763        2,614         1,929            -0-          -0-
      Guaranteed preferred
         beneficial interests in
         junior subordinated debt
         securities                        7,500
   Total equity                           18,279      16,802         14,617         12,812       10,243
</TABLE>

        (1) Adjusted for 1995 two-for-one stock split, 1992 25% stock dividend
and 1990 20% stock dividend.

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS

        The Company's plan for addressing Year 2000 is discussed in the 1998
Annual Report to stockholders. The Company has budgeted $100,000 to implement
its plan relating to Year 2000. Other information required herein is
incorporated by reference from pages 8 to 12 of the Annual Report to
Stockholders for the fiscal year ended December 31, 1998.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

        The financial statements and supplementary data required herein are
incorporated by reference from pages 20 to 40 of the Annual Report to
Stockholders for the fiscal year ended December 31,1998.

                                       20
<PAGE>

ITEM 9. CHANGES IN ACCOUNTANTS AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE

        None.

PART III.

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

        The information required herein is incorporated by reference to "The
Board of Directors", "Executive Officers Who Are Not Directors", "Security
Ownership of Certain Beneficial Owners" and "Compliance With Filing Requirements
Under the Securities Exchange Act of 1934" contained in the definitive proxy
statement for the Registrant's 1998 Annual Meeting of Stockholders to be
subsequently filed.

ITEM 11. EXECUTIVE COMPENSATION

        The information required herein is incorporated by reference to
"Remuneration" contained in the definitive proxy statement for the Registrant's
1998 Annual Meeting of Stockholders to be subsequently filed.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

        The information required herein is incorporated by reference to
"Security Ownership of Management" and "Security Ownership of Certain Beneficial
Owners" contained in the definitive proxy statement for the Registrant's 1998
Annual Meeting of Stockholders to be subsequently filed.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

        The information required herein is incorporated by reference to
"Indebtedness of Management" contained in the definitive proxy statement for the
Registrant's 1998 Annual Meeting of Stockholders to be subsequently filed.

PART IV.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

        (a)(1)  The following financial statements are incorporated by reference
                into Item 8 hereof from Exhibit 13 hereof:

                Consolidated Statements of Financial Condition as of December
                31, 1998 and 1997

                Consolidated Statements of Operations for each of the years in
                the three year period ended December 31, 1998

                Consolidated Statements of Stockholder's Equity for each of the
                years in the three year period ended December 31, 1998

                Consolidated Statements of Cash Flows for each of the years in
                the three year period ended December 31, 1998

                Notes to Consolidated Financial Statements for December 31,
                1998, 1997 and 1996

                Independent Auditors' Report

        (a)(2)  There are no financial statement schedules required to be filed
                herewith

           3a   The following exhibits are filed as part of this report on Form
                10-K, and this list includes the Exhibit Index.

                                       21
<PAGE>


                                    EXHIBITS

           3a   None

        (b)     No reports on Form 8-K have been filed during the last quarter
                of the period covered by this report.

        (c)     See (a) (3) above for all exhibits filed herewith and the
                Exhibit Index.

        (d)     Separate financial statements are not applicable.


                                       22
<PAGE>

                                   SIGNATURES

        Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

                                            HIGHLANDS BANKSHARES, INC.

Date:  March 26, 1999                       BY:___________________________
                                                  Samuel L. Neese
                                                  Executive Vice President and
                                                  Chief Executive Officer

        Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities indicated on March 26, 1999.

               Signature                                  Title

/S/ James D Morefield      03-26-99
------------------------------------
James D. Morefield           Date        Chairman of the Board, and Director


/S/ James D. Morre, Jr.    03-26-99
------------------------------------
Dr. James D. Moore, Jr.      Date        President


/S/ J. Carter Lambert      03-26-99
------------------------------------
J. Carter Lambert            Date        Vice Chairman


/S/ Samuel L. Neese        03-26-99
------------------------------------
Samuel L. Neese              Date        Executive Vice President, and Chief
                                         Executive Officer

/S/ James T. Riffe         03-26-99
------------------------------------
James T. Riffe               Date        Executive Vice President and Cashier


/S/ William E. Chaffin     03-26-99
------------------------------------
William E. Chaffin           Date        Director


/S/ V. D. Kendrick         03-26-99
------------------------------------
V.D. Kendrick                Date        Director


/S/ Clydes B. Kiser        03-26-99
------------------------------------
Clydes B. Kiser              Date        Director


/S/ Charles P. Olinger     03-26-99
------------------------------------
Charles P. Olinger           Date        Director


/S/ William J. Singleton   03-26-99
------------------------------------
William J. Singleton         Date        Director


/S/ H. Ramsey White, Jr.   03-26-99
------------------------------------
Dr. H. Ramsey White, Jr.     Date        Director

                                       23
<PAGE>


                           HIGHLANDS BANKSHARES, INC.
                                        &
                              HIGHLANDS UNION BANK

                               BOARD OF DIRECTORS

                                 J.D. MOREFIELD
                                    Chairman

J. CARTER LAMBERT                              DR. JAMES D. MOORE, JR.
Vice Chairman                                  President

WILLIAM E. CHAFFIN                             V.D. KENDRICK
CLYDES B. KISER                                CHARLES P. OLINGER
WILLIAM J. SINGLETON                           DR. H. RAMSEY WHITE, JR., DDS



<PAGE>


                           HIGHLANDS BANKSHARES, INC.
                                        &
                              HIGHLANDS UNION BANK


                                BOARD COMMITTEES

LOAN COMMITTEE                AUDIT COMMITTEE              INVESTMENT COMMITTEE
--------------                ---------------              --------------------
WILLIAM E. CHAFFIN            V.D. KENDRICK                J.D. MOREFIELD
J.D. MOREFIELD                J. CARTER LAMBERT            JAMES D. MOORE, JR.
JAMES D. MOORE, JR.           CHARLES P. OLINGER           CHARLES P. OLINGER
CHARLES P. OLINGER            H. RAMSEY WHITE, JR.
H. RAMSEY WHITE, JR.          WILLIAM E. CHAFFIN
                              WILLIAM J. SINGLETON

PERSONNEL/COMPENSATION        APPRAISAL COMMITTEE          BUILDING COMMITTEE
----------------------        --------------------         ------------------
CLYDES B. KISER               V.D. KENDRICK                V.D. KENDRICK
J. CARTER LAMBERT             J.D. MOREFIELD               CLYDES B. KISER
J.D. MOREFIELD                J. CARTER LAMBERT            J.D. MOREFIELD
CHARLES P. OLINGER            SAMUEL L. NEESE              JAMES D. MOORE, JR.
H. RAMSEY WHITE, JR.          C.B. HALE                    WILLIAM E. CHAFFIN
                              WILLIAM J. SINGLETON


                           HIGHLANDS BANKSHARES, INC.
                                    OFFICERS

DR. JAMES D. MOORE, JR.   SAMUEL L. NEESE              JAMES T. RIFFE
PRESIDENT                 EXECUTIVE VICE PRESIDENT &   EXECUTIVE VICE PRESIDENT
                          CHIEF EXECUTIVE OFFICER      CHIEF OPERATING OFFICER

W. CLARK HUTTON           ROBERT M. LITTLE, JR.        JAMES R. EDMONDSON
SENIOR VICE PRESIDENT,    CONTROLLER                   ASSISTANT CONTROLLER
SENIOR LOAN OFFICER


MELINDA S. BISHOP         MONICA M. ANDERSON
SENIOR INTERNAL AUDITOR   INTERNAL AUDITOR

<PAGE>

                              HIGHLANDS UNION BANK
                                    OFFICERS

                            JAMES D. MOORE, JR., M.D.
                                    President

        SAMUEL L. NEESE                         JAMES T. RIFFE
        Executive Vice President,               Executive Vice President,
        Chief Executive Officer                 Chief Operations Officer

<TABLE>
<S>                          <C>
C. B. HALE                   Business Development Officer, CRA Outreach Officer
W. CLARK HUTTON              Senior Vice President, Senior Loan Officer
GARY L. DUTTON               Vice President, Senior Loan Officer Washington and Smyth Counties
C. WAYNE PERRY               Vice President, Credit Review, Compliance Officer, Branch Administration
TIM L. ROBINSON              Vice President, Senior Loan Officer City of Bristol
ROBERT M. LITTLE, JR.        Controller, Stock Registrar
JAMES R. EDMONDSON           Vice President, Accounting
CHRISTINE S. ELDRETH         Vice President, Manager of Commercial Loan Operations
EDWARD T. FARMER             Vice President, Operations Officer, P. C. Coordinator
CURTIS B. FLEENOR            Vice President, Manager of Main Office Consumer Lending
LYNDA S. HAYS                Vice President, Financial Services Manager
CHARLES E. HOLMES            Vice President, Commercial Loan Officer
BETH A. MOREFIELD            Vice President, Dealer Finance Manager
M. SULEEN REEDER             Vice President, Mortgage Loan Officer, Manager of Mortgage Loan Operations
DAVID O. RHEA                Vice President, Commercial Loan Officer
DARLENE M. ROSE              Vice President, Manager of Consumer Loan Operations
MARIE F. SHY                 Vice President, Branch Manager
JOHN W. SNODGRASS            Vice President, Branch Manager
MONICA M. ANDERSON           Internal Auditor
MELINDA S. BISHOP            Senior Internal Auditor
JANICE M. ELDRETH            Assistant Vice President, Computer Operations Officer
MARK W. FARRIS               Assistant Vice President, Loan Officer
ROBIN G. FROST               Assistant Vice President, Branch Manager
ROBERT M. HOWARD             Human Resource Officer, Training Officer
WAYNE M. LARGEN              Assistant Vice President, Loan Officer
EDNA M. MOORE                Assistant Vice President, Mortgage Loan Officer, Manager Secondary Market Mortgages
MALINDA W. PICKETT           Assistant Vice President, Branch Manager
MARK B. REDMAN               Assistant Vice President, Branch Manager, Bank Security Officer
MARY JANE ROBINSON           Assistant Vice President, Student Loan Officer, Consumer Loan Officer
BEVERLY A. SHARRETT          Assistant Vice President, Assistant Branch Manager, Consumer Loan Officer
BRENDA D. WILLIAMS           Assistant Vice President, Dealer Loan Officer
C. BRYAN LAWSON              Financial Services Officer
JO ANN VINCILL               Business Development Officer
</TABLE>

<PAGE>

Dear Shareholders:

1998 was a very important and exciting year for Highlands Bankshares, Inc. and
Highlands Union Bank. It was a year of continued remarkable growth and
significant investment in the future of your company. Assets increased by $49
million, or 19.1 percent, net loans increased by $41 million, or 21.5 percent,
and deposits increased by $35 million, or 15.1 percent. Net income was
$1,775,000. Return on equity was 10.06 percent and return on assets was .61
percent. This is a decrease in earnings from 1997 of $177,000. Due to many
factors, most of this decrease in earnings was expected. The year brought us a
national trend of declining interest rates, declining interest margins, a record
number of mortgage refinancings to a lower interest rate, a record year for
prepayments in mortgage backed securities due to the home refinancings, and a
record year of filings for personal bankruptcy. The large growth in the bank's
loan portfolio continued in 1998. Due to this outstanding growth, large
contributions to the allowance for the loan loss reserve account continued to be
necessary. A contribution of over $1.2 million was made during 1998 to support
the growth and to cover 1998 loan losses. A primary factor in the reduced
earnings in 1998 was costs and expenses associated with the raising of $7.5
million in capital to support future growth and expansion.

As previously stated, the growth of Highlands Bankshares, Inc. and Highlands
Union Bank continues to be far greater than the banking industry in general. In
its brief 14-year history, Highlands Union Bank has grown to be one of the
larger banks headquartered in the State of Virginia with a significant market
share in the communities we serve. As a result of this sustained and unusual
growth, and in order to keep the company in a well-capitalized position, it
became necessary in 1998 to raise additional capital. This is the third such
recapitalization since the bank opened in 1985. After much research, it was
determined by the Board of Directors and management that it was in the best
interest of the existing shareholders to issue trust preferred securities in
lieu of another issuance of common stock. In January 1998, Highlands Bankshares,
Inc. issued $7.5 million in trust preferred capital securities with a rate of
9.25% and a maturity of 30 years. Trust preferred capital securities have three
primary benefits: the interest payments are tax deductible, the debt can be
included in tier one capital ratio up to 25% of the total capital after the
issue, and future earnings per share are not diluted by having additional shares
of common stock outstanding.

With this growth and increased market share in the communities we serve comes
the continued need to upgrade and expand our infrastructure, technology,
delivery systems, and facilities in order to properly serve our existing and
future customer base. To facilitate this, several other significant investments
in the future were made during the past few months. As previously reported, a
new branch location was added in Marion, Virginia in December of 1997. In
December of 1998 a new branch location was also added in Glade Spring, Virginia.
These branches represent a strong investment over the previous twelve-month
period. In order to provide the most convenient and modern services possible to
our customers, Highlands Union Bank has installed 17 in-store ATM facilities in
locations in the City of Bristol, Virginia, and the counties of Washington,
Smyth, Wythe, and Russell in Virginia during 1998. We believe that the addition
of the two branch locations and the in-store ATM's combined with the services
and service locations already available, provides our present and future
customers with the best and most convenient banking services available in our
area, and offers the bank opportunities for future growth and expansion.

Other investments made in preparation for future growth includes the
construction of a new drive thru facility at the main office. The previously
existing drive thru had become worn and outdated due to many

<PAGE>

years of very heavy use. We continue to invest in technologies that help keep
our operating costs very low by industry standards, and provide our customers
with the most modern services possible. Recently, the bank purchased an in-house
check printing system. This system should provide future cost savings in the
printing of loan coupon books and allow us to print customer checks at a cost
savings to the bank, as well as to our customers.

1998 was also a year that your Corporation continued to work on the Y2K issue.
As of this date, management has identified all business and operational
functions that will be impacted by the date change and is aggressively testing
and/or converting its application systems for Y2K date recognition. Conversion
and testing of all in-house systems is expected to be completed by June 1999.
Throughout 1999, the Company will be conducting testing with external entities,
such as the Federal Reserve Bank, as they become Y2K "ready". Management
estimates the Company's costs related to the Y2K fix will not have a material
impact on future earnings. However, the impact of Y2K noncompliance by all
outside parties cannot be estimated fully at this time.

We were especially excited during 1998 to declare the first cash dividend in the
history of your company. A $0.10 per share cash dividend was paid to
shareholders on April 13, 1998.

We were very proud and honored that Highlands Union Bank was selected by a
national banking news publication (INDEPENDENT BANKER) to be the featured cover
story for their August issue. The bank was selected because of its extraordinary
growth and success during its brief 13-year history. This cover story gave your
bank significant national exposure and recognition.

As you can tell, 1998 was a very challenging but exciting year. It was a year of
continued extraordinary growth and investment in the future of your company. We
believe with the addition of new capital, two new branch locations, improved
delivery systems, improved infrastructure, and a dedicated and professional
staff of officers and employees, Highlands Bankshares, Inc. and Highlands Union
Bank are positioned to move into the future with confidence. We will look at
ways to continually improve upon and expand the range of services we offer our
customers. We further believe that your company is positioned to explore and
take advantage of many opportunities that may arise in the future. We will
continue to explore these opportunities for the enhancement of future earnings
and the continued success of your company.

We continue to be humbled by and appreciative of the support that we receive
from our customers, friends, and shareholders. We look ahead with great
anticipation and excitement as we move into a new millennium. On behalf of the
directors, officers, and employees, thank you for your continued confidence and
support.

Sincerely,



------------------------------        ------------------------------------
Samuel L. Neese,                      James T. Riffe,
Chief Executive Officer                Chief Operating Officer


<PAGE>


                              FINANCIAL HIGHLIGHTS


<TABLE>
<CAPTION>
RESULTS OF OPERATIONS                                1998          1997           1996       1998/1997    1997/1996
                                               (IN THOUSANDS EXCEPT SHARE AND PER SHARE DATA)   PERCENTAGE CHANGE

<S>                                               <C>            <C>            <C>             <C>         <C>
Net Interest Income                               $  9,496       $  8,460       $  6,790        12.25%      24.59%
Net Income <Loss>                                    1,775          1,952          1,764       <9.07>       10.66


FINANCIAL CONDITION AT YEAR-END

Assets                                            $307,764       $258,236       $207,739        19.18%      24.31%
Loans                                              233,371        192,005        154,951        21.54       23.91
Securities                                          51,355         41,963         31,345        22.38       33.87
Deposits                                           272,341        236,646        189,471        15.08       24.90
Stockholders' Equity                                18,279         16,802         14,617         8.79       14.95
Shares Outstanding                                   1,247          1,232          1,222         1.22        0.82


SIGNIFICANT RATIOS


Return on average assets                              0.61%          0.84%          0.97%      <27.38%>    <13.40%>
Return on average equity                             10.06          12.53          13.01       <19.71>     <3.69>
Average stockholders' equity to
        average assets                                6.02           6.73           7.46       <10.55>     <9.79>
Allowance for loan losses as a
         percentage of total loans                    0.86           0.85           0.69         1.18       23.19
Non-performing loans to total loans                   0.87           0.99           0.43       <12.12>     130.23


PER SHARE DATA
Based on weighted-average shares outstanding

Net Income                                        $   1.44       $   1.59       $   1.45       < 9.43%>      9.66%
Stockholders' equity (book value)
         per shares outstanding at
         year-end                                    14.66          13.64          11.97         7.51       13.95
</TABLE>

<PAGE>

                     COMPARISON OF RESULTS OF OPERATIONS FOR
                   THE YEARS ENDED DECEMBER 31, 1998 AND 1997


Net interest income for the year-ended December 31, 1998 increased 12.25%,
approximately $1.04 million over 1997. Average interest earning assets increased
$57.1 million from 1997 to 1998 while average interest-bearing liabilities
increased $54.8 million. The yield on average interest-earning assets for the
year ended December 31, 1998 was 8.35% compared with 8.66% for the comparable
1997 period. The 1998 yield on average loans decreased by 5 basis points to
9.21% as compared to the 1997 period yield of 9.26%. The 1998 yield on average
investments, including federal funds sold, decreased 0.74% to 5.37% from
December 31, 1997 to 1998. The yield on average interest-bearing liabilities
increased 1 basis point during 1998 to 5.58% as compared to 5.57% during 1997.
Net income for the year-ended December 31, 1998 was $1.78 million, a decrease of
9.07% over the 1997 period. Income tax expense for 1998 decreased 7.25% to $896
thousand as compared to $966 thousand for the 1997 period.


                     COMPARISON OF RESULTS OF OPERATIONS FOR
                   THE YEARS ENDED DECEMBER 31, 1997 AND 1996

Net interest income for the year-ended December 31, 1997 increased 24.21%,
approximately $1.64 million over 1996. Average interest earning assets increased
$47.3 million from 1996 to 1997 while average interest-bearing liabilities
increased $41.1 million. The yield on average interest-earning assets for the
year ended December 31, 1997 was 8.64% compared with 8.61% for the comparable
1996 period. The 1997 yield on loans decreased by 13 basis points as compared to
1996 period at 9.36%. The yield on average investments increased 0.10% to 6.11%
from December 31, 1996 to 1997. The yield on average interest-bearing
liabilities increased 14 basis points during 1997 to 5.57% as compared to 5.43%
during 1996. Net income for the year-ended December 31, 1997 was $1.95 million,
an increase of 10.66% over the 1996 period. Income tax expense for 1997
increased 12.72% to $966 thousand as compared to $857 thousand for the 1996
period.


<PAGE>

                       COMPARISON OF FINANCIAL CONDITION
                         AT DECEMBER 31, 1998 AND 1997


        Total assets at December 31, 1998 totaled $307.8 million compared to
$258.2 million at December 31, 1997. This 19.18% growth in assets was primarily
due to the large volume of loans originated. Total loans increased 21.54%, or
$41.3 million over the comparable 1997 period. The security portfolio increased
22.38% to $51.3 million during 1998 as contrasted to the 1997 period. Total
deposits increased to $272.3 million or 15.08% from 1997's level of $236.6
million. Stockholder's equity increased 8.79% during 1998. The Financial
Accounting Standards Board's (FASB) Statement on Accounting Standards No. 115
was implemented during 1994. FASB's SAS 115 required that all securities
classified as "Available-for-Sale" be adjusted to market value through the use
of a valuation account, and that any paper gains or losses be run through the
Stockholder's Equity section of the balance sheet. The effect of implementing
SAS 115 caused an increase in Stockholder's Equity at December 31, 1997 of $104
thousand, net of the related deferred tax. As of December 31, 1998 the
Corporation's security portfolio had $100 thousand in paper losses. The
Corporation notes that it does have the ability and intent to carry to maturity
the existing $51.3 million of the "Available-for-Sale" securities.


                       COMPARISON OF FINANCIAL CONDITION
                         AT DECEMBER 31, 1997 AND 1996


        Total assets at December 31, 1997 totaled $258.2 million compared to
$207.7 million at December 31, 1996. This 24.31% growth in assets was primarily
due to the large volume of loans originated. Total loans increased 23.91%, or
$37.1 million over the comparable 1996 period. The security portfolio increased
33.87% to $42.0 million during 1997 as contrasted to the 1996 period. Total
deposits increased to $236.6 million or 24.98% from 1996's level of $189.5
million. Stockholder's Equity increased 14.95% during 1997. The Financial
Accounting Standards Board's (FASB) Statement on Accounting Standards No. 115
was implemented during 1994. FASB's SAS 115 required that all securities
classified as "Available-for-Sale" be adjusted to market value through the use
of a valuation account, and that any paper gains or losses be run through the
Stockholder's Equity section of the balance sheet. The effect of implementing
SAS 115 caused a decrease in Stockholder's Equity at December 31, 1996 of $18
thousand, net of the related deferred tax. As of December 31, 1997 the
Corporation's security portfolio had $104 thousand in unrealized gains, net of
deferred taxes. The Corporation notes that it does have the ability and intent
to carry to maturity approximately $41.9 million of the "Available-for-Sale"
securities.


<PAGE>


                      COMPARISON OF SIGNIFICANT RATIOS AT
                           DECEMBER 31, 1998 AND 1997


        Return on average assets dropped to 0.61% for the year-ended December
31, 1998 as compared to 0.84% for the comparable 1996 period. The continued
growth in assets, the absorption of the operational costs from the new branch
openings, the costs and interest expense related to the trust preferred
securities, and the addition of over $1.2 million to the allowance for loan loss
account all had significant impact relating to the decrease in this performance
ratio. Return on average equity decreased from 12.53% at December 31, 1997 to
10.06% at year-end 1998. Average stockholders' equity to average assets declined
to 6.02% at December 31, 1998 from 6.73% at December 31, 1997. Non-performing
loans to total loans decreased to 0.87% as of December 31, 1998 as compared to
0.99% for the comparable 1997 period. Allowance for loan losses as a percentage
of total loans increased 1.18% to 0.86% at December 31, 1998. The decrease in
average stockholders' equity to average assets is primarily attributable to the
enormous amount of growth which the Corporation sustained during 1998.


                      COMPARISON OF SIGNIFICANT RATIOS AT
                           DECEMBER 31, 1997 AND 1996


        Return on average assets dropped slightly to 0.84% for the year-ended
December 31, 1997 as compared to 0.97% for the comparable 1996 period. The
24.31% growth in assets, the absorption of the operational costs from the new
branch openings, and the addition of over one million to the allowance for loan
loss account all had significant impact relating to the decrease in this
performance ratio. Return on average equity decreased from 3.69% from 13.01% at
December 31, 1996 to 12.53% at year-end 1997. Average stockholders' equity to
average assets declined to 6.73% at December 31, 1997 from 7.46% at December 31,
1996. Non-performing loans to total loans increased to 0.47% as of December 31,
1997 as compared to 0.01% for the comparable 1996 period. Allowance for loan
losses as a percentage of total loans increased 23.19% to 0.85% at December 31,
1997. The decrease in average stockholders' equity to average assets is
primarily attributable to the enormous amount of growth which the Corporation
sustained during 1997.


<PAGE>

                      COMPARISON OF PER SHARE DATA FOR THE
                     YEARS ENDED DECEMBER 31, 1998 AND 1997

Net income per share, on a weighted average basis, decreased 9.43% to $1.44 at
December 31, 1998 as compared to $1.59 for the comparable 1997 period. Book
value per share of common stock increased by 7.51% to $14.66 per share as
compared to $13.64 at December 31, 1997. The Corporation had approximately $100
thousand in unrealized losses as of December 31, 1998, net of deferred taxes,
due to FASB's SAS 115 which affected the book value computation.



                      COMPARISON OF PER SHARE DATA FOR THE
                     YEARS ENDED DECEMBER 31, 1997 AND 1996

Net income per share, on a weighted average basis, increased 9.66% to $1.59 at
December 31, 1997 as compared to $1.45 for the comparable 1996 period. Book
value per share of common stock increased by 13.95% to $13.64 per share as
compared to $11.97 at December 31, 1996. The Corporation has approximately $104
thousand in paper gains as of December 31, 1997, net of deferred taxes,
due to FASB's SAS 115 which affected the book value computation.


<PAGE>

                                    YEAR 2000

Like most financial service providers, the Company and its operations may be
significantly affected by the Y2K issue due to its dependence on technology and
date-sensitive data. Computer software and hardware and other equipment, both
within and outside the Company's direct control, and third parties with whom the
Company electronically or operationally interfaces (including without limitation
its customers and third party vendors) are likely to be affected. If computer
systems are not modified in order to be able to identify the year 2000, many
computer applications could fail or create erroneous results. Likewise, under
certain circumstances, at failure to adequately address the Y2K issue could
adversely affect the viability of the Company's suppliers and creditors and the
creditworthiness of its borrowers. Thus, if not adequately addressed, the Y2K
issue could result in a significant adverse impact on the Company's operations
and, in turn, its financial condition and results of operations.

The Company has formulated its plan to address the Y2K issue. Following are the
primary phases of the Company's Y2K plan:

          1.   Awareness phase
          2.   Assessment phase
          3.   Renovation phase
          4.   Validation or testing phase
          5.   Implementation phase

The Company is expensing all costs associated with required system changes as
those costs are incurred and such costs are being funded through operating cash
flows.

During the assessment phase, the Company began to develop back-up or contingency
plans for each of its mission critical systems. Virtually all of the Company's
mission critical systems are dependent upon third party vendors or service
providers, therefore, contingency plans include selecting a new vendor or
service provider and converting to their system. In the event a current vendor's
system fails during the validation phase and it is determined the vendor is
unable or unwilling to correct the failure, the Company will convert to a new
system from a pre-selected list of prospective vendors. In each case, realistic
trigger dates have been established to allow for orderly and successful
conversions. For some systems, contingency plans consist of reverting to manual
systems until problems can be corrected.

The majority of the Company's mission critical systems fall into the categories
of its core-banking system, its proof of deposit system and its automatic teller
machine network. The Company has received warranties from vendors to the effect
that the core-banking system and its automatic teller machine network software
is Y2K compliant. Further, the Company has received warranties that its proof of
deposit system will be Y2K ready subject to specific changes which the Company
is currently implementing. Additionally, the core-banking system, used by a
number of banking institutions, has been reviewed by the Federal Reserve Bank of
Richmond. 

With respect to each third party with whom the Company interfaces electronically
or from whom it obtains significant services or supplies, the Company has
requested information regarding that party's preparations and state of
preparedness with respect to Y2K issues. Interruptions in the services provided
by such third parties have been taken into account in the Company's contingency
plans (which, for example, provide for increased inventories of business forms
and supplies, increased levels of cash on hand, use of a generator to operate
the Company's main computer system and operations function, manual processing of
branch transactions, direct clearing of checks through the Federal Reserve
rather than through a correspondent bank, and, where possible, a change to a
different third party supplier.)

<PAGE>

                   HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

                          CONSOLIDATED FINANCIAL REPORT

                                DECEMBER 31, 1998




<PAGE>


                                 C O N T E N T S


<TABLE>
<CAPTION>
                                                                                          Page
                                                                                          ----
<S>                                                                                  <C>
INDEPENDENT AUDITOR'S REPORT                                                                F1

FINANCIAL STATEMENTS
  Consolidated Balance Sheets                                                               F2
  Consolidated Statements of Income                                                         F3
  Consolidated Statements of Comprehensive Income                                           F4
  Consolidated Statements of Stockholders' Equity                                           F5
  Consolidated Statements of Cash Flows                                                     F6
  Notes to Consolidated Financial Statements                                          F7 - F26
</TABLE>


<PAGE>

Brown,
Edwards &                                                                Page F1
Company, L.L.P.
Certified Public Accountants


                          INDEPENDENT AUDITOR'S REPORT


Board of Directors and Stockholders
Highlands Bankshares, Inc. and Subsidiaries
Abingdon, Virginia

We have audited the accompanying consolidated balance sheets of Highlands
Bankshares, Inc. and Subsidiaries as of December 31, 1998, 1997, and 1996 and
the related consolidated statements of income, comprehensive income,
stockholders' equity, and cash flows for the years then ended. These
consolidated financial statements are the responsibility of the Bank's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the consolidated financial statements are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the consolidated financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Highlands
Bankshares, Inc. and Subsidiaries as of December 31, 1998, 1997 and 1996 and the
results of their operations and their cash flows for the years then ended in
conformity with generally accepted accounting principles.


                                            /s/ Brown, Edwards & Company, L.L.P.
                                            ------------------------------------
                                            CERTIFIED PUBLIC ACCOUNTANTS

468 East Main Street
Abingdon, VA 24210
February 1, 1999

<PAGE>

                   HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES
                                                                         Page F2
                           CONSOLIDATED BALANCE SHEETS
                        December 31, 1998, 1997 and 1996
                                 (In thousands)

<TABLE>
<CAPTION>

                ASSETS                                                 1998            1997           1996
                                                                   ----------       ---------      ---------
<S>                                                                 <C>             <C>            <C>
 Cash and due from banks (Note 17)                                  $   9,324       $   7,712      $   8,008
 Federal funds sold                                                     1,670           7,213          7,948
                                                                    ---------       ---------      ---------

                Total Cash and Cash Equivalents                        10,994          14,925         15,956

 Investment securities available for sale (Note 2)                     51,355          41,963         31,345
 Loans, net of allowance for loan losses of $2,008,
   $1,636 and $1,072 1998, 1997 and 1996,
   respectively (Notes 3 and 4)                                       231,363         190,369        153,879
 Premises and equipment (Note 5)                                        8,270           7,062          4,583
 Interest receivable                                                    1,875           1,495          1,271
 Other assets (Note 6)                                                  3,907           2,422            705
                                                                    ---------       ---------      ---------
                Total Assets                                        $ 307,764       $ 258,236      $ 207,739
                                                                    =========       =========      =========

              LIABILITIES AND STOCKHOLDERS' EQUITY
 Deposits (Note 7)
      Noninterest bearing                                           $  36,187       $  30,930      $  26,003
      Interest bearing                                                236,154         205,716        163,468
                                                                    ---------       ---------      ---------
                Total Deposits                                        272,341         236,646        189,471
                                                                    ---------       ---------      ---------

 Federal funds purchased                                                  503              --             --
 Interest, taxes and other liabilities                                  2,378           2,174          1,722
 Long-term debt (Note 8)                                                6,763           2,614          1,929
 Capital securities (Note 9)                                            7,500              --             --
                                                                    ---------       ---------      ---------
                                                                       17,144           4,788          3,651
                                                                    ---------       ---------      ---------
                Total Liabilities                                     289,485         241,434        193,122
                                                                    ---------       ---------      ---------

 STOCKHOLDERS' EQUITY
      Common stock (Notes 11 and 13)                                    3,116           3,081          3,054
      Surplus                                                           5,265           5,271          5,187
      Undivided profits                                                 9,998           8,346          6,394
      Net unrealized gains (losses) on securities available
        for sale, net of taxes of $(51), $54 and $(9) in 1998,
        1997 and 1996, respectively                                      (100)            104            (18)
                                                                    ---------       ---------      ---------
                Total Stockholders' Equity                             18,279          16,802         14,617
                                                                    ---------       ---------      ---------
                Total Liabilities and Stockholders' Equity          $ 307,764       $ 258,236      $ 207,739
                                                                    =========       =========      =========
</TABLE>

The Notes to Consolidated Financial Statements are an integral part of these
statements.

<PAGE>

                   HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES
                                                                         Page F3
                        CONSOLIDATED STATEMENTS OF INCOME
                  Years Ended December 31, 1998, 1997 and 1996
                                 (In thousands)



<TABLE>
<CAPTION>
 INTEREST INCOME                                                  1998          1997        1996
                                                                --------      -------     --------
<S>                                                            <C>           <C>          <C>
     Loans receivable and fees on loans                          $19,618      $16,249      $12,326
     Securities available for sale                                 3,057        2,363        2,082
     Federal funds sold                                              222          169          204
                                                                 -------      -------      -------
           Total Interest Income                                  22,897       18,781       14,612
                                                                 -------      -------      -------

INTEREST EXPENSE
    Deposits                                                      12,336       10,099        7,714
    Federal funds purchased                                           58           29            9
    Other borrowed funds                                             342          176           99
    Long-term debt                                                   665           17           --
                                                                 -------      -------      -------
          Total interest expense                                  13,401       10,321        7,822
                                                                 -------      -------      -------

          Net interest income                                      9,496        8,460        6,790
PROVISION FOR LOAN LOSSES                                          1,230        1,002          374
                                                                 -------      -------      -------
          Net interest income after provision for loan losses      8,266        7,458        6,416
                                                                 -------      -------      -------

NON-INTEREST INCOME
     Securities gains (losses), net                                  359           10           23
     Service charges on deposit accounts                             545          514          474
     Other service charges, commissions and fees                     324          186          104
     Other operating income, rents                                   139          132           43
                                                                 -------      -------      -------
            Total Non-Interest Income                              1,367          842          644
                                                                 -------      -------      -------

NON-INTEREST EXPENSES
     Salaries and employee benefits (Note 12)                      3,785        3,004        2,534
     Occupancy expense of bank premises                              615          441          298
     Furniture and equipment expense                                 729          596          564
     Other operating expenses (Note 19)                            1,833        1,341        1,043
                                                                 -------      -------      -------
            Total Non-Interest Expenses                            6,962        5,382        4,439
                                                                 -------      -------      -------
            Income Before Income Taxes                             2,671        2,918        2,621
     Income Tax Expense (Note 6)                                     896          966          857
                                                                 -------      -------      -------
            Net Income                                           $ 1,775      $ 1,952      $ 1,764
                                                                 =======      =======      =======
Earnings Per Common Share (Note 11)                              $  1.44      $  1.59      $  1.45
                                                                 =======      =======      =======
Earnings Per Common Share - assuming dilution                    $  1.38      $  1.53      $  1.38
                                                                 =======      =======      =======
</TABLE>

The Notes to Consolidated Financial Statements are an integral part of these
statements.

<PAGE>

                   HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES
                                                                         Page F4
                 CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
                  Years Ended December 31, 1998, 1997 and 1996
                                 (In thousands)

<TABLE>
<CAPTION>
                                                                  1998           1997         1996
                                                                --------       -------      --------
<S>                                                             <C>           <C>           <C>
Net income                                                       $ 1,775       $ 1,952       $ 1,764
                                                                 -------       -------       -------

Other comprehensive income(loss), before tax
     Unrealized gain(loss) on securities available-for-sale         (309)          185           (55)
     Less: reclassification adjustment for (gain)loss
       included in net income                                        (24)           --            --
                                                                 -------       -------       -------

               Other comprehensive income(loss)                     (333)          185           (55)

Federal income tax (expense) benefit related to
     other comprehensive income(loss)                                113           (63)           19
                                                                 -------       -------       -------

               Other comprehensive income(loss), net of tax         (220)          122           (36)
                                                                 -------       -------       -------

               Total comprehensive income                        $ 1,555       $ 2,074       $ 1,728
                                                                 =======       =======       =======

</TABLE>
The Notes to Consolidated Financial Statements are an integral part of these
statements.

<PAGE>

                   HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES
                                                                         Page F5
                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                  Years Ended December 31, 1998, 1997 and 1996
                                 (In thousands)

<TABLE>
<CAPTION>
                                                                                                  Gain (loss) on
                                               Common Stock                                        Securities      Total
                                          ---------------------                    Undivided        Available    Stockholders'
                                          Shares      Par Value      Surplus        Profits         for sale       Equity
                                          ------      ---------      -------        -------         --------       ------
 <S>                                   <C>            <C>              <C>            <C>              <C>             <C>
Balance, December 31, 1995                 1,218      $  3,044      $  5,120       $  4,630       $     18       $ 12,812
     Net income                               --            --            --          1,764             --          1,764
     Common stock issued for
        stock options exercised                4            10            14             --             --             24
     Stock options granted                    --            --            53             --             --             53
          (Note 13)
     Net changes in unrealized
       gains (losses) on available
       for sale securities, net of
       taxes of $(19)                         --            --            --             --            (36)           (36)
                                          -------     --------      --------       --------       --------       --------

Balance, December 31, 1996                 1,222      $  3,054      $  5,187       $  6,394       $    (18)      $ 14,617
     Net income                               --            --            --          1,952             --          1,952
     Common stock issued for
        stock options exercised               10            27            84             --             --            111
     Net changes in unrealized
       gains (losses) on available
       for sale securities, net of
       taxes of $63                           --            --            --             --            122            122
                                          ------      --------      --------       --------       --------       --------

Balance, December 31, 1997                 1,232      $  3,081      $  5,271       $  8,346       $    104       $ 16,802
     Net income                               --            --            --          1,775             --          1,775
     Common stock issued for
        stock options exercised               14            35            (6)            --             --             29
     Net changes in unrealized
       gains (losses) on available
       for sale securities, net of
       taxes of $(105)                        --            --            --             --           (204)          (204)
     Cash dividend                            --            --            --           (123)            --           (123)
                                          ------      --------      --------       --------       --------       --------
Balance, December 31, 1998                 1,246      $  3,116      $  5,265       $  9,998       $   (100)      $ 18,279
                                          ======      ========      ========       ========       ========       ========
</TABLE>

The Notes to Consolidated Financial Statements are an integral part of these
statements.

<PAGE>
                   HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES
                                                                         Page F6
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                  Years Ended December 31, 1998, 1997 and 1996
                                 (In thousands)
<TABLE>
<CAPTION>

                                                                           1998          1997           1996
                                                                        ---------      ---------      --------
<S>                                                                     <C>              <C>            <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
     Net income                                                          $  1,775       $  1,952       $  1,764
     Adjustments to reconcile net income to net cash
       provided by operating activities:
          Provision for loan losses                                         1,230          1,002            374
          Provision for deferred income taxes                                 (15)          (124)           (67)
          Deferred compensation expense                                        --             --             53
          Depreciation and amortization                                       529            328            214
          Net realized gains on available for sale securities                (359)           (10)           (23)
          Net amortization on securities                                      540            190            125
          (Increase) decrease in interest receivable                         (380)          (224)          (203)
          (Increase) decrease in other assets                              (1,076)        (1,593)           227
          Increase (decrease) in interest, taxes and other
            liabilities                                                       204            452            318
                                                                         --------       --------       --------
               Net Cash Provided by Operating Activities                    2,448          1,973          2,782
                                                                         --------       --------       --------

CASH FLOWS FROM INVESTING ACTIVITIES:
     Securities available for sale:
          Proceeds from sale of securities                                 45,339         14,560         12,779
          Proceeds from maturities of debt securities                         500            565          2,125
          Purchase of securities                                          (55,706)       (25,740)       (14,128)
     Net increase in loans                                                (42,224)       (37,492)       (41,418)
     Premises and equipment expenditures                                   (1,722)        (2,800)          (446)
                                                                         --------       --------       --------
               Net Cash Used in Investing Activities                      (53,813)       (50,907)       (41,088)
                                                                         --------       --------       --------

CASH FLOWS FROM FINANCING ACTIVITIES:
     Net increase in certificates of deposit                               12,397         35,683         29,811
     Net increase in demand, savings and other deposits                    23,298         11,492         12,333
     Increase (decrease) in federal funds purchased                           503             --             --
     Proceeds from issuance of long-term debt                               6,125            840             --
     Repayment of long-term debt                                           (1,976)           (12)            --
     Proceeds from issuance of junior subordinated
       debt securities                                                      7,500             --             --
     Repayment of short-term borrowings                                        --           (143)           929
     Capital securities issuance cost                                        (319)           (68)            --
     Cash dividends paid                                                     (123)            --             --
     Proceeds from issuance of common stock                                    29            111             36
                                                                         --------       --------       --------
               Net cash provided by financing activities                   47,434         47,903         43,109
                                                                         --------       --------       --------
               Net increase (decrease) in cash and cash equivalents        (3,931)        (1,031)         4,803

CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR                             14,925         15,956         11,153
                                                                         --------       --------       --------

CASH AND CASH EQUIVALENTS AT END OF YEAR                                 $ 10,994       $ 14,925       $ 15,956
                                                                         ========       ========       ========

SUPPLEMENTAL DISCLOSURE OF NON-CASH
  TRANSACTIONS:

     Unrealized gain (loss) in value of securities available for
       sale (net of tax effects of  $(105), $63, and $(19), at
       December 31, 1998, 1997 and 1996, respectively                    $   (204)      $    122       $    (36)
                                                                         ========       ========       ========

SUPPLEMENTAL DISCLOSURES OF CASH FLOW
  INFORMATION:
Cash paid during the year for:
     Interest                                                            $ 13,280       $  9,802       $  7,595
                                                                         ========       ========       ========
     Income taxes                                                        $    952       $  1,011       $    901
                                                                         ========       ========       ========
</TABLE>


The Notes to Consolidated Financial Statements are an integral part of these
statements.

<PAGE>

                   HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES
                                                                         Page F7
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                December 31, 1998
                                 (In thousands)


        Note  1.      Summary of Significant Accounting Policies

               Basis of Presentation:

               The accounting and reporting policies of Highlands Bankshares,
               Inc. and Subsidiaries conform to generally accepted accounting
               principles and the predominant practices within the banking
               industry. The accompanying consolidated financial statements have
               been prepared on the accrual basis.

               Principles of Consolidation:

               The accompanying consolidated financial statements include the
               accounts of Highlands Bankshares, Inc. (the "Parent Company") and
               its wholly-owned subsidiaries, Highlands Union Bank (the "Bank"),
               and Highlands Capital Trust I (the "Trust"). All significant
               intercompany balances and transactions have been eliminated in
               consolidation.

               Nature of Operations:

               Highlands Bankshares, Inc. and Subsidiaries (the "Company")
               operates in Abingdon, Virginia and surrounding Southwest
               Virginia, under the laws of the Commonwealth of Virginia. The
               Company was organized December 29, 1995. Highlands Union Bank,
               its wholly-owned subsidiary, began banking operations on April
               27, 1985. The Bank operates under a state bank charter and
               provides full banking services. As a state bank, the Bank is
               subject to regulation by the Federal Reserve Board and the
               Virginia State Bureau of Financial Institutions. Highlands
               Capital Trust I, its wholly-owned subsidiary became effective on
               January 14, 1998. The nature of the trust is described more fully
               in Note 7.

               Securities Available for Sale:

               Securities classified as available for sale are those debt
               securities that the Company intends to hold for an indefinite
               period of time, but not necessarily to maturity. Any decision to
               sell a security classified as available for sale would be based
               on various factors, including significant movements in interest
               rates, changes in the maturity mix of the Company's assets and
               liabilities, liquidity needs, regulatory capital considerations,
               and other similar factors.

               Securities available for sale are carried at fair value.
               Unrealized gains or losses are reported as increases or decreases
               in stockholders' equity, net of the related deferred tax effect.
               Realized gains or losses, determined on the basis of the cost of
               specific securities sold, are included in earnings. Premiums and
               discounts are recognized in interest income using the interest
               method over the period to maturity.

               Loans Receivable and Allowance for Loan Losses:

               The reserve for possible loan losses for financial statement
               purposes is based upon management's evaluation of amounts
               required to maintain the reserve at an adequate level upon
               consideration of losses charged to the reserve, current economic
               conditions, changes in the size and character of the loan
               portfolio, and other relevant factors which, in management's
               judgment, deserve current recognition.


                                         (Continued)

<PAGE>
                   HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES
                                                                         Page F8
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                December 31, 1998
                                 (In thousands)

        Note  1.      Summary of Significant Accounting Policies (Continued)

               Premises and Equipment:

               Premises and equipment are stated at cost less accumulated
               depreciation. Depreciation is computed on the straight-line
               method over estimated useful lives. Maintenance and repairs are
               charged to current operations while improvements are capitalized.
               Disposition gains and losses are reflected in current operations.

               Intangible Assets:

               Organizational costs are stated at cost less accumulated
               amortization. Amortization is computed on the straight-line
               method over 60 months. Capital issue costs relating to the junior
               subordinated debt securities are stated at cost less accumulated
               amortization. Amortization is computed on the straight-line
               method over the life of the securities - 30 years.

               Income Taxes:

               Under the asset and liability method, deferred income taxes are
               recognized for the tax consequences of "temporary differences" by
               applying enacted statutory tax rates to the differences between
               the financial statement carrying amounts and the tax bases of
               existing assets and liabilities. Under SFAS No. 109, the effect
               on deferred taxes of a change in tax rates is recognized in
               income in the period that includes the enactment date.

               Income on Loans and Loan Fees:

               Accrual of interest on commercial loans and consumer
               single-payment loans are computed using 365 days per year.
               Interest accruals on mortgage loans is computed using 360 days
               per year. Interest on installment loans is reported as income
               over the term of the loan under the simple interest method and
               the sum-of-the-months'-digits (Rule of 78's) method. The Rule of
               78's method is not materially different from the interest method.
               Beginning with 1996 the Bank discontinued the use of the "Rule of
               78's".

               It is the Bank's policy to discontinue the accrual of interest on
               loans based on their delinquency status and evaluation of the
               related collateral and the financial strength of the borrower.
               The accrual of interest income is normally discontinued when a
               loan becomes 90 days past due as to principal or interest.
               Management may elect to continue the accrual of interest when the
               net realizable value of collateral is sufficient to cover the
               principal balance and accrued interest. When interest accruals
               are discontinued, interest accrued and not collected in the
               current year is reversed and interest accrued and not collected
               in prior years is charged to the allowance for credit losses when
               the loan is actually charged off.

               Loan origination fees that exceed the direct costs of
               underwriting and closing loans are deferred. The deferred fees
               received are amortized to income over the estimated lives of the
               loans using a straight line method. The aforementioned
               amortization methods are not materially different from the
               interest method.

               Earnings Per Common Share:

               Earnings per common share are calculated based on the weighted
               average outstanding shares during the year. Earnings per common
               share assuming dilution are calculated based on the weighted
               average outstanding shares during the year plus stock options
               outstanding at year end.

                                         (Continued)
<PAGE>


                   HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES
                                                                         Page F9
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                December 31, 1998
                                 (In thousands)

        Note  1.      Summary of Significant Accounting Policies (Continued)

               Estimates:

               The preparation of financial statements in conformity with
               generally accepted accounting principles requires management to
               make estimates and assumptions that affect certain reported
               amounts and disclosures. Actual results could differ from those
               estimates.

               Business Segments:

               The Company reports its activities as a single business segment.
               In determining the appropriateness of segment definition, the
               Company considers components of the business about which
               financial information is available and regularly evaluated
               relative to resource allocation and performance assessment.

               Reclassification of Financial Statement Presentation:

               Certain reclassifications have been made to the 1997 and 1996
               financial statements to conform with the 1998 financial statement
               presentation. Such reclassifications had no effect on net income
               as previously reported.

        Note  2.      Investment Securities

               Debt and equity securities have been classified in the
               consolidated statements of financial condition according to
               management's intent. The amortized cost and market value of
               securities classified as available for sale are as follows:


<TABLE>
<CAPTION>

                                                             1998
                                      ------------------------------------------------
                                                      Gross        Gross
                                      Amortized     Unrealized   Unrealized      Fair
                                         Cost         Gains        Losses        Value
                                      ---------     ----------   ----------     -------
<S>                                      <C>          <C>          <C>          <C>
U.S. Government agencies and
  corporations                           $ 3,250      $    14      $    --      $ 3,264
State and political subdivisions             754            5           --          759
Collateralized Mortgage Obligations        7,886           --           13        7,873
Mortgage Backed securities                38,288           --          157       38,131
Other securities                           1,328           --           --        1,328
                                         -------      -------      -------      -------

                                         $51,506      $    19      $   170      $51,355
                                         =======      =======      =======      =======
</TABLE>

<TABLE>
<CAPTION>
                                                            1997
                                      ------------------------------------------------
                                                      Gross        Gross
                                      Amortized     Unrealized   Unrealized      Fair
                                         Cost         Gains        Losses        Value
                                      ---------     ----------   ----------     -------
<S>                                      <C>          <C>          <C>          <C>

U.S. Treasury securities                   $ 1,493      $    10      $    --      $ 1,503
U.S. Government agencies and
  corporations                               1,500           --           14        1,486
State and political subdivisions               939           33           --          972
Collateralized Mortgage Obligations          3,987           --           12        3,975
Mortgage Backed securities                  32,788          141           --       32,929
Other securities                             1,098           --           --        1,098
                                           -------      -------      -------      -------

                                           $41,805      $   184      $    26      $41,963
                                           =======      =======      =======      =======
</TABLE>


                                   (Continued)

<PAGE>


                   HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES
                                                                        Page F10
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                December 31, 1998
                                 (In thousands)

        Note  2.      Investment Securities (Continued)

<TABLE>
<CAPTION>

                                                            1996
                                      ------------------------------------------------
                                                      Gross        Gross
                                      Amortized     Unrealized   Unrealized      Fair
                                         Cost         Gains        Losses        Value
                                      ---------     ----------   ----------     -------
<S>                                   <C>            <C>           <C>            <C>

U.S. Treasury securities                 $ 1,003      $    --      $     4      $   999
U.S. Government agencies and
  corporations                             3,500           --           38        3,462
State and political subdivisions           1,004           27           --        1,031
Collateralized Mortgage Obligations        2,372           --           25        2,347
Mortgage Backed securities                22,633           12           --       22,645
Other securities                             861           --           --          861
                                         -------      -------      -------      -------

                                         $31,373      $    39      $    67      $31,345
                                         =======      =======      =======      =======

</TABLE>

               Investment securities available for sale with a carrying value of
               $4,787, $3,571, and $1,003 at December 31, 1998, 1997 and 1996
               respectively, and a market value of $4,783, $3,595, and $998 at
               December 31, 1998, 1997 and 1996 were pledged as collateral on
               public deposits and for other purposes as required or permitted
               by law.

               Federal Home Loan Bank (FHLB) and Federal Reserve Bank (FRB)
               stock with a carrying value of $1,246, $1,029 and $806 at
               December 31, 1998, 1997 and 1996, respectively are included in
               the caption "Other Securities". These investments are considered
               to be restricted as the Company is required by FHLB and FRB to
               hold these investments, and the only market for this stock is the
               issuing agency.

               The amortized cost and estimated fair value of securities
               available for sale at December 31, 1998 by contractual maturity
               are shown below. Expected maturities may differ from contractual
               maturities, because borrowers may have the right to call or
               prepay obligations with or without call or prepayment penalties.

<TABLE>
<CAPTION>
                                                                                    Approximate
                                                                     Amortized        Market
                                                                        Cost           Value
                                                                        ----           -----
                     <S>                                              <C>                  <C>

                      Due in one year or less                          $      -        $     -
                      Due after one year through five years                2,000         2,010
                      Due after five years through ten years               1,049         1,059
                      Due after ten years                                    955           954
                                                                     -----------    ----------
                                                                           4,004         4,023
                                                                      ----------     ---------

                      Mortgage-backed securities                          46,174        46,004
                      Other securities                                     1,328         1,328
                                                                      ----------     ---------
                                                                          47,502        47,332
                                                                      ----------     ---------

                                                                       $  51,506     $  51,355
                                                                        ========      ========
</TABLE>

                      Gross realized gains and on investment securities
                      available for sale are as follows:
<TABLE>
<CAPTION>
                                                           1998           1997          1996
                                                           ----           ----          ----
                        <S>                                <C>             <C>          <C>

                      Realized gains                     $  369         $   34       $    50
                      Realized losses                    $ ( 10)        $ ( 24)      $(   27)
</TABLE>


<PAGE>


                   HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES
                                                                        Page F11
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                December 31, 1998
                                 (In thousands)


        Note  3.      Loans

               The composition of the net loans is as follows:

<TABLE>
<CAPTION>

                                                     1998           1997          1996
                                                     ----           ----          ----
                <S>                                 <C>             <C>            <C>

               Commercial                        $   24,240  $      24,404    $   20,370
               Real estate                          136,339        104,899       101,570
               Installment                           70,137         59,798        30,656
               Other                                  2,821          3,139         2,967
                                                 ----------  -------------   -----------
                                                    233,537        192,240       155,563
                                                 ----------    -----------     ---------

               Deduct:
               Unearned discount                         31            127           455
               Allowance for loan losses              2,008          1,636         1,072
               Net deferred loan fees                   135            108           157
                                                 ----------  ------------- -------------
                                                      2,174          1,871         1,684
                                                 ----------   ------------  ------------
                                                  $ 231,363    $   190,369     $ 153,879
                                                  =========    ===========     =========
</TABLE>


               Nonaccruing loans totaling $1,396, $888, and $99 at December 31,
               1998, 1997 and 1996 are included in the above loans. Interest
               income lost on these nonaccruing loans was approximately $146,
               $71, and $6, for December 31, 1998, 1997 and 1996, respectively.

               Loans have been pledged as part of the floating  blanket lien to
               secure Federal Home Loan Bank advances.      (Note 14)

        Note  4.      Allowance for Loan Losses

               Activity in the allowance for loan losses is as follows:
<TABLE>
<CAPTION>

                                                             1998           1997          1996
                                                             ----           ----          ----
                 <S>                                        <C>             <C>            <C>

               Balance, beginning                       $   1,636     $    1,072     $     908
               Provisions charged to
                operations                                  1,230          1,002           374
               Loans charged to reserve                  (  1,057)      (    512)     (    255)
               Recoveries                                     199             74            45
                                                       ----------      ---------     ---------

               Balance, ending                          $   2,008     $    1,636      $  1,072
                                                        =========      =========       =======
</TABLE>


<PAGE>
                   HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES
                                                                        Page F12
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                December 31, 1998
                                 (In thousands)

        Note  5.  Premises and Equipment

               Premises and equipment, stated at cost, are comprised of the
following:
<TABLE>
<CAPTION>

                                                             1998           1997          1996
                                                             ----           ----          ----
                <S>                                         <C>             <C>           <C>

               Land                                      $  1,870       $  1,847      $  1,451
               Bank premises                                5,374          4,445         2,909
               Equipment                                    2,954          2,184         1,316
                                                        ---------       --------      --------
                                                           10,198          8,476         5,676
               Less accumulated
                depreciation                                1,928          1,414         1,093
                                                        ---------       --------     ---------
                                                         $  8,270       $  7,062       $ 4,583
                                                         ========       -=======       =======
  </TABLE>

               Depreciation  expense  is $514,  $321,  and  $209 for  1998,
               1997,  and  1996, respectively.

        Note  6     Income Taxes

               The components of the net deferred tax asset are as follows:
<TABLE>
<CAPTION>

                                                             1998           1997          1996
                                                            -----           ----          ----
                <S>                                          <C>             <C>           <C>
               Deferred tax assets:
               Allowance for loan loss                  $     532      $     471      $    323
               Deferred compensation                           73             84            90
               Loss on securities available for sale           51              -             9
                                                       ----------   ------------   -----------
                                                              656            555           422
                                                        ---------      ---------     ---------

               Deferred tax liability:
               Depreciation                                  (195)          (160)         (128)
               Gain on securities available for sale            -            (54)          (-)
                                                        ---------     -----------  -----------
                                                             (195)          (214)         (128)
                                                        ---------      ---------      --------
               Net deferred tax asset                   $     461      $     341      $    294
                                                        =========      =========      ========
</TABLE>

               The net deferred tax asset is included in the balance sheet under
               the caption "Other Assets".

               The components of income tax expense (benefit) related to
               continuing operations are as follows:
<TABLE>
<CAPTION>

                                                             1998           1997          1996
                                                            -----           ----          ----
                <S>                                          <C>             <C>            <C>
               Federal:
                 Current                                 $    911       $  1,090       $   924
                 Deferred                                     (15)          (124)          (67)
                                                         ---------      --------      ---------
                     Total                               $    896       $    966       $   857
                                                         ========       ========       =======

</TABLE>
                                         (Continued)
<PAGE>


                   HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES
                                                                        Page F13
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                December 31, 1998
                                 (In thousands)

        Note  6    Income Taxes (Continued)

               The Bank's income tax expense differs from the statutory federal
               rate of 34% as follows:
<TABLE>
<CAPTION>

                                                             1998           1997          1996
                                                             ----           ----          ----
            <S>                                         <C>            <C>           <C>


               Statutory rate applied to
                earnings before income taxes              $   908       $    992       $   891
               Tax exempt interest                            (53)           (10)          (15)
               Other, net                                      41            (16)          (19)
                                                         --------      ---------      ---------
                                                          $   896       $    966       $   857
                                                          =======       ========       =======
</TABLE>

        Note  7.  Deposits

               The composition of deposits is as follows:
<TABLE>
                                                             1998           1997          1996
                                                             ----           ----          ----
              <S>                                       <C>            <C>            <C>
               Noninterest bearing demand               $  36,187      $  30,930    $   26,003
               Interest bearing demand                     21,936         15,065        13,378
               Savings deposits                            35,640         26,808        21,930
               Time deposits, in amounts of
                $100,000 or more                           41,302         37,890        31,007
               Other time deposits                        137,276        125,953        97,153
                                                       ----------     ----------      --------

                                                        $ 272,341      $ 236,646     $ 189,471
                                                        =========      =========      ========
</TABLE>

               The remaining maturities of time deposits at December 31, 1998
are as follows:

<TABLE>
<S>                                                  <C>
               Three months or less                  $     37,370
               Three through twelve months                 87,882
               Over twelve months                          53,326
                                                      -----------
                                                       $  178,578
                                                       ==========

</TABLE>


<PAGE>


                                   HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES
                                                                        Page F14
                                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                                December 31, 1998
                                                 (In thousands)


        Note 8. Long-Term Debt

               At December 31,  Highlands  Bankshares Inc. and  Subsidiaries
had the following long-term debt agreements:

<TABLE>
<CAPTION>

                                                                                   1998       1997        1996
                                                                                   ----       ----        ----
<S>                                                                                <C>       <C>        <C>
Note payable Federal Home Loan Bank dated June 6, 1996 for $1,000
with an annual interest rate of 6.07%, due June 8, 1998. The note
requires annual interest payments. The loan is secured by a
floating blanket lien on assets of the Bank, including loans                       $   --      $1,000      $1,000

Note payable Federal Home Loan Bank dated June 6, 1996 for $1,000
with an annual interest rate of 7.02%, due June 6, 2003. The note
requires semi-annual installments of $71 plus interest. The loan
is secured by a floating blanket lien on assets of the Bank, including loans          643         786         929

Note payable Federal Home Loan Bank dated March 26, 1998 for
$6,000 with an annual interest rate of 5.51%, due March 26, 2008
The note requires quarterly interest payments and has an early
conversion option at March 26, 2003. The loan is secured by a
floating blanket lien on assets of the Bank, including loans                        6,000          --          --

Note payable resulting from a seller-financing transaction dated
September 10, 1998 for $125 with an annual interest rate of
8.50%, due September 10, 2003. The note requires monthly
installments of principal and interest of $3. The loan is secured
by a first deed of trust on real estate                                               120          --          --

Note payable to Company's Subsidiary (amount participated with
other financial institutions only) dated March 4, 1997 for $900
with an annual interest rate of 8.25%, due March 4, 2002. The
note requires monthly installments of $8 with a balloon payment
at maturity. The loan is secured by a first deed of trust on
a commercial building                                                                  --         828          --
                                                                                   ------      ------      ------
       Total long-term debt                                                        $6,763      $2,614      $1,929
                                                                                   ======      ======      ======

</TABLE>

                                         (Continued)


<PAGE>


                                   HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES
                                                                        Page F15
                                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                                December 31, 1998
                                                 (In thousands)

        Note 8. Long-Term Debt (Continued)

               Principal maturities of notes payable at December 31, 1998 are as
follows:

               1999                                     $   164
               2000                                         166
               2001                                         168
               2002                                         171
               2003                                          94
               Thereafter                                 6,000
                                                          -----
                                                        $ 6,763
                                                        =======


        Note  9.      Capital Securities

               On January 21, 1998, Highlands Capital Trust I, a statutory
               business trust (the "Trust") created by the Parent Company,
               issued $7,500 of 9.25% Capital Securities which will mature on
               January 15, 2028. The principal asset of the Trust is $7,500 of
               the Parent Company's junior subordinated debt securities with
               like maturities and like interest rates to the Capital
               Securities. Additionally, the Trust has issued 9,000 shares of
               common securities to the Parent Company. The 9.25% Capital
               Securities had $7,500 outstanding at December 31, 1998 and an
               estimated fair value of $7,923. The related junior subordinated
               debt securities had an estimated fair value of $7,923.

               The Capital Securities, the assets of the Trust and the common
               securities issued by the Trust are redeemable in whole or in part
               on or after January 15, 2008, or at any time in whole but not in
               part from the date of issuance on the occurrence of certain
               events.

               The Capital Securities may be included in Tier I capital up to
               25% of capital before inclusion for regulatory capital adequacy
               determination purposes. The remaining 75% of the Capital
               Securities may be included in Tier II capital. Distributions to
               the holders of the Capital Securities are included in interest
               expense.

               The obligations of the Parent Company with respect to the
               issuance of the Capital Securities constitute a full and
               unconditional guarantee by the Parent Company of the Trust's
               obligations with respect to the Capital Securities.

               Subject to certain exceptions and limitations, the Parent Company
               may elect from time to time to defer junior subordinated debt
               securities interest payments, which would result in a deferral of
               distribution payments on the related Capital Securities.

               Amortization of capital issue costs and interest expense related
               to the Trust is $10 and $662, respectively for 1998.


<PAGE>

                   HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES
                                                                        Page F16
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                December 31, 1998
                                 (In thousands)

        Note 10.      Operating Leases

               The following is a schedule by years of future minimum rental
               payments required under operating leases that have initial or
               remaining noncancelable terms in excess of one year as follows:

               Year ending December 31:


                 1999                                         199
                 2000                                         111
                                                        ---------
               Total minimum payments required           $    310
                                                         ========


               Total operating  lease expense was $342,  $330, and $359 for
               December 31, 1998, 1997 and 1996 respectively.

               The Company owns several buildings for use by its' subsidiaries,
               and leases the remaining space. The following is a schedule by
               years of future minimum rental payments due to be received under
               operating leases that have initial or remaining noncancelable
               terms in excess of one year as follows:

               Year Ending December 31:

                 1999                                   $      92
                 2000                                          42
                 2001                                          14
                 2002                                           1
                                                         --------
               Total minimum payments required           $    149
                                                         ========

        Total operating lease income was $90, $90 and $0 for December 31, 1998,
1997 and 1996, respectively.


        Note 11.      Common Stock, Stock Split, and Earnings Per Common Share

               On April 15, 1995, the Board authorized a 2 for 1 stock split to
               be distributed to all shareholders of record as of April 12,
               1995. As a result, authorized shares increased from 5,000,000 to
               10,000,000 and par value decreased from $5.00 to $2.50 per share.
               All references in the financial statements to number of shares,
               per share amounts and market prices of the Company's common stock
               have been retroactively restated to reflect the increased number
               of common shares outstanding.

               Earnings per common share is computed using the weighted average
               outstanding shares as of December 31. The stock options (Note 13)
               have a dilutive effect on earnings per share.

                                   (Continued)

<PAGE>

                   HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES
                                                                        Page F17
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                December 31, 1998
                                 (In thousands)

        Note 11. Common Stock, Stock Split, and Earnings Per Common Share
(Continued)

               The following is a reconciliation of the numerators and the
               denominators of the basic and diluted earnings per common share
               computation:
<TABLE>
<CAPTION>

                                                        1998
                                       -------------------------------------
                                         Income        Shares      Per-Share
                                       (Numerator)  (Denominator)    Amount
                                       -----------  -------------    ------
<S>                                       <C>         <C>           <C>
Net income                                $1,775
                                          ======
Basic Earnings per Common Share
  Income available to common
  stockholders                             1,775         1,236        $1.44
                                                                      =====
Effect of Dilutive Stock options
  outstanding                                 --            46
                                          ------        ------
Diluted Earnings per Common Share
  Income available to common
  stockholders + assumed conversions      $1,775         1,282        $1.38
                                          ======        ======        =====
</TABLE>



<TABLE>
<CAPTION>
                                                         1997
                                         -------------------------------------
                                          Income        Shares       Per-Share
                                        (Numerator)  (Denominator)     Amount
                                        -----------  -------------     ------
<S>                                       <C>         <C>           <C>
Net income                                $1,952
                                          ======
Basic Earnings per Common Share
  Income available to common
  stockholders                             1,952          1,228         $1.59
                                                                        =====
Effect of Dilutive Stock options
  outstanding                                 --             51
                                          ------         ------
Diluted Earnings per Common Share
  Income available to common
  stockholders + assumed conversions      $1,952          1,279         $1.53
                                          ======         ======         =====
</TABLE>


<TABLE>
<CAPTION>
                                                         1996
                                        ---------------------------------------
                                         Income         Shares       Per-Share
                                       (Numerator)   (Denominator)     Amount
                                       -----------   -------------     ------
<S>                                       <C>         <C>           <C>
Net income                                $1,764
                                          ======
Basic Earnings per Common Share
  Income available to common
  stockholders                             1,764          1,220         $1.45
                                                                        =====
Effect of Dilutive Stock options
  outstanding                                 --             54
                                          ------          -----
Diluted Earnings per Common Share
  Income available to common
  stockholders + assumed conversions      $1,764          1,274         $1.38
                                          ======         ======         =====

</TABLE>





<PAGE>


                   HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES
                                                                        Page F18
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                December 31, 1998
                                 (In thousands)

        Note 12.      Profit Sharing and Retirement Savings Plan

               From January 1, 1986 to June 30, 1997, the Bank provided a profit
               sharing plan covering substantially all employees with over one
               year of service. The plan provided for contributions in such
               amounts as the Board of Directors determined annually, but not in
               excess of the amount permitted under the Internal Revenue Code as
               a deductible expense. The Bank accrued to the plan $120 for the
               year ended December 31, 1996, which represents approximately 6%
               of qualifying salaries and wages of the Bank.

               On July 1, 1997 the Bank converted its existing profit sharing
               plan to a 401(K) saving plan. The plan is available to
               substantially all employees meeting minimum eligibility
               requirements. The Bank makes a 2% contribution to all employees
               exclusive of employee contributions and employer matching.
               Employees may elect to make voluntary contributions to the plan
               up to 15% of their base pay. The Bank matches 50% of the
               employee's initial 6% contribution; therefore, the maximum
               employer contribution per employee could be 5% of base pay. The
               cost of Bank contributions under the savings plan was $115 and
               $34, in 1998 and 1997 respectively.

        Note 13.      Stock Option Plan

               In 1996, Highlands Bankshares, Inc. adopted a non-qualified stock
               incentive option plan, which is identical to and replaced the
               plan adoped by Highlands Union Bank in 1986, for key employees,
               officers, and directors and reserved 150,000 shares of common
               stock for issuance thereunder. Options granted under the plan
               expire ten years from date of grant.

               Shares under options which are canceled are available for
               subsequent grant. Option prices are determined by the Board of
               Directors, but shall not be less than the greater of the par
               value of such stock or 100% of the book value of such stock as
               shown by the Company's last published statement prior to granting
               of the option. Proceeds received upon exercise of options are
               credited to common stock, to the extent of par value of the
               related shares, and the balance is credited to surplus.

               Options outstanding at weighted-average exercise price for the
               years ended December 31, are as follows:

<TABLE>
<CAPTION>
                                                        1998                   1997                    1996
                                                ----------------------  ---------------------  ----------------------
                                                  Dollars    Number of    Dollars   Number of    Dollars    Number of
                                                (Per Share)   Shares    (Per Share)  Shares    (Per Share)    Shares
                                                -----------  ---------  -----------  ------    -----------  ---------
               <S>                                <C>        <C>          <C>        <C>         <C>        <C>
               Options outstanding January 1      $  9.20     83,856       $ 7.02     82,668     $ 5.56     73,962
               Granted                              29.65     23,750        23.00     11,650      15.00     12,900
               Exercised                             4.80    (14,401)        7.38    (10,462)      5.84     (4,194)
                                                             --------                -------               -------

               Options outstanding December 31    $ 15.28     93,205       $ 9.20     83,856     $ 7.02     82,668
                                                             ========                =======               =======
</TABLE>


               At the time options are granted, the difference in the market
               value of the stock and the option price is recorded as an expense
               and the related accrual is included in surplus. For 1996 $53
               thousand was recorded as compensation as a result of options
               granted. The 1998 and 1997 stock options were granted at the
               current market value of the stock. The grant date fair value of
               options is determined by the difference between market value and
               option price on the grant date. The weighted-average grant-date
               fair value of options granted during 1998, 1997 and 1996 was $0,
               $0 and $3.50, respectively.

               As of December 31, 1998, exercise prices of options outstanding
               range from $4.14 to $31.00 per share, and carry a
               weighted-average remaining contractual life of 6.77 years.




<PAGE>


                   HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES
                                                                        Page F19
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                December 31, 1998
                                 (In thousands)

        Note 14.      Commitments, Contingencies and Concentrations of Credit

               The Bank is party to various financial instruments with
               off-balance sheet risk arising in the normal course of business
               to meet the financing needs of their customers. Those financial
               instruments include commitments to extend credit and standby
               letters of credit. These commitments include standby letters of
               credit of approximately $859, $2,408, and $2,026 and unused
               portions of credit lines of $16,655, $12,297 and 10,335 for the
               years ended December 31, 1998, 1997 and 1996, respectively. These
               instruments contain various elements of credit and interest rate
               risk in excess of the amount recognized in the statements of
               financial condition.

               The Bank's exposure to credit loss, in the event of
               non-performance by the other party to the financial instrument
               for commitments to extend credit and standby letters of credit,
               is the contractual amount of those instruments. The Bank uses the
               same credit policies in making commitments and conditional
               obligations that they do for on-balance sheet instruments.

               The Bank has made arrangements with and has available from other
               corresponding banks, approximately $52,592 of unused lines of
               credit to fund any necessary cash requirements. The Bank has
               $6,643 of Federal Home Loan Bank advances outstanding as of
               December 31, 1998. Specific mortgage loans with a balance of
               $81,180 at December 31, 1998 were pledged to the FHLB as
               collateral.

               The Bank grants various types of credit including but not limited
               to, agribusiness, commercial, consumer, and residential loans to
               customers primarily located throughout Southwest Virginia. Each
               customer's credit worthiness is examined on a case by case basis.
               The amount of collateral obtained, if any, is determined by
               management's credit evaluation of the customer. Collateral held
               varies, but may include property, accounts receivable, inventory,
               plant and equipment, securities and other income producing
               properties. Although the loan portfolio is generally well
               diversified and geographically dispersed within the region,
               aggregate loans extended for real estate mortgages represent
               greater than 50% of the loan portfolio. A substantial portion of
               the customers' ability to honor their contractual commitment is
               largely dependent upon the economic conditions of the region.

               The Bank has committed to enter a lease agreement for the use of
               a new main frame computer. The final agreement is expected to
               close by the end of the first quarter in 1999. The lease will be
               for five years with a fixed rate of interest requiring annual
               installments. The principal amount will be approximately $930
               including approximately $140 on an existing lease that will be
               rolled into the new agreement. As a part of this transaction, the
               Bank made a downpayment on the main frame of $794 which is
               included in the balance sheet under the caption "Other Assets".
               This amount will be refunded to the Bank when the lease agreement
               becomes effective.

        Note 15.      Fair Values of Financial Instruments

               The carrying amounts and fair values of the Company's financial
               instruments at December 31 were as follows:


<TABLE>
<CAPTION>
                                       1998                        1997                     1996
                                -------------------       ---------------------     ---------------------
                               Carrying       Fair        Carrying        Fair      Carrying        Fair
                                Amount        Value        Amount         Value       Amount        Value
                                ------       -------       ------        -------     --------      -------
<S>                             <C>          <C>           <C>            <C>        <C>           <C>
Cash and cash equivalents       $  10,994    $  10,994      $  14,925    $  14,925    $  15,956    $  15,956
Securities available for sale      51,355       51,355         41,963       41,963       31,345       31,345
Loans, net                        231,363      234,290        190,369      195,020      153,879      156,977
Deposits                         (272,341)    (273,551)      (236,646)    (237,429)    (189,471)    (190,071)
Federal funds purchased              (503)        (503)            --           --           --           --
Long-term debt                     (6,763)      (6,767)        (2,614)      (2,448)      (1,929)      (1,837)
Capital securities                 (7,500)      (7,923)            --           --           --           --
</TABLE>


                                         (Continued)


<PAGE>


                   HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES
                                                                        Page F20
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                December 31, 1998
                                 (In thousands)

        Note 15.      Fair Values of Financial Instruments (Continued)

               Cash and Cash Equivalents

               The carrying amount reported in the balance sheets for cash and
               short-term investments approximates fair value.

               Securities Available for Sale

               The carrying amount reported in the balance sheets for securities
               available for sale approximates fair value.

               Loans

               The fair values of loans represent the amount at which the loans
               of the Bank could be exchanged on the open market, as determined
               based on the current lending rate for similar types of lending
               arrangements discounted over the remaining life of the loans.

               Deposits

               The fair values of deposits represent the amount at which the
               liabilities of the Bank could be exchanged on the open market, as
               determined based on the incremental borrowing rate of the Bank
               for similar types of borrowing arrangements.

               Federal Funds Purchased

               The carrying amount reported in the balance sheets for federal
               funds purchased approximates fair value.

               Long-Term Debt and Capital Securities

               Rates currently available to the Company for debt with similar
               terms and remaining maturities are used to estimate fair value of
               existing debt.

               Commitments  to Extend  Credit,  Stand-by  Letters  of  Credit,
               and  Financial Guarantees

               The amount of off-balance sheet commitments to extend credit,
               stand-by letters of credit, and financial guarantees, is
               considered equal to fair value. Because of the uncertainty
               involved in attempting to assess the likelihood and timing of
               commitments being drawn upon, coupled with the lack of an
               established market and the wide diversity of fee structures, the
               Company does not believe it is meaningful to provide an estimate
               of fair value that differs from the given value of the
               commitment.



<PAGE>

                   HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES
                                                                       Page F21
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                December 31, 1998
                                 (In thousands)


        Note 16.      Related Party Transactions

               In the normal course of business, the Bank has made loans to
               directors and officers of the Bank. All loans and commitments
               made to such officers and directors and to companies in which
               they are officers or have significant ownership interest have
               been made on substantially the same terms, including interest
               rates and collateral, as those prevailing at the time for
               comparable transactions with unrelated persons, and did not, in
               the opinion of management, involve more than normal credit risk
               or present other unfavorable features. The activity of such loans
               are approximately as follows:
<TABLE>
<CAPTION>


                                           1998          1997          1996
                                         -------       -------       -------
              <S>                      <C>          <C>              <C>
               Balance, beginning       $  5,766      $  5,541       $  6,317
               Loan additions              3,652         3,889          2,712
               Amounts collected        (  2,761)     (  3,664)      (  3,488)
                                        --------      --------       --------
               Balance, ending           $ 6,657       $ 5,766       $  5,541
                                         =======       =======       ========
               Unused Commitments       $    410      $    216      $     107
                                        ========      ========      =========
</TABLE>


        Note 17.      Restrictions on Cash

               The Bank is required to maintain reserve balances in cash with
               the Federal Reserve Bank. The total of those reserve balances at
               December 31, 1998, 1997 and 1996 were $1,239, $1,034 and $789,
               respectively.

        Note 18.      Undivided Profits and Capital

               Banking laws and regulations limit the amount of dividends that
               may be paid without prior approval of the Bank's regulatory
               agency. Under that limitation, the Company could have declared
               dividends of $2,939 $3,534 and $3,686 in 1998, 1997 and 1996
               respectively. The Company paid dividends of $123 or $.10 per
               share in 1998. The Company declined to pay cash dividends for
               1997 and 1996, in order to maintain the capital necessary to
               support the present rate of growth.

               The Company is subject to various regulatory capital requirements
               administered by its primary regulator, the Federal Reserve Board.
               Failure to meet the minimum regulatory capital requirements can
               initiate certain mandatory and possible additional discretionary
               actions by regulators, that if undertaken, could have a direct
               material effect on the Company and the consolidated financial
               statements. Under the regulatory capital adequacy guidelines and
               the regulatory framework for prompt corrective action, the
               Company must meet specific capital guidelines involving
               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
               classification under the prompt corrective action guidelines are
               also subject to qualitative judgments by the regulators about
               components, risk weightings, and other factors.


                                         (Continued)

<PAGE>


                   HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES
                                                                        Page F22
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                December 31, 1998
                                 (In thousands)

        Note 18.      Undivided Profits and Capital (Continued)

               Quantitative measures established by regulation to ensure capital
               adequacy require the Company to maintain minimum amounts and
               ratios of: total risk-based capital and Tier I capital to
               risk-weighted assets (as defined in the regulations), and Tier I
               capital to adjusted total assets (as defined). Management
               believes, as of December 31, 1998, that the Company meets all the
               capital adequacy requirements to which it is subject.

               The Company received notification from the Virginia State
               Corporation Commission dated February 10, 1999 that as of October
               5, 1998 the Company was categorized as well capitalized under the
               regulatory framework for prompt corrective action. To remain
               categorized as well capitalized, the Company will have to
               maintain minimum total risk-based, Tier I risk-based, and Tier I
               leverage ratios as disclosed in the table below. There are no
               conditions or events since the most recent notification that
               management believes have changed the Company's prompt corrective
               action category.

               The Parent company's actual and required capital amounts and
               ratios are as follows:
<TABLE>
<CAPTION>
                                                                                                  To Be Well Capitalized
                                                                                                     under the Prompt
                                                                                 For Capital         Corrective Action
                                                           Actual             Adequacy Purposes         Provisions
                                                     ------------------       ------------------    ------------------
                                                     Amount       Ratio       Amount      Ratio     Amount       Ratio
                                                     ------       -----       ------      -----     ------       -----
               <S>                                 <C>          <C>          <C>         <C>        <C>          <C>


               As of December 31, 1998:
                  Total Risk-Based Capital
                     (to Risk-Weighted Assets)       $27,887       12.79%     $17,447       >=8.0%     $21,808      >=10.0%
                  Tier I Capital
                     (to Risk-Weighted Assets)        24,505       11.24%       8,723       >=4.0%      13,085       >=6.0%
                  Tier I Capital
                     (to Adjusted Total Assets)       24,505        8.09%      12,112       >=4.0%      15,140       >=5.0%

               As of December 31, 1997:
                  Total Risk-Based Capital
                     (to Risk-Weighted Assets)       $18,334        9.91%     $14,800       >=8.0%     $18,500      >=10.0%
                  Tier I Capital
                     (to Risk-Weighted Assets)        16,698        9.03%       7,400       >=4.0%      11,100       >=6.0%
                  Tier I Capital
                     (to Adjusted Total Assets)       16,698        6.68%       9,994       >=4.0%      12,492       >=5.0%

               As of December 31, 1996:
                  Total Risk-Based Capital
                     (to Risk-Weighted Assets)       $15,213       10.12%     $12,022       >=8.0%     $15,028      >=10.0%
                  Tier I Capital
                     (to Risk-Weighted Assets)        14,141        9.41%       6,011       >=4.0%       9,016       >=6.0%
                  Tier I Capital
                     (to Adjusted Total Assets)       14,141        6.82%       8,298       >=4.0%      10,372       >=5.0%
</TABLE>


                                         (Continued)

<PAGE>


                   HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES
                                                                        Page F23
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                December 31, 1998
                                 (In thousands)

        Note 18.      Undivided Profits and Capital (Continued)


               The Bank's actual and required capital amounts and ratios are as
follows:
<TABLE>
<CAPTION>
                                                                                                  To Be Well Capitalized
                                                                                                      under the Prompt
                                                                                 For Capital         Corrective Action
                                                           Actual             Adequacy Purposes          Provisions
                                                     -------------------      ------------------     ------------------
                                                     Amount        Ratio      Amount       Ratio     Amount       Ratio
                                                     ------        -----      ------       -----     ------       -----
              <S>                                   <C>           <C>        <C>           <C>       <C>          <C>
               As of December 31, 1998:
                  Total Risk-Based Capital
                     (to Risk-Weighted Assets)       $21,241       10.15%     $17,232       >=8.0%     $21,054      >=10.0%
                  Tier I Capital
                     (to Risk-Weighted Assets)        19,865        9.22%       8,616       >=4.0%      12,924       >=6.0%
                  Tier I Capital
                     (to Adjusted Total Assets)       19,865        6.69%      11,875       >=4.0%      14,844       >=5.0%

               As of December 31, 1997:
                  Total Risk-Based Capital
                     (to Risk-Weighted Assets)       $17,874        9.74%     $14,686       >=8.0%     $18,358      >=10.0%
                  Tier I Capital
                     (to Risk-Weighted Assets)        16,238        8.85%       7,343       >=4.0%      11,015       >=6.0%
                  Tier I Capital
                     (to Adjusted Total Assets)       16,238        6.53%       9,942       >=4.0%      12,427       >=5.0%

               As of December 31, 1996:
                  Total Risk-Based Capital
                     (to Risk-Weighted Assets)       $15,213       10.12%     $12,022       >=8.0%     $15,028      >=10.0%
                  Tier I Capital
                     (to Risk-Weighted Assets)        14,141        9.41%       6,011       >=4.0%       9,016       >=6.0%
                  Tier I Capital
                     (to Adjusted Total Assets)       14,141        6.82%       8,298       >=4.0%      10,372       >=5.0%
</TABLE>


        Note 19.      Other Operating Expenses

               Other operating expenses consist of the following:

<TABLE>
<CAPTION>
                                                            1998           1997           1996
                                                          -------        -------        -------
              <S>                                         <C>          <C>              <C>
               Data processing                            $    14        $     9       $     9
               FDIC insurance                                  67             24             2
               Postage and freight                            251            197           161
               Regulatory agency assessments                   45             40            33
               Supplies                                       216            183           146
               Bank stock tax                                 146            151           122
               Other                                        1,094            737           570
                                                          -------       --------      --------

                                                          $ 1,833        $ 1,341       $ 1,043
                                                          =======        =======       =======

</TABLE>

<PAGE>


                   HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES
                                                                        Page F24
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                December 31, 1998
                                 (In thousands)

        Note 20.      Subsequent Events

               In January 1999, the Company committed to purchase real estate in
               Abingdon, VA for $485,000. The property will be used as a future
               expansion site of the Company.

        Note 21.      Condensed Parent Company Financial Statements

               The condensed financial statements below relate to Highlands
               Bankshares, Inc. as of December 31, 1998, 1997 and 1996 and for
               the years then ended. Highlands Bankshares, Inc. was formed
               December 29, 1995 and exchanged common stock for the common stock
               of Highlands Union Bank.
<TABLE>
<CAPTION>
               CONDENSED BALANCE SHEETS
                                                                     1998         1997         1996
                                                                    -------      -------      -------
              <S>                                               <C>             <C>          <C>
               ASSETS
                 Cash                                             $    202       $      1      $    331
                 Investment securities available
                   for sale (Note 2)                                 2,480             --            --
                 Federal funds sold                                  1,670             --            --
                 Investments in subsidiaries                        19,772         16,343        14,122
                 Premises and equipment, net                         1,402          1,276           141
                 Other assets                                          406             86            24
                                                                  --------       --------      --------
                         Total Assets                             $ 25,932       $ 17,706      $ 14,618
                                                                  ========       ========      ========

               LIABILITIES AND STOCKHOLDERS' EQUITY
                 Interest, taxes and other
                    liabilities                                   $    153       $     23      $     --
                 Long-term debt                                         --            886            --
                 Capital securities                                  7,500             --            --
                                                                  --------       --------      --------
                         Total Liabilities                           7,653            909            --
                                                                  --------       --------      --------

               STOCKHOLDERS' EQUITY
                 Common stock                                        3,116          3,081         3,055
                 Surplus                                             5,265          5,271         5,187
                 Undivided profits                                   9,998          8,341         6,394
                 Net unrealized gains (losses) on securities          (100)           104           (18)
                                                                  --------       --------      --------
                         Total Stockholders'  Equity                18,279         16,797        14,618
                                                                  --------       --------      --------
                         Total Liabilities and
                          Stockholders' Equity                    $ 25,932       $ 17,706      $ 14,618
                                                                  ========       ========      ========
               </TABLE>

                                          (Continued)

<PAGE>


                   HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES
                                                                        Page F25
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                December 31, 1998
                                 (In thousands)

        Note 21.      Condensed Parent Company Financial Statements (Continued)
<TABLE>
<CAPTION>


               CONDENSED STATEMENTS OF INCOME
                                                                       1998          1997           1996
                                                                    ---------     ----------     ----------
                <S>                                                  <C>           <C>             <C>


                  Cash dividends received from subsidiary             $    --       $    --       $   500
                  Revenues                                                373           102            --
                  Long-term debt interest expense                          (9)          (61)           --
                  Capital securities expense                             (672)           --            --
                  Operating expense                                       (68)          (57)           (5)
                                                                      -------       -------       -------
                                                                         (376)          (16)          495

                  Income tax (expense) benefit                            128             5            (2)
                  Equity in undistributed earnings of subsidiary        2,023         1,963         1,271
                                                                      -------       -------       -------

                  Net income                                          $ 1,775       $ 1,952       $ 1,764
                                                                      =======       =======       =======
               </TABLE>


                                         (Continued)

<PAGE>


                   HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES
                                                                        Page F26

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                December 31, 1998
                                 (In thousands)

               Note 21.Condensed Parent Company Financial Statements (Continued)
<TABLE>
<CAPTION>


               CONDENSED STATEMENTS OF CASH FLOWS

                                                                                 1998             1997           1996
                                                                                 ----             ----           ----
                <S>                                                            <C>               <C>           <C>
               CASH FLOWS FROM OPERATING ACTIVITIES:
                 Net income                                                    $ 1,775           $ 1,952       $ 1,764
                 Adjustments to reconcile net income to
                  net cash provided by operating activities:
                     Depreciation and amortization                                  42                25             5
                     Provision for deferred income taxes                            (3)               --            --
                     Equity in undistributed earnings of
                      subsidiary                                                (2,023)           (1,963)       (1,271)
                     Net amortization on securities                                 25                --            --
                     (Increase) decrease in other assets                          (110)              (69)          (24)
                     Increase (decrease) in other liabilities                      130                25            (2)
                                                                               -------           -------       -------
                     Net cash provided by operating activities                    (164)              (30)          472
                                                                               -------           -------       -------

               CASH FLOWS FROM INVESTING ACTIVITIES:
                   Securities available for sale:
                     Proceeds from sale of securities                            1,072                --            --
                     Purchase of securities                                     (3,586)               --            --
                 Net (increase) in federal funds sold                           (1,670)               --            --
                 Premises and equipment expenditures                              (152)           (1,154)         (141)
                                                                               -------           -------       -------
                     Net cash provided by investing activities                  (4,336)           (1,154)         (141)
                                                                               -------           -------       -------

               CASH FLOWS FROM FINANCING ACTIVITIES:
                 Proceeds from issuance of long-term debt                           --               900            --
                 Repayment of long-term debt                                      (886)              (14)           --
                 Proceeds from issuance of junior subordinated
                   debt securities                                               7,500                --            --
                 Capital securities issuance cost                                 (319)              (68)           --
                 Cash dividends paid                                              (123)               --            --
                 Proceeds from issuance of common stock                             29               111            --
                 Purchase of subsidiary stock                                   (1,500)              (75)           --
                                                                               -------           -------       -------
                     Net cash provided by financing activities                   4,701               854            --
                                                                               -------           -------       -------
                     Net increase (decrease) in cash and cash equivalents          201              (330)          331

                 CASH AND CASH EQUIVALENTS
                   AT BEGINNING OF YEAR                                              1               331            --
                                                                               -------           -------       -------
                 CASH AND CASH EQUIVALENTS
                    AT END OF YEAR                                             $   202           $     1       $   331
                                                                               =======           =======       =======
               </TABLE>