|U. S. SECURITIES AND EXCHANGE COMMISSION
		WASHINGTON, D.C. 20549                                                                                                                                                                                                                                                                                                               
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|FORM 10-Q                                                                                                                                                                                                                                                                                                                                                                       
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|Commission file number  0-26016                                                                                                                                                                                                                                                                                                                                                 
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|PALMETTO BANCSHARES, INC.                                                                                                                                                                                                                                                                                                                                                       
|(Exact name of registrant as specified in its charter)                                                                                                                                                                                                                                                                                                                          
|                                                                                                                                                                                                                                                                                                                                                                                
|South Carolina                                                                                                                                                                                                                                                                                                                                                                  
|(State or other jurisdiction of incorporation or
		organization)                                                                                                                                                                                                                                                                                                                
|                                                                                                                                                                                                                                                                                                                                                                                
|301 Hillcrest Drive, Laurens, South Carolina                                                                                                                                                                                                                                                                                                                                    
|(Address of principal executive offices)                                                                                                                                                                                                                                                                                                                                        
|                                                                                                                                                                                                                                                                                                                                                                                
|(864) 984-4551                                                                                                                                                                                                                                                                                                                                                                  
|(Registrant's telephone number)                                                                                                                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                                
|Indicate by check mark whether the registrant (1) has filed all reports
		required to be filed by Section 13 or 15(d) of the Securities Exchange
		Act of 1934 during the preceding 12 months (or for such shorter period
		that the registrant was required to file such reports), and (2) has been
		subject to such filing requirements for the past 90 days. Yes X  
		No __
|                                                                                                                                                                                                                                                                                                                                                                                
|Indicate by check mark whether the registrant is a large accelerated
		filer, an accelerated filer, or a non-accelerated filer.  See
		definition of "accelerated filer and large accelerated filer" in Rule
		12b-2 of the Exchange Act.                                                                                                                                       
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|Indicate by check mark whether the registrant is a shell company (as
		defined by Rule 12b-2 of the Exchange Act).  Yes [ ] No [x]                                                                                                                                                                                                                                              
|                                                                                                                                                                                                                                                                                                                                                                                
|Indicate the number of shares outstanding of each of the issuer's
		classes of common stock, as of the latest practicable date.                                                                                                                                                                                                                                                 
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|PALMETTO BANCSHARES, INC. AND SUBSIDIARY
|----------------------------------------
|Table of Contents                       
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|                                        
|PART I.  FINANCIAL INFORMATION          
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|PART II.  OTHER INFORMATION             
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|SIGNATURES                              
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2




|PALMETTO BANCSHARES, INC. AND SUBSIDIARY                        
|----------------------------------------------------------------
|Consolidated Balance Sheets                                     
|(dollars in thousands, except common and per share data)        
|                                                                
|                                                                
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|                                                                
|ASSETS                                                          
|Cash and cash equivalents                                       
|                                                                
|                                                                
|                                                                
|                                                                
|Federal Home Loan Bank ("FHLB") stock, at cost                  
|Investment securities available for sale, at fair market value  
|Mortgage loans held for sale                                    
|                                                                
|Loans                                                           
|                                                                
|                                                                
|                                                                
|Premises and equipment, net                                     
|Accrued interest receivable                                     
|Goodwill                                                        
|Other intangible assets                                         
|Other                                                           
|                                                                
|                                                                
|LIABILITIES AND SHAREHOLDERS' EQUITY                            
|Liabilities                                                     
|Deposits                                                        
|                                                                
|                                                                
|                                                                
|                                                                
|Retail repurchase agreements                                    
|Commercial paper (Master notes)                                 
|Federal funds purchased                                         
|FHLB borrowings                                                 
|Other                                                           
|                                                                
|                                                                
|Commitments and contingencies (Note 14)                         
|                                                                
|Shareholders' Equity                                            
|Common stock - par value $5.00 per share;  authorized 10,000,000
|                                                                
|                                                                
|Capital surplus                                                 
|Retained earnings                                               
|Accumulated other comprehensive loss, net of tax                
|                                                                
|                                                                
|                                                                
|                                                                
|See Notes to Consolidated Interim Financial Statements.         

3




|PALMETTO BANCSHARES, INC. AND SUBSIDIARY                 
|---------------------------------------------------------
|Consolidated Statements of Income                        
|(dollars in thousands, except common and per share data) 
|                                                         
|                                                         
|                                                         
|Interest income                                          
|                                                         
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|Interest expense                                         
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|Provision for loan losses                                
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|Noninterest income                                       
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|Noninterest expense                                      
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|Provision for income taxes                               
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|Common Share Data                                        
|                                                         
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|                                                         
|                                                         
|                                                         
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|                                                         
|                                                         
|See Notes to Consolidated
		Interim Financial Statements.

4




|PALMETTO BANCSHARES, INC. AND SUBSIDIARY                 
|---------------------------------------------------------
|Consolidated Statements of Income                        
|(dollars in thousands, except common and per share data) 
|                                                         
|                                                         
|                                                         
|Interest income                                          
|                                                         
|                                                         
|                                                         
|                                                         
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|                                                         
|Interest expense                                         
|                                                         
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|                                                         
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|Provision for loan losses                                
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|Noninterest income                                       
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|Noninterest expense                                      
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|Provision for income taxes                               
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|                                                         
|Common Share Data                                        
|                                                         
|                                                         
|                                                         
|                                                         
|                                                         
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|                                                         
|See Notes to Consolidated
		Interim Financial Statements.

5




|PALMETTO BANCSHARES, INC. AND SUBSIDIARY                                           
|-----------------------------------------------------------------------------------
|Consolidated Statements of Changes in Shareholders' Equity and Comprehensive Income
|(dollars in thousands, except common and per share data)                           
|(unaudited)                                                                        
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|Balance at December 31, 2004                                                       
|                                                                                   
|Net income                                                                         
|Other comprehensive income, net of tax:                                            
|Unrealized holding losses arising during period, net                               
|of tax effect of $433                                                              
|Less:  reclassification adjustment included                                        
|in net income, net of tax effect of $27                                            
|Net unrealized losses on securities                                                
|                                                                                   
|Comprehensive income                                                               
|                                                                                   
|Cash dividend declared and paid ($0.32 per share)                                  
|Exercise of stock options                                                          
|                                                                                   
|Balance at June 30, 2005                                                           
|                                                                                   
|                                                                                   
|Balance at December 31, 2005                                                       
|                                                                                   
|Net income                                                                         
|Other comprehensive income, net of tax:                                            
|Unrealized holding losses arising during period, net                               
|of tax effect of $513                                                              
|Less:  reclassification adjustment included                                        
|in net income, net of tax effect of $1                                             
|Net unrealized losses on securities                                                
|                                                                                   
|Comprehensive income                                                               
|                                                                                   
|Cash dividend declared and paid ($0.36 per share)                                  
|Compensation
		expense related to stock options                                    
|Exercise of stock options                                                          
|                                                                                   
|Balance at June 30, 2006                                                           
|                                                                                   

See Notes to Consolidated
		Interim Financial Statements.

6




|PALMETTO BANCSHARES, INC. AND SUBSIDIARY                              
|----------------------------------------------------------------------
|Consolidated Statements of Cash Flows                                 
|(in thousands)                                                        
|                                                                      
|                                                                      
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|                                                                      
|Cash flows from operating activities                                  
|                                                                      
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|Cash flows from investing activities                                  
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|Cash flows from financing activities                                  
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|                                                                      
|Net increase in cash and cash equivalents                             
|Cash and cash equivalents, beginning of the period                    
|                                                                      
|Cash and cash equivalents, end of the period                          
|                                                                      
|Supplemental Information                                              
|Cash paid during the period for:                                      
|                                                                      
|                                                                      
|                                                                      
|Supplemental schedule of non-cash investing and financing transactions
|                                                                      
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|                                                                      
|See Notes to Consolidated Interim Financial Statements.               

7




PALMETTO BANCSHARES, INC. AND
SUBSIDIARY
Notes To Consolidated Interim Financial Statements
(Unaudited)

Palmetto Bancshares, Inc. is
a regional financial services company headquartered in Laurens, South Carolina
and organized in 1982 under the laws of South Carolina. Through its wholly
owned subsidiary, The Palmetto Bank (the "Bank"), Palmetto
Bancshares, Inc. engages in the general banking business through 31 retail
banking offices in the upstate South Carolina markets of Laurens, Greenville, Spartanburg,
Greenwood, Anderson, Cherokee, Abbeville, Pickens, and Oconee counties (the
"Upstate").  Brokerage operations are conducted through the Bank's wholly owned
subsidiary, Palmetto Capital, Inc. ("Palmetto Capital"). The Bank was
organized and chartered under South Carolina law in 1906.  Throughout this
report, the "Company" shall refer to Palmetto Bancshares, Inc. and
its subsidiary, the Bank, which includes its subsidiary, Palmetto Capital, except where the context requires
otherwise.

1.  SUMMARY OF SIGNIFICANT ACCOUNTING
POLICIES

The significant accounting
policies followed by the Company for interim financial reporting are consistent
with the accounting policies followed for annual financial reporting.  The
unaudited Consolidated Interim Financial Statements and footnotes are presented
in accordance with the instructions for the Quarterly Report on Form
10-Q.  The information contained in the footnotes included in the
Company's latest Annual Report on Form 10-K should be referred to in connection
with the reading of these unaudited Consolidated Interim Financial
Statements.

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

Use of EstimatesThe accounting and reporting
policies of the Company conform to accounting principles generally accepted in
the United States of America and to general practices within the banking
industry. In preparing its Consolidated Financial Statements, the Company's
management makes estimates and assumptions that impact the reported amounts of
assets and liabilities and the disclosure of contingent assets and liabilities
as of the date of the Consolidated Financial Statements for the periods
presented. Actual results could differ from these estimates and assumptions. As
such, the results of operations for the three and six month periods ended June
30, 2006 are not necessarily indicative of the results of operations that may
be expected in future periods.

ReclassificationsCertain amounts previously
presented in the Company's Consolidated Financial Statements for prior periods
have been reclassified to conform to current classifications.  All such
reclassifications had no impact on the prior periods' net income or retained
earnings as previously reported. During the first quarter of 2006, due to the
nature of the account, the Company began classifying its interest bearing
overnight investment account at the Federal Home Loan Bank as federal funds
sold.  Prior to 2006, this account had been classified within the cash and due
from banks financial statement line item.  As such, this change resulted in
reclassifications within the Consolidated Balance Sheets and Consolidated
Statements of Income.

Stock Option PlansIn an effort to provide
investors and other users of financial statements with more complete and
consistent financial information, the Financial Accounting Standards Board
("FASB") published Statement of Financial Accounting Standards ("SFAS") No. 123
(revised 2004), "Share-Based Payment," which requires that the compensation
cost relating to stock-based payment transactions be measured based on the fair
value of the equity or liability instruments issued and recognized in financial
statements. Prior
to its revision, SFAS No. 123, "Accounting for Stock-Based Compensation,"
allowed a company to adopt either the fair value method of valuation or the
intrinsic valuation method presented under APB Opinion No. 25, "Accounting for Stock Issued to Employees,"
("APB No. 25") to
account for stock-based compensation. SFAS No. 123 permitted companies to
recognize as expense over the instrument's vesting period the fair value of all
stock-based awards on the date of grant. In management's opinion, the existing
stock option valuation models did not provide a reliable measure of stock
option fair value. Therefore, as permitted, the Company applied the accounting
rules permitted under APB No. 25 and provided pro forma net income and pro
forma net income per common share disclosures for stock option grants as if the
fair value based method defined in SFAS No. 123 had been applied. The
provisions of APB No. 25 and related interpretations required compensation cost
for options to be recognized only if the market price of the underlying stock
exceeded the exercise price on the date of grant. As such, no stock-based compensation cost has typically been
reflected in net income of the Company, as all stock-based awards granted under
current and past plans have historically had an exercise price equal to the
fair value of the underlying common stock on the date of grant.

8






On January 1, 2006, the Company adopted the
fair value recognition provisions of SFAS No. 123(R) to account
for compensation costs under its current stock option plan.  In conjunction
with the adoption of SFAS No. 123(R), the Company elected to use the modified
prospective method to account for the transition from the intrinsic value
method to the fair value recognition method.  Under the modified prospective
method, compensation cost is recognized from the adoption date forward for all
new stock options granted and for any outstanding unvested awards as if the
fair value method had been applied to those awards as of the date of grant. The
following table summarizes the impact on net income and net income per share as
if the fair value method had been applied to all outstanding and unvested
awards for the
periods indicated (in thousand, except common
share data).

For the three month period
  
	ended June 30,
  
  For the six month period
	
	ended
  June 30,2006
  
  2005
  
  2006
  
  2005Net
  income, as reported
  $
  3,731
  
  3,547
  
  7,381
  
  6,958Add: stock-based compensation expense included in reportednet
  income, net of related tax effects
  
  31
  
  -
  
  55
  
  -Deduct: stock-based compensation expense determined under fair marketvalue
  based method for all awards, net of related tax effects
  
  (31)
  
  (24)
  
  (55)
  
  (48)Pro forma net income including stock-based compensation expensebased
  on fair market value method
  $
  3,731
  
  3,523
  
  7,381
  
  6,910Common
  Share Data:Net
  income - basic, as reported
  $
  0.59
  
  0.56
  
  1.16
  
  1.10Net
  income - basic, pro forma
  
  0.59
  
  0.56
  
  1.16
  
  1.09Net
  income - diluted, as reported
  $
  0.58
  
  0.55
  
  1.15
  
  1.08Net
  income - diluted, pro forma
  
  0.58
  
  0.55
  
  1.15
  
  1.08


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

For awards granted during the
  
	three month period ended June 30,
  
  For awards granted during the
  
	six month period ended June 30,2006
  
  2005
  
  2006
  
  2005Awards
  granted
  5,000
  
  -
  
  15,000
  
  33,000Dividend
  yields
  2.7
  %
  -
  
  2.7
  
  2.6Expected volatility
  5
  
  -
  
  5
  
  10Risk-free
  interest rate
  4
  
  -
  
  4
  
  4Expected term (years)
  10
  
  -
  
  10
  
  10Vesting period (years)
  5
  
  -
  
  5
  
  5


See
Note 12 contained herein for further discussion regarding the Company's stock
option plan.

9




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

|                    |                                                     |                   |                       |  | June 30, 2006                      |   |                                   |  
|------------------- | --------------------------------------------------- | ----------------- | --------------------- |  | ---------------------------------- | - | --------------------------------- | -
|                    |                                                     |                   | Outstanding 
	balance |  | As a percentage
 of total equity   |   | As a percentage
	
	of total loans |  
|Loans
  secured by: |                                                     |                   |                       |  |                                    |   |                                  
|                    | Commercial
  and industrial nonmortgage instruments | $                 | 121,404               |  | 130                                | % | 14                                | %
|                    | Residential
  mortgage instruments                  |                   | 169,875               |  | 181                                |   | 19                                |  
|                    | Nonresidential
  mortgage instruments               |                   | 497,527               |  | 531                                |   | 56                                |  
|                    |                                                     |                   |                       |  |                                    |   |                                   |  
|                    |                                                     | December 31, 2005
|                    |                                                     |                   | Outstanding 
	balance |  | As a percentage
	
	of total equity |   | As a percentage
	
	of total loans |  
|Loans
  secured by: |                                                     |                   |                       |  |                                    |   |                                  
|                    | Commercial
  and industrial nonmortgage instruments | $                 | 143,334               |  | 161                                | % | 17                                | %
|                    | Residential
  mortgage instruments                  |                   | 167,693               |  | 189                                |   | 19                                |  
|                    | Nonresidential
  mortgage instruments               |                   | 458,154               |  | 515                                |   | 53                                |  
|                    |                                                     |                   |                       |  |                                    |   |                                   |  
|                    |                                                     |                   |                       |  |                                    |   |                                   |  
|                    |                                                     |                   |                       |  |                                    |   |                                   |  

In addition to
monitoring potential concentrations of loans to particular borrowers or groups
of borrowers, industries, geographic regions, and loan types, management
monitors whether or not the Company has exposure to credit risk from other
lending practices such as loans that subject borrowers to substantial payment
increases (e.g. principal deferral periods, loans with initial interest-only
periods, etc.) and loans with high loan-to-value ratios.  Management has
determined that, at June 30, 2006, the Company has no concentrations in such
loans, as the Company does not typically engage in such lending practices.

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

The Company's
investment portfolio consists principally of obligations of the United States, its
agencies, and / or its corporations and general obligation municipal
securities.  In the opinion of management, there is no concentration of credit
risk in its investment portfolio.  The Company places its deposits and
correspondent accounts with, and sells its federal funds to, high quality
institutions.  Management believes credit risk associated with correspondent
accounts is not significant.

Other InformationThe Bank's website,
www.palmettobank.com, includes a link to the Securities and Exchange Commission's
Electronic Data Gathering, Analysis, and Retrieval ("EDGAR") system which makes
various reports filed with the Securities and Exchange Commission by the
Company, including, but not limited to, its Annual Report on Form 10-K,
Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, Ownership Reports
filed in conjunction with Section 16, and amendments to such reports,
available, free of charge.  These reports are made available as soon as
reasonably practicable after these reports are filed with, or furnished to, the
Securities and Exchange Commission.  The Securities and Exchange Commission's
EDGAR database may also be accessed through its website, www.sec.gov.

Recently Issued Accounting
PronouncementsManagement is aware of no
recent authoritative pronouncements that could impact the accounting,
reporting, and / or disclosure of financial information by the Company though
there may have been accounting standards that have been issued or proposed by
the FASB or other standards-setting bodies that are not expected to have a
material impact on the Company's financial position, results of operations and
cash flows.



10




2.   CASH AND
CASH EQUIVALENTS

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

June 30,
  December 31,2006
  2005Cash
  working funds
  $
  6,933
  8,377Noninterest-earning
  demand deposits in other banks
  
  21,779
  18,911In-transit
  funds
  
  14,558
  9,690Federal
  funds sold
  
  23,380
  998Total
  cash and cash equivalents
  $
  66,650
  37,976


Liability management continues to be a critical key to enhancing the Company's profitability. Understanding the balance in costs between asset-based and liability-based liquidity and knowing which funding alternatives are most effective are factors the Company considers with regard to its liquidity and funds management.  The increase in cash and cash equivalents during the first six months of 2006 is a result of the growth in interest-bearing deposits outpacing the growth in the Company's loan and investment securities portfolios during the same period.   Excess balances of cash and cash equivalents will be employed by the Company to fund future interest-earning asset growth as adequate liquidity allows the Company to meet asset and liability obligations without delay.

The average outstanding
federal funds sold for the six month periods ended June 30, 2006 and 2005 was
$24.4 million and $4.5 million, respectively.  The maximum amount of federal
funds sold at any month-end during the six month periods ended June 30, 2006
and 2005 was $28.6 million and $7.3 million, respectively.

The average outstanding
federal funds sold for the year ended December 31, 2005 was $4.1 million,
respectively.  The maximum amount of federal funds sold at any month-end during
the same period was $13.3 million.

The
Company is required to maintain average reserve balances computed by applying
prescribed percentages to its various types of deposits.  At June 30, 2006 and
December 31, 2005, the Federal Reserve required that the Company maintain $6.9
million and $8.5 million in reserve balances, respectively.  These required
reserves were met through vault cash and deposits at the Federal Reserve and
correspondent banks.

3.   INVESTMENT SECURITIES AVAILABLE
FOR SALE

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

11

---



June 30, 2006Amortized 
	cost
  
  Gross 
	unrealized 
	gains
  
  Gross 
	unrealized 
	losses
  
  Fair market 
	valueInvestment
  securities available for saleU.S.
  Government agencies
  $
  42,433
  
  -
  
  (516)
  
  41,917State
  and municipal
  
  56,765
  
  31
  
  (1,620)
  
  55,176Mortgage-backed
  
  19,045
  
  -
  
  (698)
  
  18,347Total
  investment securities
	available for sale
  $
  118,243
  
  31
  
  (2,834)
  
  115,440December 31, 2005Amortized 
	cost
  
  Gross 
	unrealized 
	gains
  
  Gross 
	unrealized 
	losses
  
  Fair market 
	valueInvestment
  securities available for saleU.S.
  Government agencies
  $
  50,257
  
  -
  
  (297)
  
  49,960State
  and municipal
  
  56,766
  
  185
  
  (945)
  
  56,006Mortgage-backed
  
  20,438
  
  1
  
  (417)
  
  20,022Total
  investment securities
	available for sale
  $
  127,461
  
  186
  
  (1,659)
  
  125,988


See
Consolidated Statements of Cash Flows for a further discussion of the activity
impacting the Company's investment securities available for sale portfolio during the six month period ended June 30, 2006.

During the quarter ended June
30, 2006, the Company had realized gains totaling $1 thousand and no realized
losses on sales of investment securities available for sale compared with
realized gains of $264 thousand and realized losses amounting to $249 thousand
during the same quarter of 2005.  During the six month period ended June 30,
2006, the Company had realized gains of $25 thousand and realized losses
amounting to $22 thousand on sales of investment securities available for sale
compared with realized gains of $382 thousand and realized losses amounting to
$313 thousand during the same period of 2005.  Specific identification is the basis on which
cost is determined in computing realized gains and losses.

The following table
summarizes the gross unrealized losses, fair market value, and the number of
securities in each category of investment securities available for sale,
aggregated by investment category and length of time that individual securities
have been in a continuous unrealized loss position, at June 30, 2006 (dollars
in thousands).

Less than 12 months
  
  12 months or longer
  
  Total#
  
  Fair market value
  
  Gross unrealized losses
  
  #
  
  Fair market value
  
  Gross unrealized losses
  
  #
  
  Fair market value
  
  Gross unrealized lossesU.S.
  Government agencies
  7
  $
  31,738
  $
  (292)
  
  6
  
  10,179
  
  (224)
  
  13
  
  41,917
  
  (516)State
  and municipal
  58
  
  23,489
  
  (552)
  
  74
  
  25,687
  
  (1,068)
  
  132
  
  49,176
  
  (1,620)Mortgage-backed
  8
  
  3,350
  
  (144)
  
  24
  
  14,810
  
  (554)
  
  32
  
  18,160
  
  (698)Total
  investment securities 
	available for sale
  73
  $
  58,577
  $
  (988)
  
  104
  
  50,676
  
  (1,846)
  
  177
  
  109,253
  
  (2,834)


Management believes that
these unrealized losses are due to interest rate changes, rather than credit
quality, on investments that the Company classifies to indicate that sale is a
possibility but also for which the Company has the ability to hold until
maturity.  Having investments that can be liquidated to meet loan demand or for
deposit withdrawals is intrinsic to the Company's business of banking. To meet
customer needs, the Company must have the ability to liquidate these funds
easily and quickly, yet if unneeded, the investments typically are held until
maturity. If liquidity is needed, the Company does not automatically chose an
impaired or the most impaired security to sell to provide needed liquidity, but
rather considers many constraints including, but not limited to, asset -
liability management. Since the Company has the ability and intent to hold
these investments until a market price recovery or maturity, management does
not consider these investments to be other-than-temporarily impaired.

12

---



Investment securities
available for sale with an aggregate carrying value totaling $108.9 million and
$104.9 million at June 30, 2006 and December 31, 2005, respectively, were
pledged to secure public deposits, securities sold under agreements to
repurchase, and for other purposes as required or permitted by law.

4.   LOANS

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

June 30, 2006
  
  December 31, 2005Total
  
  % of Total
  
  Total
  
  % of TotalCommercial
  business
  $
  95,656
  
  10.8
  %
  90,345
  
  10.5Commercial
  real estate
  
  566,267
  
  64.1
  
  561,574
  
  65.1Installment
  
  20,146
  
  2.3
  
  18,677
  
  2.2Installment
  real estate
  
  59,815
  
  6.7
  
  55,682
  
  6.5Indirect
  
  35,686
  
  4.0
  
  30,481
  
  3.5Credit
  line
  
  1,946
  
  0.2
  
  2,022
  
  0.2Prime
  access
  
  54,808
  
  6.2
  
  54,296
  
  6.3Residential
  mortgage
  
  37,029
  
  4.2
  
  34,453
  
  4.0Bankcards
  
  11,219
  
  1.3
  
  11,744
  
  1.4Business
  manager
  
  613
  
  0.1
  
  230
  
  -Other
  
  1,783
  
  0.2
  
  2,059
  
  0.2Loans
  in process
  
  3,423
  
  0.4
  
  3,857
  
  0.4Deferred
  loans fees and costs
  
  726
  
  0.1
  
  761
  
  0.1Loans
  
  889,117
  
  100.6
  
  866,181
  
  100.4Mortgage
  loans held for sale
  
  3,247
  
  0.4
  
  4,821
  
  0.6Total
  loans, gross
  
  892,364
  
  101.0
  
  871,002
  
  101.0Allowance
  for loan losses
  
  (8,879)
  
  (1.0)
  
  (8,431)
  
  (1.0)Total
  loans, net
  $
  883,485
  
  100.0
  %
  862,571
  
  100.0


Loans
included in the preceding table are net of participations sold and mortgage
loans sold and serviced for others.  Mortgage loans serviced for the benefit of
others amounted to $312.8 million and $304.2 million at June 30, 2006 and
December 31, 2005, respectively. The majority of these mortgage loans sold and serviced for others are serviced for the Federal
Home Loan Mortgage Corporation. See Note
6 contained herein for further discussion regarding mortgage loans serviced by the
Company for others. Net gains on the sale
of mortgage loans, included in Mortgage-Banking Income in the Company's
Consolidated Statements of Income, totaled $132 thousand and $413 thousand for
the quarters ending June 30, 2006 and 2005, respectively, and $290 thousand and
$616 thousand for the six month periods ending June 30, 2006 and 2005,
respectively.

During the first six months of 2006, the Company's
indirect lending portfolio increased by $5.2 million, or 17.1%.  Management attributes this indirect loan growth to a
program offered by the Company that targets high credit scoring consumers
at competitive rates. The goal of this program is to introduce the Company and
its products to reputable automobile dealers.  Once introduced, the Company's
goal is to continue to build and maintain relationships with these dealers and
their customers.

See
Note 1 contained herein for discussion regarding the Company's concentration of
credit risk.

13

---





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

June 30,
  
  December 31,2006
  
  2005Nonaccrual
  loans
  $
  6,551
  
  9,913Loans
  past due 90 days and still accruing (1)
  
  122
  
  207$
  6,673
  
  10,120(1)
  Substantially all of these loans are bankcard loans


At December 31, 2005, two
loans, both of which were secured by other real estate, were placed in
nonaccrual status.  In accordance with the Bank's lending policy, the loans
were downgraded to substandard. At December 31, 2005, the principal balance of
these loans totaled $7.2 million, and management believed the collateral
securing these loans was sufficient to cover the Bank's exposure.  Payment was
received during the first quarter of 2006 on one of these loans (balance of
approximately $3.3 million) that warranted the removal of nonaccrual status at
that time. Additionally, current payments have been received since the loan was
brought current and removed from nonaccrual status.  After taking into
consideration the removal of this loan from nonaccrual status during the first
six months of 2006, the balance of nonaccrual loans has remained relatively
unchanged since December 31, 2005.  Management believes the collateral securing
the remaining isolated loan circumstance as discussed in the Company's Annual
Report on Form 10-K for the year ended December 31, 2005 continued to be
sufficient to cover the Bank's exposure at June 30, 2006.

As noted above, at December
31, 2005 two loans totaling $7.2 million, both of which were
secured by other real estate, were placed in nonaccrual status.  At June 30,
2006, one of these loans had been removed from nonaccrual status and one loan
remained in nonaccrual status.  As noted above, management believes that the
collateral securing the loan remaining in nonaccrual status is sufficient to
cover the Bank's exposure.  The following table summarizes nonaccrual loan trends over the twelve month period ended June 30, 2006 after
adjusting the nonaccrual loan balance for the special circumstance loan
remaining in nonaccrual status at June 30, 2006 (in thousands).

June 30,
  
  June 30,2006
  
  2005Nonaccrual
  loans
  $
  6,551
  
  2,343Less:
  remaining loan discussed above
  
  (3,903)
  
  -Adjusted
  nonaccrual loans
  $
  2,648
  
  2,343Ending
  loans (1)
  $
  889,117
  
  826,802Nonaccrual
  loans as a percentage of loans (1)
  
  0.30
  %
  0.28Nonperforming
  loans as a percentage oftotal
  assets
  
  0.24
  %
  0.22Allowance
  for loan losses to nonaccrualloans
  
  3.35
  x
  3.44(1)  Calculated
  using loans excluding mortgage loans held for sale, net of unearned,
  excluding the Allowance


Nonaccrual loan trends remained relatively
unchanged over the six and twelve month periods ended June 30, 2006 after
adjusting for the special circumstance loans discussed herein.

14

---



The table set forth below summarizes the activity impacting the
allowance for loan losses (the "Allowance") for the periods indicated (in
thousands).

For the three month period
  
  For the six month periodended June 30,
  
  ended June 30,2006
  
  2005
  
  2006
  
  2005Allowance,
  beginning of period
  $
  8,727
  
  7,838
  
  8,431
  
  7,619Provision
  for loan losses
  
  525
  
  600
  
  1,050
  
  1,200Loans
  charged-off
  
  (433)
  
  (455)
  
  (712)
  
  (858)Loan
  recoveries
  
  60
  
  68
  
  110
  
  90Net
  loans charged-off
  
  (373)
  
  (387)
  
  (602)
  
  (768)Allowance,
  end of period
  $
  8,879
  
  8,051
  $
  8,879
  
  8,051


As
of June 30, 2006, management was aware of no potential problem loans that were
not already categorized as nonaccrual, past due, or restructured, that had
borrower credit problems causing management to have serious doubt as to the
ability of the borrower to comply with the present loan repayment terms.

Any
troubled debt restructurings entered into by the Company for the three and six
month periods ended June 30, 2006 and 2005 were immaterial when considered
individually, or in the aggregate, with regard to the Company's Consolidated
Financial Statements.

The
Bank makes contractual commitments to extend credit that are legally binding
agreements to lend money to customers at predetermined interest rates for a
specific period of time.  The Bank also provides standby letters of credit. See
Note 14 contained herein for further discussion regarding the Company's
commitments.

5.   PREMISES AND EQUIPMENT, NET

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

June 30,
  December 31,2006
  2005Land
  $
  6,297
  5,856Buildings
  
  16,137
  15,552Leasehold
  improvements
  
  2,821
  2,775Furniture
  and equipment
  
  17,216
  16,578Software
  
  3,102
  2,858Bank
  automobiles
  
  870
  816Premises
  and equipment, gross
  
  46,443
  44,435Accumulated
  depreciation and amortization
  
  (22,710)
  (21,759)Premises
  and equipment, net
  $
  23,733
  22,676


15

---



The following table
summarizes the depreciation of premises and equipment for the years indicated
(in thousands). Depreciation on buildings and leasehold improvements is
included in Net Occupancy Expense on the Company's Consolidated Statements on
Income. Depreciation on furniture and equipment, software, and bank automobiles
is included in Furniture And Equipment Expense on the Company's Consolidated
Statements on Income.

For the three month period
  
  For the six month periodended June 30,
  
  ended June 30,2006
  
  2005
  
  2006
  
  2005Buildings
  $
  117
  
  105
  
  233
  
  210Leasehold
  improvements
  
  46
  
  68
  
  82
  
  84Furniture
  and equipment
  
  248
  
  241
  
  496
  
  483Software
  
  68
  
  66
  
  135
  
  132Bank
  automobiles
  
  39
  
  38
  
  76
  
  75Total
  depreciation
  $
  518
  
  518
  
  1,022
  
  984


Contributing
to the increase in building depreciation expense for both the three and six
month periods ended June 30, 2006 over the same periods of 2005 was the
completion of the building of the Easley banking office during the third quarter
of 2005 as well as the commencing of construction of the Boiling Springs
banking office during early 2006.

The Bank entered into
additional leases in 2005, and therefore additional leasehold improvements and
related depreciation, in conjunction with the move of the Bank's banking office
on East Blackstock Road in Spartanburg, South Carolina to W.O. Ezell Boulevard
in Spartanburg, South Carolina and with regard to the banking office used
temporarily during the construction of the new Easley banking office opened in
2005.  The lease relating to the temporary Easley banking office expired in
December 2005 but nonetheless resulted in increased leasehold improvement
expense during 2005.  During 2006, the Bank entered into a one year lease with
regard to the banking office used temporarily during the construction of the
new Boiling Springs banking office to be opened in 2006.  Based on these
circumstances, leasehold improvement deprecation would likely increase. 
However, when comparing both the three and six month periods ended June 30,
2006 with those periods of 2005, such depreciation actually declined.  In
conjunction with the issuance of EITF 05-06 during June 2005, the Company
reevaluated its leasehold improvements to ensure useful lives were limited to
lease terms including renewals that are deemed to be reasonably assured.  As
such additional one-time amounts were taken in 2005 resulting in higher than
historical leasehold improvement depreciation balances.

6.   MORTGAGE-SERVICING RIGHTS

The
Company sells a portion of its originated fixed-rate and adjustable-rate
mortgage loans servicing retained. All of the Company's loan sales have been
without provision for recourse. Mortgage loans serviced for the benefit of
others amounted to $312.8 million and $304.2 million at June 30, 2006 and
December 31, 2005, respectively. The majority of these mortgage loans sold and serviced for others are serviced for the Federal
Home Loan Mortgage Corporation.

The following table summarizes
the changes in the the Company's mortgage-servicing right portfolio for the
periods indicated (in thousands).

For the three month
  
  For the six monthperiod ended June 30,
  
  period ended June 30,2006
  
  2005
  
  2006
  
  2005Mortgage-servicing
  right portfolio, net ofvaluation
  allowance, beginning of period
  $
  2,628
  
  2,371
  
  2,626
  
  2,316Capitalized
  mortgage-servicing rights
  
  149
  
  352
  
  238
  
  527Mortgage-servicing
  right portfolio amortization
  
  (123)
  
  (259)
  
  (290)
  
  (397)Change
  in mortgage-servicing right valuation allowance
  
  19
  
  84
  
  99
  
  102Mortgage-servicing
  right portfolio, net ofvaluation
  allowance, end of period
  $
  2,673
  
  2,548
  
  2,673
  
  2,548


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

The aggregate fair market value of mortgage-servicing rights at June 30,
2006, December 31, 2005, and June 30, 2005 was $2.7 million, $2.6 million, and
$2.5 million, respectively.

16

---



The decline in
mortgage-servicing rights capitalized is primarily due to the lower level of
mortgage loan sales during the three and six month periods ended June 30, 2006
when compared with the same periods of 2005. This decline in mortgage loan
sales was the result of a decline in mortgage loan originations. The decline in
amortization of capitalized mortgage-servicing rights during the three and six
month periods ended June 30, 2006 when compared with the same periods of 2005
was due primarily to a slowing level of mortgage loan prepayment activity. 
Additionally, over the last several years the Company was required to record
reserves for impairment as declining interest rates caused the estimated fair
value of its mortgage-servicing right portfolio to fall below recorded values.
Recent increases in market interest rates for mortgage loans resulted in
increases in the estimated fair value of the Company's mortgage-servicing right
portfolio, allowing the Company to recover a portion of previously recorded
impairment reserves through the mortgage-servicing right valuation allowance.

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

For the three month
  
  For the six monthperiod ended June 30,
  
  period ended June 30,2006
  
  2005
  
  2006
  
  2005Valuation
  allowance, beginning of period
  $
  34
  
  114
  
  114
  
  132Aggregate
  additions charged and reductions credited to operations
  
  (19)
  
  (84)
  
  (99)
  
  (102)Valuation
  allowance, end of period
  $
  15
  
  30
  
  15
  
  30


As
reported in the Company's Annual Report on Form 10-K for the year ended December
31, 2005, the Company estimates amortization expense related to its
mortgage-servicing right portfolio of $628 thousand for the year ended December
31, 2006, $513 thousand for the year ended December 31, 2007, $417 thousand for
the year ended December 31, 2008, $337 thousand for the year ended December 31,
2009, $270 thousand for the year ended December 31, 2010, and $461 thousand
thereafter.  Management is aware of no material events or uncertainties that
would cause reported projected amortization related to its mortgage-servicing
right portfolio not to be indicative of future financial condition or results
of operations or that would cause future financial condition or results of
operations to differ material from these projections. However, amortization
expense is calculated based on current available information regarding loan
payments and prepayments and could change in future periods based on changes in
volume of prepayments and other economic factors.

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

7.   INTANGIBLE ASSETS

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

|                            |                           |       | June 30, |       | December 31, |       | June 30,
|--------------------------- | ------------------------- | ----- | -------- | ----- | ------------ | ----- | --------
|                            |                           |       | 2006     |       | 2005         |       | 2005    
|Goodwill                    | $                         | 3,691 |          | 3,691 |              | 3,691
|Customer
  list intangibles |                           | 151   |          | 175   |              | 247  
|                            | Total
  intangible assets | $     | 3,842    |       | 3,866        |       | 3,938   
|                            |                           |       |          |       |              |       |         

17

---

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

For the three month
  
  For the six monthperiod ended June 30,
  
  period ended June 30,2006
  
  2005
  
  2006
  
  2005Balance,
  at beginning of period
  $
  163
  
  283
  
  175
  
  320Less: amortization
  
  (12)
  
  (36)
  
  (24)
  
  (73)Balance,
  at end of period
  $
  151
  
  247
  
  151
  
  247


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

|                                   |   | June 30, |  | December 31, |  | June 30,
|---------------------------------- | - | -------- |  | ------------ |  | --------
|                                   |   | 2006     |  | 2005         |  | 2005    
|Customer
  list intangibles, gross | $ | 1,779    |  | 1,779        |  | 1,779   
|Less: accumulated amortization     |   | (1,628)  |  | (1,604)      |  | (1,532) 
|Customer
  list intangibles, net   | $ | 151      |  | 175          |  | 247     
|                                   |   |          |  |              |  |         

As
reported in the Company's Annual Report on Form 10-K for the year ended
December 31, 2005, the Company estimates amortization expense related to intangible assets with finite lives of $48 thousand for
the years ended December 31, 2006 and 2007, $45 thousand for the year ended
December 31, 2008, and $34 thousand for the year ended December 31, 2009. 
Management is aware of no material events or uncertainties that would cause
amortization expense related to the Company's intangible
assets with finite lives not to be indicative of future financial condition or
results of operations or that would cause future financial condition or results
of operations to differ materially from these projections.

The Company's intangible assets with infinite lives (goodwill) are
subject to periodic impairment tests that are performed by the Company as of
June 30 annually, or more often, if events or circumstances indicate that there
may be impairment. No changes were made to the carrying amount of goodwill
during the three or six month periods ended June 30, 2006 as a result of such
impairment tests. Additionally, management is aware of no material events or
uncertainties that have occurred since June 30, 2006 that would indicate that
there might be impairment.

8.   REAL ESTATE AND PERSONAL PROPERTY
ACQUIRED IN SETTLEMENT OF LOANS

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

|                                                          |   | June 30, |  | December 31, |  | June 30,
|--------------------------------------------------------- | - | -------- |  | ------------ |  | --------
|                                                          |   | 2006     |  | 2005         |  | 2005    
|Real
  estate acquired in settlement of loans             | $ | 728      |  | 1,954        |  | 2,323   
|Repossessed
  automobiles acquired in settlement of loans |   | 303      |  | 167          |  | 180     
|Total property acquired in settlement of loans            | $ | 1,031    |  | 2,121        |  | 2,503   
|                                                          |   |          |  |              |  |         

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

|                                                                   |                                                        |                       | At and for the three month |       | At and for the six month
|------------------------------------------------------------------ | ------------------------------------------------------ | --------------------- | -------------------------- | ----- | ------------------------
|                                                                   |                                                        |                       | period ended June 30,      |       | period ended June 30,   
|                                                                   |                                                        |                       |                            | 2006  |                         
|Real
  estate acquired in settlement of loans, beginning of period | $                                                      | 932                   |                            | 2,346 |                         
|                                                                   | Add:
  New real estate acquired in settlement of loans |                       | 31                         |       | 362                     
|                                                                   | Less:
  Sales / recoveries of real estate acquired in  |                       |                            |       |                         
|                                                                   |                                                        | settlement
  of loans |                            | (190) |                         
|                                                                   | Less:
  Provision charged to expense                   |                       | (45)                       |       | (149)                   
|Real
  estate acquired in settlement of loans, end of period       | $                                                      | 728                   |                            | 2,323 |                         
|                                                                   |                                                        |                       |                            |       |                         

18

---

9.   DEPOSITS

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

|                                |                                      | June 30, 2006 |         | December 31, 2005
|------------------------------- | ------------------------------------ | ------------- | ------- | -----------------
|                                |                                      |               | Total   |                  
|Transaction
  deposit accounts  | $                                    | 401,562       |         | 41.6             
|Money
  market deposit accounts |                                      | 124,080       |         | 12.8             
|Savings
  deposit accounts      |                                      | 46,222        |         | 4.8              
|Time
  deposit accounts         |                                      | 394,413       |         | 40.8             
|                                | Total
  traditional deposit accounts | $             | 966,277 |                  
|                                |                                      |               |         |                  

10.   FEDERAL HOME LOAN BANK BORROWINGS

At June 30, 2006, of its approximately $185 million available
credit based on qualifying loans to serve as collateral against short-term or long-term
borrowings from the FHLB, the Company employed $10.0 million in borrowings, all
of which was determined to be long-term when employed, and employed $19.0
million in a letter of credit used to secure public deposits as required or
permitted by law.

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

|                                                               | June 30, 2006     |          
|-------------------------------------------------------------- | ----------------- | ---------
|                                                               |                   | Long-term
|Borrowing
  balance outstanding                                | $                 | 10,000   
|Interest
  rate                                                |                   | 3.85%    
|Maturity
  date                                                |                   | 6/14/2007
|                                                               |                   |          
|                                                               | December 31, 2005 |          
|                                                               |                   | Long-term
|Borrowing
  balance outstanding                                | $                 | 13,000   
|Interest
  rate                                                |                   | 3.27%    
|Maturity
  date                                                |                   | 6/14/2006
|                                                               |                   |          
|(1)
  Represents weighted average rate at the dates indicated. |                   |          
|                                                               |                   |          

The
following table summarizes the Company's FHLB borrowing informationat
and for the dates indicated (dollars in thousands).

|                             |                                                | At and for the six month |        | At and for the year ended
|---------------------------- | ---------------------------------------------- | ------------------------ | ------ | -------------------------
|                             |                                                | periods ended June 30,   |        | December 31,             
|                             |                                                |                          | 2006   |                          
|Short-term
  FHLB borrowings |                                                |                          |        |                          
|                             | Amount
  outstanding at period-end             | $                        | -      |                          
|                             | Average
  amount outstanding during period     |                          | 4,316  |                          
|                             | Maximum
  amount outstanding at any month-end  |                          | 10,900 |                          
|                             | Rate
  paid at period-end                      |                          | -      | %                        
|                             | Weighted
  average rate paid during the period |                          | 4.67   |                          
|                             |                                                |                          |        |                          
|Long-term
  FHLB borrowings  |                                                |                          |        |                          
|                             | Amount
  outstanding at period-end             | $                        | 10,000 |                          
|                             | Average
  amount outstanding during period     |                          | 21,779 |                          
|                             | Maximum
  amount outstanding at any month-end  |                          | 23,000 |                          
|                             | Rate
  paid at period-end                      |                          | 3.85   | %                        
|                             | Weighted
  average rate paid during the period |                          | 3.54   |                          
|                             |                                                |                          |        |                          
|                             |                                                |                          |        |                          

19

---



FHLB
advances with fixed interest rates are subject to a prepayment fee in the event
of full or partial repayment prior to maturity or the expiration of any interim
interest rate period.  Management was not aware of any circumstances at June
30, 2006 that would require prepayment of any of the Company's FHLB advances.

11.  OTHER BORROWINGS

The following table
summarizes short-term borrowing informationat and for the periods
indicated (dollars in thousands).

|                               |                                                                                                                                       | At and for the six month |        | At and for the year ended
|------------------------------ | ------------------------------------------------------------------------------------------------------------------------------------- | ------------------------ | ------ | -------------------------
|                               |                                                                                                                                       | periods ended June 30,   |        | December 31,             
|                               |                                                                                                                                       |                          | 2006   |                          
|Retail
  repurchase agreements |                                                                                                                                       |                          |        |                          
|                               | Amount
  outstanding at period-end                                                                                                    | $                        | 17,961 |                          
|                               | Average
  amount outstanding during period                                                                                            |                          | 18,204 |                          
|                               | Maximum
  amount outstanding at any month-end                                                                                         |                          | 23,344 |                          
|                               | Rate
  paid at period-end*                                                                                                            |                          | 3.63   | %                        
|                               | Weighted
  average rate paid during the period                                                                                        |                          | 3.89   |                          
|                               |                                                                                                                                       |                          |        |                          
|Commercial
  paper             |                                                                                                                                       |                          |        |                          
|                               | Amount
  outstanding at period-end                                                                                                    | $                        | 22,104 |                          
|                               | Average
  amount outstanding during period                                                                                            |                          | 18,221 |                          
|                               | Maximum
  amount outstanding at any month-end                                                                                         |                          | 22,104 |                          
|                               | Rate
  paid at period-end*                                                                                                            |                          | 3.81   | %                        
|                               | Weighted
  average rate paid during the period                                                                                        |                          | 3.81   |                          
|                               |                                                                                                                                       |                          |        |                          
|Federal
  funds purchased      |                                                                                                                                       |                          |        |                          
|                               | Amount
  outstanding at period-end                                                                                                    | $                        | -      |                          
|                               | Average
  amount outstanding during period                                                                                            |                          | 541    |                          
|                               | Maximum
  amount outstanding at any month-end                                                                                         |                          | 3,000  |                          
|                               | Rate
  paid at period-end                                                                                                             |                          | -      | %                        
|                               | Weighted
  average rate paid during the period                                                                                        |                          | 5.22   |                          
|                               |                                                                                                                                       |                          |        |                          
|*                              | Rates
  paid are tiered based on level of deposit.  Rate presented represents the
  average rate for all tiers offered at period-end.
|                               |                                                                                                                                       |                          |        |                          

If needed, alternative
funding sources have been arranged through federal funds lines at correspondent
banks and through the Federal Reserve Discount Window.  At June 30, 2006, the
Company had unused short-term lines of credit at correspondent banks totaling
of $40 million (which were accessible at the Company's option).

12.   EMPLOYEE BENEFIT PLANS

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

20

---



|                                     |                                  |       | For the three month period |       | For the six month period
|------------------------------------ | -------------------------------- | ----- | -------------------------- | ----- | ------------------------
|                                     |                                  |       | ended June 30,             |       | ended June 30,          
|                                     |                                  |       |                            | 2006  |                         
|Service
  cost                       | $                                | 141   |                            | 346   |                         
|Interest
  cost                      |                                  | 165   |                            | 392   |                         
|Expected
  return on plan assets     |                                  | (229) |                            | (586) |                         
|Amortization
  of prior service cost |                                  | 3     |                            | 5     |                         
|Amortization
  of loss               |                                  | 20    |                            | 58    |                         
|                                     | Postretirement
  benefit expense | $     | 100                        |       | 215                     
|                                     |                                  |       |                            |       |                         

The Company expects to contribute $1.2 million to the
plan during 2006. During the three month periods ended June 30, 2006 and 2005,
$308 thousand and $300 thousand was contributed, respectively. During the six
month periods ended June 30, 2006 and 2005, $617 thousand and $623 thousand was
contributed, respectively.

Stock Option PlanAs of June 30, 2006, 429,200
options, net of cancellations, had been granted that expire at various dates
through December 31, 2015. Of these, 242,485 remained outstanding at June 30,
2006 at prices ranging from $8.75 to $27.30. These options are not granted in
lieu of otherwise payable cash compensation. All options granted have a vesting
term of five years and an exercise period of ten years. At June 30, 2006, there
were 20,800 remaining options available for grant under this plan.

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

Stock options
  
  Weighted-average
 exercise priceOutstanding
  at December 31, 2004
  257,835
  
  $      
  14.59Granted
  33,000
  
  26.60Forfeited
  / Cancelled
  -
  
  -Exercised
  (20,000)
  
  12.44Outstanding
  at June 30, 2005
  270,835
  
  $      
  16.22Outstanding
  at December 31, 2005
  252,785
  
  $      
  16.63Granted
  15,000
  
  27.30Forfeited
  / Cancelled
  -
  
  -Exercised
  (25,300)
  
  14.00Outstanding
  at June 30, 2006
  242,485
  
  $      
  17.57


401(k) Retirement PlanDuring the three month
periods ended June 30, 2006 and 2005, the Company made matching contributions
to employee 401(k) retirement plans totaling $65 thousand and $76 thousand, respectively.
During the six month periods ended June 30, 2006 and 2005, the Company made
matching contributions to employee 401(k) retirement plans totaling $134
thousand and $142 thousand, respectively.

21

---



13.   NET INCOME PER COMMON SHARE

The
following table summarizes the Company's reconciliation
of the numerators and denominators of the basic and diluted net income per
common share computations for the periods indicated (dollars in thousand,
except common share data).

|                                                       |                                                                   | For the three month period
  ended June 30, |        | For the six month period ended
  June 30,
|------------------------------------------------------ | ----------------------------------------------------------------- | ------------------------------------------- | ------ | -----------------------------------------
|                                                       |                                                                   |                                             | 2006   |                                          
|Weighted
  average common shares outstanding - basic   |                                                                   | 6,354,888                                   |        | 6,314,043                                
|                                                       | Dilutive
  impact resulting from potential common share issuances |                                             | 74,871 |                                          
|Weighted
  average common shares outstanding - diluted |                                                                   | 6,429,759                                   |        | 6,420,995                                
|                                                       |                                                                   |                                             |        |                                          
|Common
  Share Data                                    |                                                                   |                                             |        |                                          
|                                                       | Net
  income - basic                                              | $                                           | 0.59   |                                          
|                                                       | Net
  income - diluted                                            |                                             | 0.58   |                                          
|                                                       |                                                                   |                                             |        |                                          

At June 30, 2006, there were
no option shares excluded from the calculation of diluted net income per common
share because the exercise price was greater than the average market price as
determined by an independent valuation of common shares.

The Company paid cash
dividends of $0.18 and $0.16 per share for the three month periods ended June
30, 2006 and 2005, respectively.  The Company paid cash dividends of $0.36 and
$0.32 per share for the six month periods ended June 30, 2006 and 2005,
respectively.

14.   COMMITMENTS AND CONTINGENCIES

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

Lease AgreementsLease
payments for rental commitments under noncancelable ground and building
operating leases totaled $188 thousand and $160 thousand during the three month
periods ended June 30, 2006 and 2005,
respectively. For the six month periods ended June 30, 2006 and 2005, such
payments totaled $367 thousand and $319 thousand, respectively.  Such payments
are included in Occupancy Expense in the Consolidated Statements of Income.

During the first quarter of 2006, the Bank completed
negotiations with a third party with regard to the sublease of its previous
Blackstock Road banking office location. Also during the first quarter of 2006,
the Bank entered into a one year lease
agreement with regard to the banking office used temporarily during the
construction of the new Boiling Springs banking office to be opened in 2006.

Four
of five ground lease agreements that will house automatic teller machines were
executed during the first quarter of 2006. Three of these ground leases commenced
during the second quarter of 2006.  One of the ground leases will commence
during the third quarter of 2006, and the final ground lease is expected to be
commenced by the end of 2006. All five ground lease agreements have original
five year terms (from commencement date) each with two five year option terms. 
All of these ground leases are located in market areas in which the Company
currently serves.

22

---



Lending CommitmentsThe following table
summarizes the Company's contractual commitments to extend credit at June 30,
2006 (in thousands).

Home
  equity loans
  $
  47,786Credit
  cards
  
  45,231Commercial
  real estate development
  
  52,729Other
  unused lines of credit
  
  55,142Total
  contractual obligations
  $
  200,888


GuaranteesAt June
30, 2006, the Company recorded no liability for the current carrying amount of
the obligation to perform as a guarantor, and no contingent liability was
considered necessary as such amounts were not considered material. The maximum
potential amount of undiscounted future payments related to standby letters of
credit at June 30, 2006 was $6.0 million.  Past experience indicates that these
standby letters of credit will expire unused. However, through its various
sources of liquidity, the Company believes that it has the necessary resources
available to meet these obligations should the need arise.  Additionally, the
Company does not believe that the current fair market value of such guarantees
was material at June 30, 2006.

Other Off-Balance Sheet ArrangementsAt June 30, 2006, the Company
had no interest in nonconsolidated special purpose entities nor was it involved
in other off-balance sheet contractual relationships, unconsolidated related
entities that have off-balance sheet arrangements, or transactions that could
result in liquidity needs (other than those discussed herein).

15.    DERIVATIVE FINANCIAL INSTRUMENTS
AND HEDGING ACTIVITIES

At June 30, 2006, the
Company's derivative instruments consisted of forward sales commitments relating
to the Company's commitments to originate certain residential loans held for
sale.

Outstanding commitments on mortgage loans not yet
closed (primarily single-family loan commitments) amounted to approximately
$2.5 million at June 30, 2006.  The fair market value of derivative assets
related to commitments to originate such residential loans held for sale and
forward sales commitments was not significant at June 30, 2006.

16.   DIVIDEND RESTRICTIONS AND
REGULATORY CAPITAL REQUIREMENTS

At
June 30, 2006, the most recent notification from federal banking agencies
categorized the Company and the Bank as well capitalized under the regulatory
framework. To be categorized as well capitalized, minimum total risk-based
capital, Tier 1 capital, and Tier 1 leverage ratios as set forth in
the following table (dollars in thousands) must be maintained. Since June 30,
2006, there have been no events or conditions that management believes would
changed these categories.



23

---







|                                         |         |  |   |         | Actual |        | For capital adequacy purposes |        | To be well capitalized under
  
	prompt corrective action 
	provisions
|---------------------------------------- | ------- |  | - | ------- | ------ | ------ | ----------------------------- | ------ | ----------------------------------------------------------------------
|                                         |         |  |   |         | amount |        | ratio                         |        | amount                                                                
|At
  June 30, 2006                       |         |  |   |         |        |        |                               |        |                                                                       
|Total
  capital to risk-weighted assets  |         |  |   |         |        |        |                               |        |                                                                       
|                                         | Company |  | $ | 100,119 |        | 10.34% |                               | 77,457 |                                                                       
|                                         | Bank    |  |   | 98,902  |        | 10.21  |                               | 77,457 |                                                                       
|                                         |         |  |   |         |        |        |                               |        |                                                                       
|Tier
  1 capital to risk-weighted assets |         |  |   |         |        |        |                               |        |                                                                       
|                                         | Company |  |   | 91,240  |        | 9.42   |                               | 38,728 |                                                                       
|                                         | Bank    |  |   | 90,023  |        | 9.30   |                               | 38,728 |                                                                       
|                                         |         |  |   |         |        |        |                               |        |                                                                       
|Tier
  1 capital to average assets       |         |  |   |         |        |        |                               |        |                                                                       
|                                         | Company |  |   | 91,240  |        | 8.22   |                               | 44,416 |                                                                       
|                                         | Bank    |  |   | 90,023  |        | 8.10   |                               | 44,429 |                                                                       
|                                         |         |  |   |         |        |        |                               |        |                                                                       
|                                         |         |  |   |         |        |        |                               |        |                                                                       
|At
  June 30, 2005                       |         |  |   |         |        |        |                               |        |                                                                       
|Total
  capital to risk-weighted assets  |         |  |   |         |        |        |                               |        |                                                                       
|                                         | Company |  | $ | 88,901  |        | 10.18% |                               | 69,864 |                                                                       
|                                         | Bank    |  |   | 88,157  |        | 10.09  |                               | 69,864 |                                                                       
|                                         |         |  |   |         |        |        |                               |        |                                                                       
|Tier
  1 capital to risk-weighted assets |         |  |   |         |        |        |                               |        |                                                                       
|                                         | Company |  |   | 80,850  |        | 9.26   |                               | 34,932 |                                                                       
|                                         | Bank    |  |   | 80,106  |        | 9.17   |                               | 34,932 |                                                                       
|                                         |         |  |   |         |        |        |                               |        |                                                                       
|Tier
  1 capital to average assets       |         |  |   |         |        |        |                               |        |                                                                       
|                                         | Company |  |   | 80,850  |        | 7.76   |                               | 41,699 |                                                                       
|                                         | Bank    |  |   | 80,106  |        | 7.68   |                               | 41,711 |                                                                       
|                                         |         |  |   |         |        |        |                               |        |                                                                       
|                                         |         |  |   |         |        |        |                               |        |                                                                       
|                                         |         |  |   |         |        |        |                               |        |                                                                       

24

---



Item 2.  Management's
Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and
analysis is presented to assist the reader with understanding the financial
condition and results of operations of the Company.  The information presented
in the following discussion of financial condition and results of operations of
the Company results from the activities of its subsidiary, the Bank, which
comprises the majority of the consolidated net income, revenues, and assets of
the Company.  This discussion should be read in conjunction with the
Consolidated Financial Statements and related notes and other financial data
appearing in this report as well as in the Company's Annual Report on Form 10-K
for the year ended December 31, 2005.  Results of operations for the three and
six month periods ended June 30, 2006 are not necessarily indicative of results
that may be attained for any other period.

FORWARD-LOOKING STATEMENTS

The
Company makes forward-looking statements in this report and in other reports
and proxy statements filed with the Securities and Exchange Commission
("SEC").  In addition, certain statements in future filings by the Company with
the SEC, in press releases, and in oral and written statements made by or with
the approval of the Company, which are not statements of historical fact,
constitute forward-looking statements. Broadly speaking, forward-looking
statements include, but are not limited to, projections of the Company's
revenues, income, net income per common share, capital expenditures, dividends,
capital structure, or other financial items, descriptions of plans or
objectives of management for future operations, products or services, forecasts
of the Company's future economic performance, and descriptions of assumptions
underlying or relating to any of the foregoing.

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

CRITICAL ACCOUNTING POLICIES

The
Company's significant accounting policies are discussed in Item 8, Note 1 to
the Consolidated Financial Statements of the Annual Report on Form 10-K for the
year ended December 31, 2005.  Of
these significant accounting policies, the Company considers its policies
regarding the accounting for its allowance for loan losses (the "Allowance"),
pension plan, mortgage-servicing right portfolio, past acquisitions, and income
taxes to be its most critical accounting policies due to the valuation
techniques used and the sensitivity of these financial statement amounts to the
methods, assumptions, and estimates underlying these balances.  Accounting for
these critical areas requires a significant degree of judgment that could be
subject to revision as newer information becomes available.







25

---



COMPANY OVERVIEW

Palmetto Bancshares, Inc. is
a regional financial services company headquartered in Laurens, South Carolina
and organized in 1982 under the laws of South Carolina. Through its wholly
owned subsidiary, The Palmetto Bank (the "Bank"), Palmetto
Bancshares, Inc. engages in the general banking business through 31 retail
banking offices in the upstate South Carolina markets of Laurens, Greenville,
Spartanburg, Greenwood, Anderson, Cherokee, Abbeville, Pickens, and Oconee
counties (the "Upstate").  In addition to retail offices, at June 30, 2006, the
Bank had 33 automatic teller machine ("ATM") locations (including four at
nonretail office locations) and five-limited service offices located in
retirement centers in the Upstate. Additionally, as noted in Note 14 contained
within Part I, Item
1 of this Quarterly Report on Form 10-Q, the Bank anticipates the opening of
two additional ATM locations by the end of 2006 as well as the opening of its
Boiling Springs banking office during this timeframe.  The Bank was organized and chartered under South
Carolina law in 1906.  Throughout this report, the "Company" shall
refer to Palmetto Bancshares, Inc. and its subsidiary, the Bank, which includes
its brokerage subsidiary, Palmetto Capital, Inc. ("Palmetto Capital"), except where the context requires
otherwise.

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

FINANCIAL CONDITION

The following information is intended to supplement any
information relating to the Consolidated Balance Sheets contained within Part
I, Item 1 of this Quarterly Report on Form 10-Q.



26

---

Overview

|PALMETTO BANCSHARES, INC. AND
  SUBSIDIARY                       |                                 
|---------------------------------------------------------------- | --------------------------------
|Consolidated Balance Sheets                                      |                                 
|(dollars in thousands, except
  common and per share data)       |                                 
|                                                                 |                                 
|                                                                 |                                 
|                                                                 |                                 
|                                                                 |                                 
|ASSETS                                                           |                                 
|Cash
  and cash equivalents                                      |                                 
|                                                                 | Cash
  and due from banks       
|                                                                 | Federal
  funds sold            
|                                                                 |                                 
|                                                                 |                                 
|Federal
  Home Loan Bank ("FHLB") stock, at cost                 |                                 
|Investment
  securities available for sale, at fair market value |                                 
|Mortgage
  loans held for sale                                   |                                 
|                                                                 |                                 
|Loans                                                            |                                 
|                                                                 | Less
  allowance for loan losses
|                                                                 |                                 
|                                                                 |                                 
|Premises
  and equipment, net                                    |                                 
|Accrued
  interest receivable                                    |                                 
|Goodwill                                                         |                                 
|Other
  intangible assets                                        |                                 
|Other
  assets                                                   |                                 
|                                                                 |                                 
|                                                                 |                                 
|LIABILITIES
  AND SHAREHOLDERS' EQUITY                           |                                 
|Liabilities                                                      |                                 
|Deposits                                                         |                                 
|                                                                 | Noninterest-bearing             
|                                                                 | Interest-bearing                
|                                                                 |                                 
|                                                                 |                                 
|Retail
  repurchase agreements                                   |                                 
|Commercial
  paper (Master notes)                                |                                 
|Federal
  funds purchased                                        |                                 
|FHLB
  borrowings                                                |                                 
|Other
  liabilities                                              |                                 
|                                                                 |                                 
|                                                                 |                                 
|Shareholders'
  Equity                                           |                                 
|Common
  stock                                                   |                                 
|Capital
  surplus                                                |                                 
|Retained
  earnings                                              |                                 
|Accumulated
  other comprehensive loss, net of tax               |                                 
|                                                                 |                                 
|                                                                 |                                 
|                                                                 |                                 
|                                                                 |                                 



27

---



During
the first six months of 2006 growth in deposits, retail repurchase agreements,
and commercial paper totaling $68.3 million coupled with net cash flows from
purchases, sales, maturities, calls, and paydowns within the investment
securities portfolio totaling $9.3 million was used to funds loan growth during
the period of $21.4 million, including mortgage loans held for sale, and
paydown federal funds purchased and FHLB borrowings totaling $30.9 million. 
Excess funds resulting from these activities resulted in an increase in cash
and cash equivalents at June 30, 2006 over December 31, 2005.

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

|                                                     |                                   |        | June 30, | December 31,
|---------------------------------------------------- | --------------------------------- | ------ | -------- | ------------
|                                                     |                                   |        | 2006     | 2005        
|Cash
  working funds                                 | $                                 | 6,933  | 8,377   
|Noninterest-earning
  demand deposits in other banks |                                   | 21,779 | 18,911  
|In-transit
  funds                                   |                                   | 14,558 | 9,690   
|Federal
  funds sold                                 |                                   | 23,380 | 998     
|                                                     | Total
  cash and cash equivalents | $      | 66,650   | 37,976      
|                                                     |                                   |        |          |             

As interest rates continue to rise, liability management continues to be a critical key to enhancing the Company's profitability. Understanding the balance in costs between asset-based and liability-based liquidity and knowing which funding alternatives are most effective are factors the Company considers with regard to its liquidity and funds management.  The increase in cash and cash equivalents during the first six months of 2006 is a result of the growth in interest-bearing deposits outpacing the growth in the Company's loan and investment securities portfolios during the same period.   Excess balances of cash and cash equivalents will be employed by the Company to fund future interest-earning asset growth as adequate liquidity allows the Company to meet asset and liability obligations without delay.

FHLB
StockAs
a member of the FHLB System, the Bank is required to maintain an investment in
the FHLB.  Under the FHLB's capital structure, a member's stock requirement
must total an amount equal to the sum of a membership requirement and an
activity-based requirement as described in the FHLB's Capital Plan. The Bank's
investment at June 30, 2006 was in compliance with this requirement.

Investment
Securities Available For SaleInvestment securities available for sale totaled
$115.4 million at June 30, 2006, a decrease of $10.5 million, or 8.4%, when compared
with December 31, 2005.  Average balances of available for sale investment
securities decreased to $121.1 million during the three months ended June 30,
2006 from $138.1 million during the same period of 2005. Average balances of
available for sale investment securities decreased to $123.5 million during the
first six months of 2006 from $140.0 million during the same period of 2005.
The following table summarizes the composition of the Company's investment
securities available for sale portfolio at the dates indicated (dollars in
thousands).

|                                                                                   |                                                    | June 30, 2006 |         | December 31, 2005
|---------------------------------------------------------------------------------- | -------------------------------------------------- | ------------- | ------- | -----------------
|                                                                                   |                                                    |               | Total   |                  
|U.S.
  Government agencies                                                         | $                                                  | 41,917        |         | 36.3             
|State
  and municipal                                                              |                                                    | 55,176        |         | 47.8             
|Mortgage-backed                                                                    |                                                    | 18,347        |         | 15.9             
|                                                                                   | Total
  investment securities 
	available for sale | $             | 115,440 |                  
|                                                                                   |                                                    |               |         |                  
|Total
  investment securities available 
	for sale as a percentage of total assets |                                                    | 10.3          | %       |                  
|                                                                                   |                                                    |               |         |                  

Investment securities
available for sale as a percentage of total assets declined from December 31,
2005 to June 30, 2006 as a result of mortgage-backed security prepayment and
paydown funds as well as short-term taxable agencies not being reinvested but
instead being used to repay $13.0 million in long-term FHLB borrowings in June
2006.

See Consolidated Statements
of Cash Flows contained within Part I, Item 1 of this Quarterly Report on Form 10-Q for a further discussion of the activity impacting the
Company's investment securities available for sale portfolio during the three
and six month periods ended June 30, 2006.

28

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The following table
summarizes the
amortized costs and fair market values with regard to the Company's investment
securities portfolio at the dates indicated (dollars in thousands).

|                           |                                                  | June 30, 2006 |                | December 31, 2005
|-------------------------- | ------------------------------------------------ | ------------- | -------------- | -----------------
|                           |                                                  |               | Amortized cost |                  
|U.S.
  Government agencies | $                                                | 42,433        |                | 41,917           
|State
  and municipal      |                                                  | 56,765        |                | 55,176           
|Mortgage-backed            |                                                  | 19,045        |                | 18,347           
|                           | Total
  investment securities available for sale | $             | 118,243        |                  
|                           |                                                  |               |                |                  

See Note 3 contained within Part I, Item 1 of this Quarterly
Report on Form 10-Q for further
discussion regarding the Company's investment securities portfolio.

Loans
General. Loans represent the
most significant component of the Company's interest-earning assets.  The
Company strives to maintain a diversified loan portfolio in an effort to spread
risk and reduce exposure to economic downturns that may occur within different
segments of the economy, geographic locations, or in particular industries. 
Although the Company may originate loans outside of its market area, the
Company originates the majority of its loans in its primary market area of
Upstate, South Carolina.

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

|                             |               | June 30, 2006 |         | December 31, 2005
|---------------------------- | ------------- | ------------- | ------- | -----------------
|                             |               |               | Total   |                  
|Commercial
  and industrial  | $             | 121,404       |         | 13.6             
|Real
  estate - 1 - 4 family |               | 169,875       |         | 19.0             
|Real
  estate - construction |               | 25,165        |         | 2.8              
|Real
  estate - other        |               | 497,527       |         | 55.8             
|General
  consumer           |               | 61,409        |         | 6.9              
|Credit
  line                |               | 4,673         |         | 0.5              
|Bankcards                    |               | 11,219        |         | 1.3              
|Others                       |               | 1,092         |         | 0.1              
|                             | Total
  loans | $             | 892,364 |                  
|                             |               |               |         |                  

Since
December 31, 2005 the Company has continued to emphasize growth in loans
secured by real estate as such loans typically include less risk than loans
secured by collateral other than real estate or unsecured loans.  As such, the
loan portfolio secured by real estate has grown from comprising 75.3% of the
Company's loan portfolio at December 31, 2005 to 77.6% at June 30, 2006.  The
majority of this growth was offset by a decline in loans, as a percentage of
the loan portfolio, secured by commercial and industrial security other than
real estate.

29

---



The
following table summarizes the Company's loan portfolio, by loan purpose, net
of the allowance for loan losses, at the dates indicated (dollars in
thousands).

|                                |                      | June 30, 2006 |         | December 31, 2005
|------------------------------- | -------------------- | ------------- | ------- | -----------------
|                                |                      |               | Total   |                  
|Commercial
  business           | $                    | 95,656        |         | 10.8             
|Commercial
  real estate        |                      | 566,267       |         | 64.1             
|Installment                     |                      | 20,146        |         | 2.3              
|Installment
  real estate       |                      | 59,815        |         | 6.7              
|Indirect                        |                      | 35,686        |         | 4.0              
|Credit
  line                   |                      | 1,946         |         | 0.2              
|Prime
  access                  |                      | 54,808        |         | 6.2              
|Residential
  mortgage          |                      | 37,029        |         | 4.2              
|Bankcards                       |                      | 11,219        |         | 1.3              
|Business
  manager              |                      | 613           |         | 0.1              
|Other                           |                      | 1,783         |         | 0.2              
|Loans in
  process              |                      | 3,423         |         | 0.4              
|Deferred
  loans fees and costs |                      | 726           |         | 0.1              
|                                | Loans                |               | 889,117 |                  
|                                |                      |               |         |                  
|Mortgage
  loans held for sale  |                      | 3,247         |         | 0.4              
|                                | Total
  loans, gross |               | 892,364 |                  
|                                |                      |               |         |                  
|Allowance
  for loan losses     |                      | (8,879)       |         | (1.0)            
|                                | Total
  loans, net   | $             | 883,485 |                  
|                                |                      |               |         |                  

At June 30, 2006, the
Company's net loan portfolio approximated $883.5 million, or 79.2%, of the
Company's total assets compared with $862.6 million, or 80.2%, at December 31,
2005. Mortgage loans held for sale decreased $1.6 million from December 31,
2005 to June 30, 2006.

During the first six months of 2006, the Company's
indirect lending portfolio increased by $5.2 million, or 17.1%.  Management attributes this indirect loan growth to a
program offered by the Company that targets high credit scoring consumers
at competitive rates. The goal of this program is to introduce the Company and
its products to reputable automobile dealers.  Once introduced, the Company's
goal is to continue to build and maintain relationships with these dealers and
their customers.

See
Note 4 contained within Part I, Item 1 of this Quarterly Report on Form 10-Q for further discussion regarding the Company's loan
portfolio.

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



30

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|                             |                           | June 30, 2006    
|---------------------------- | ------------------------- | -----------------
|                             |                           |                  
|Commercial
  and industrial  | $                         | 306              
|Real
  estate - 1 - 4 family |                           | 32               
|Real
  estate - construction |                           | -                
|Real
  estate - other        |                           | 165              
|General
  consumer           |                           | 5                
|Credit
  line                |                           | 5                
|                             | Total
  classified assets | $                
|                             |                           |                  
|                             |                           | December 31, 2005
|                             |                           |                  
|Commercial
  and industrial  | $                         | 230              
|Real
  estate - 1 - 4 family |                           | 1,147            
|Real
  estate - construction |                           | -                
|Real
  estate - other        |                           | 82               
|General
  consumer           |                           | 25               
|Credit
  line                |                           | 6                
|                             | Total
  classified assets | $                
|                             |                           |                  
|                             |                           |                  

Management
is aware of no material relationships or specific events or trends that led to
the decrease in classified assets during the first six months of 2006 and believes that the decrease can be attributed to
fluctuations in the normal course of business.

The Company's loan portfolio
is periodically reviewed and loans are, in the opinion of management,
appropriately classified. Allowances have been established against all assets
requiring classification.

The following table
summarizes trends in problem assets and other asset quality indicators at the dates indicated (dollars in thousands).

|                                                |                                                                                                             |         | June 30, |         | December 31, |  | 
|----------------------------------------------- | ----------------------------------------------------------------------------------------------------------- | ------- | -------- | ------- | ------------ |  | 
|                                                |                                                                                                             |         | 2006     |         | 2005         |  | 
|                                                |                                                                                                             |         |          |         |              |  | 
|Nonaccrual
  loans                              | $                                                                                                           | 6,551   |          | 9,913   |              | 
|                                                | Total
  nonperforming loans                                                                                 |         | 6,551    |         | 9,913        |  | 
|                                                |                                                                                                             |         |          |         |              |  | 
|Real
  estate acquired in settlement of loans   |                                                                                                             | 728     |          | 1,954   |              | 
|Repossessed
  automobiles                       |                                                                                                             | 303     |          | 167     |              | 
|                                                | Total
  nonperforming assets                                                                                | $       | 7,582    |         | 12,034       |  | 
|                                                |                                                                                                             |         |          |         |              |  | 
|Loans
  past due 90 days and still accruing (1) | $                                                                                                           | 122     |          | 207     |              | 
|                                                |                                                                                                             |         |          |         |              |  | 
|Ending
  loans (2)                              | $                                                                                                           | 889,117 |          | 866,181 |              | 
|Nonaccrual
  loans as a percentage of loans (2) |                                                                                                             | 0.74    | %        | 1.14    |              | 
|Nonperforming
  assets as a percentage of       |                                                                                                             |         |          |         |              | 
|                                                | total
  assets                                                                                              |         | 0.68     | %       | 1.12         |  | 
|Allowance
  for loan losses to nonaccrual       |                                                                                                             |         |          |         |              | 
|                                                | loans                                                                                                       |         | 1.36     | x       | 0.85         |  | 
|                                                |                                                                                                             |         |          |         |              |  | 
|(1)                                             | Substantially
  all of these loans are bankcard loans                                                       |         |          |         |             
|(2)                                             | Calculated
  using loans excluding mortgage loans held for sale, net of unearned,
  excluding the Allowance
|                                                |                                                                                                             |         |          |         |              |  | 
|                                                |                                                                                                             |         |          |         |              |  | 
|                                                |                                                                                                             |         |          |         |              |  | 
|                                                |                                                                                                             |         |          |         |              |  | 
|                                                |                                                                                                             |         |          |         |              |  | 

31

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The following table
summarizes the
composition of nonaccrual loans, by collateral type, at the dates indicated
(dollars in thousands).

June 30, 2006
  
  
  December 31,
  2005Total
  
  % of Total
  
  
  Total
  
  % of TotalReal estate
  $
  6,005
  
  91.7
  %
  
  9,165
  
  92.4Commercial and industrial
  
  528
  
  8.1
  
  
  631
  
  6.4Credit cards
  
  -
  
  -
  
  
  -
  
  -Other consumer
  
  18
  
  0.2
  
  
  117
  
  1.2Total nonaccrual loans
  $
  6,551
  
  100.0
  %
  
  9,913
  
  100.0


At December 31, 2005, two
loans, both of which were secured by other real estate, were placed in
nonaccrual status.  In accordance with the Bank's lending policy, the loans
were downgraded to substandard. At December 31, 2005, the principal balance of
these loans totaled $7.2 million, and management believed the collateral
securing these loans was sufficient to cover the Bank's exposure.  Payment was
received during the first quarter of 2006 on one of these loans (balance of
approximately $3.3 million) that warranted the removal of nonaccrual status at
that time. Additionally, current payments have been received since the loan was
brought current and removed from nonaccrual status.  After taking into
consideration the removal of this loan from nonaccrual status during the first
six months of 2006, the balance of nonaccrual loans has remained relatively
unchanged since December 31, 2005.  Management believes the collateral securing
the remaining isolated loan circumstance as discussed in the Company's Annual
Report on Form 10-K for the year ended December 31, 2005 continued to be
sufficient to cover the Bank's exposure at June 30, 2006.

See Note 4 contained within Part I, Item 1 of this Quarterly
Report on Form 10-Q for further
discussion regarding the Company's loans in nonaccrual status.

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

At and for the three month
  
  At and for the six monthperiod ended June 30,
  
  period ended June 30,2006
  
  2005
  
  2006
  
  2005Real
  estate acquired in settlement of loans, beginning of period
  $
  932
  
  2,346
  
  1,954
  
  2,413Add:
  New real estate acquired in settlement of loans
  
  31
  
  362
  
  83
  
  516Less:
  Sales / recoveries of real estate acquired insettlement
  of loans
  
  (190)
  
  (236)
  
  (1,121)
  
  (397)Less:
  Provision charged to expense
  
  (45)
  
  (149)
  
  (188)
  
  (209)Real
  estate acquired in settlement of loans, end of period
  $
  728
  
  2,323
  
  728
  
  2,323


Activity
in real estate acquired in settlement of loans is correlated to current
economic conditions that impact the borrower's ability to service their debt. 
Management believes that the decrease in property added to the portfolio during
three and six month periods ended June 30, 2006 was a direct reflection of
continued general economic improvement. Management
believes that the increase in sales over the periods presented is the result of
increasing consumer confidence, which is directly correlated to consumer
spending, and reflects the marketability of the properties within the
portfolio.  Based on the Company's policies and procedures regarding the
regular review of fair market values of real estate acquired in settlement of
loans and writedowns taken accordingly, management believes that the properties
within the portfolio were properly valued at June 30, 2006. Additionally,
management believes that the excess of sales from the portfolio during the
three and six month periods ended June 30, 2006 over additions during the same
periods of 2005 indicate that the properties within the portfolio are
marketable.

See Note 8 contained within Part I, Item 1 of this Quarterly
Report on Form 10-Q for further
discussion regarding the Company's real estate acquired in settlement of loans
portfolio.

As
of June 30, 2006, management was aware of no potential problem loans that were
not already categorized as nonaccrual, past due, or restructured, that had
borrower credit problems causing management to have serious doubt as to the
ability of the borrower to comply with the present loan repayment terms.

Any
troubled debt restructurings entered into by the Company for the three and six
month periods ended June 30, 2006 and 2005 were immaterial when considered individually,
or in the aggregate, with regard to the Company's Consolidated Financial
Statements.

32

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The Company believes that the
economic conditions of recent years have had an impact on consumer confidence,
especially on consumer expectations. Though consumer confidence appears to be
improving from levels in recent years, management believes that higher than
historical fuel costs combined with continued economic uncertainty will
continue to curb both consumer confidence and spending, at least temporarily, when
compared with historical levels, in the short-term. As projected in the
Company's Annual Report on Form 10-K, as rebuilding efforts take hold and job
growth gains momentum, management believes that consumer confidence will
continue to show signs of rebound during 2006. Management believes that because
the Company's loan portfolio is closely monitored, any changes within the
Company's loan portfolio are promptly addressed in its Allowance model.
Additionally, management believes that there will always remain a core level of
delinquent loans and real estate and personal property acquired in settlement
of loans from normal lending operations.

Allowance for Loan Losses
The Allowance totaled $8.9
million and $8.4 million, at June 30, 2006 and December 31, 2005, respectively
representing 1.00% and 0.97% of loans, calculated using loans excluding
mortgage loans held for sale, net of unearned income, excluding allowance for
loan losses.

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

|                             |       | June 30, |                 | December 31,
|---------------------------- | ----- | -------- | --------------- | ------------
|                             |       | 2006     |                 | 2005        
|                             |       |          | Total allowance |             
|Commercial
  and industrial  | $     | 1,463    |                 | 13.6        
|Real
  estate - 1 - 4 family |       | 1,530    |                 | 19.0        
|Real
  estate - construction |       | 28       |                 | 2.8         
|Real
  estate - other        |       | 2,776    |                 | 55.8        
|General
  consumer           |       | 1,736    |                 | 6.9         
|Credit
  line                |       | 166      |                 | 0.5         
|Bankcards                    |       | 382      |                 | 1.3         
|Others                       |       | 798      |                 | 0.1         
|                             | Total | $        | 8,879           |             
|                             |       |          |                 |             

Since
December 31, 2005 the Company has continued to emphasize growth in loans
secured by real estate as such loans typically include less risk than loans
secured by collateral other than real estate or unsecured loans.  As such, the
loan portfolio secured by real estate has grown from comprising 75.3% of the
Company's loan portfolio at December 31, 2005 to 77.6% at June 30, 2006.  The
majority of this growth was offset by a decline in loans, as a percentage of
the loan portfolio, secured by commercial and industrial security other than
real estate.

As discussed herein, the
allowance model takes into account factors such as the composition of the loan
portfolio including risk grade classifications, historical asset quality trends
including, but not limited to, previous loss experience ratios, management's
assessment of current economic conditions, and reviews of specific high risk
sectors of the portfolio.  See Loans contained herein for discussion regarding
the composition of the loan portfolio as well as the fluctuations within the
portfolio for the period from December 31, 2005 to June 30, 2006.

33

---





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

|                                                                                                                                    |                              |                           | At and for the three month |         | At and for the six month |         | At and for the year
|----------------------------------------------------------------------------------------------------------------------------------- | ---------------------------- | ------------------------- | -------------------------- | ------- | ------------------------ | ------- | -------------------
|                                                                                                                                    |                              |                           | periods ended June 30,     |         | periods ended June 30,   |         | ended December 31, 
|                                                                                                                                    |                              |                           |                            | 2006    |                          | 2005    |                    
|Allowance
  balance, beginning of period                                                                                            | $                            | 8,727                     |                            | 7,838   |                          | 8,431   |                    
|                                                                                                                                    |                              |                           |                            |         |                          |         |                    
|Provision
  for loan losses                                                                                                         |                              | 525                       |                            | 600     |                          | 1,050   |                    
|                                                                                                                                    |                              |                           |                            |         |                          |         |                    
|Loans
  charged-off                                                                                                                 |                              |                           |                            |         |                          |         |                    
|                                                                                                                                    | Commercial
  and industrial  |                           | 98                         |         | 101                      |         | 214                
|                                                                                                                                    | Real
  estate - 1 - 4 family |                           | 21                         |         | 54                       |         | 40                 
|                                                                                                                                    | Real
  estate - construction |                           | -                          |         | -                        |         | -                  
|                                                                                                                                    | Real
  estate - other        |                           | 100                        |         | 43                       |         | 100                
|                                                                                                                                    | Consumer                     |                           | 214                        |         | 257                      |         | 358                
|                                                                                                                                    |                              | Total
  loans charged-off |                            | 433     |                          | 455     |                    
|                                                                                                                                    |                              |                           |                            |         |                          |         |                    
|Recoveries                                                                                                                          |                              |                           |                            |         |                          |         |                    
|                                                                                                                                    | Commercial
  and industrial  |                           | 7                          |         | 1                        |         | 29                 
|                                                                                                                                    | Real
  estate - 1 - 4 family |                           | 13                         |         | -                        |         | 13                 
|                                                                                                                                    | Real
  estate - construction |                           | -                          |         | -                        |         | -                  
|                                                                                                                                    | Real
  estate - other        |                           | 1                          |         | 34                       |         | 3                  
|                                                                                                                                    | Consumer                     |                           | 39                         |         | 33                       |         | 65                 
|                                                                                                                                    |                              | Total
  recoveries        |                            | 60      |                          | 68      |                    
|                                                                                                                                    |                              |                           |                            |         |                          |         |                    
|                                                                                                                                    |                              | Net
  loans charged-off   |                            | 373     |                          | 387     |                    
|                                                                                                                                    |                              |                           |                            |         |                          |         |                    
|Allowance
  balance, end of period                                                                                                  | $                            | 8,879                     |                            | 8,051   |                          | 8,879   |                    
|                                                                                                                                    |                              |                           |                            |         |                          |         |                    
|Average
  loans (1)                                                                                                                 | $                            | 876,226                   |                            | 828,913 |                          | 870,735 |                    
|Ending
  loans (1)                                                                                                                  |                              | 889,117                   |                            | 826,802 |                          | 889,117 |                    
|Net
  loans charged-offs to average loans (1)                                                                                       |                              | 0.17                      | %                          | 0.19    |                          | 0.14    |                    
|Allowance
  for loan losses to ending loans (1)                                                                                     |                              | 1.00                      |                            | 0.97    |                          | 1.00    |                    
|                                                                                                                                    |                              |                           |                            |         |                          |         |                    
|(1)  Calculated
  using loans excluding mortgage loans held for sale, net of unearned income,
  excluding allowance for loan losses
|                                                                                                                                    |                              |                           |                            |         |                          |         |                    

See
Quarterly Net Income Review, Provision for Loan Losses and Year-to-Date Net Income Review, Provision
for Loan Losses for a discussion of the fluctuation in the provision for loan
losses when comparing the three and month periods ended June 30, 2005 with the
same period of 2006.

Total net loans charged-off
totaled $373 thousand during the three month period ended June 30, 2006 down
slightly from $387 thousand during the same period of 2005. When comparing the
six month periods ended June 30, 2006, net loans charged-off declined $166
thousand to $602 thousand for the six month period ended June 30, 2006. 
Management attributes the overall decline in net loans charged-off to the
careful management of the Company's loan portfolio and the resulting impact
such management has had on asset quality as well as overall economic
improvements that generally increase the likelihood of consumer repayment of
debt.

34

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As discussed in Loans, although classified assets increased from June 30,
2005 to June 30, 2006, management believes that the increase was attributed to
the isolated loan conditions concentrated within two lending relationships
discussed in Note 4 contained within Part I, Item 1 of this Quarterly Report on Form 10-Q rather than credit deterioration within the loan
portfolio.  When considering key performance indicators without these two loan
relationships, the balances of classified assets declined slightly from June
30, 2005 to June 30, 2006.  After adjusting the June 30, 2006 results for these
two loan relationships, classified assets declined $4.1 million at June 30,
2006 from June 30, 2005.  In addition, classified assets declined from December
31, 2005 to June 30, 2006 by approximately $1 million.

At December 31, 2005, two
loans, both of which were secured by other real estate, were placed in
nonaccrual status.  In accordance with the Bank's lending policy, the loans
were downgraded to substandard. At December 31, 2005, the principal balance of
these loans totaled $7.2 million, and management believed the collateral securing
these loans was sufficient to cover the Bank's exposure.  Payment was received
during the first quarter of 2006 on one of these loans (balance of
approximately $3.3 million) that warranted the removal of nonaccrual status at
that time. Additionally, current payments have been received since the loan was
brought current and removed from nonaccrual status.  After taking into
consideration the removal of this loan from nonaccrual status during the first
six months of 2006, the balance of nonaccrual loans has remained relatively
unchanged since December 31, 2005.  Management believes the collateral securing
the remaining isolated loan circumstance as discussed in the Company's Annual
Report on Form 10-K for the year ended December 31, 2005 continued to be
sufficient to cover the Bank's exposure at June 30, 2006.

In an effort to mitigate any credit deterioration resulting from economic conditions, management has and continues to emphasize conservative underwriting in an effort to manage credit quality as evidenced by the key performance indicators relative to the Allowance discussed herein.

Based on the current economic
environment and other factors that impact the assessment of the Company's
Allowance as discussed above, management believes that the Allowance at June
30, 2006 was maintained at a level adequate to provide for estimated probable
losses in the loan portfolio.  However, assessing the adequacy of the Allowance
is a process that requires considerable judgment. Management's judgments are
based on numerous assumptions about current events believed to be reasonable
but which may or may not be valid. Thus, there can be no assurance that loan
losses in future periods will not exceed the current Allowance or that future
increases in the Allowance will not be required. No assurance can be given that
management's ongoing evaluation of the loan portfolio, in light of changing
economic conditions and other relevant circumstances, will not require future
additions to the Allowance, thus adversely impacting the results of operations
of the Company.

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

|                                |                                      | June 30, 2006 |         | December 31, 2005
|------------------------------- | ------------------------------------ | ------------- | ------- | -----------------
|                                |                                      |               | Total   |                  
|Transaction
  deposit accounts  | $                                    | 401,562       |         | 41.6             
|Money
  market deposit accounts |                                      | 124,080       |         | 12.8             
|Savings
  deposit accounts      |                                      | 46,222        |         | 4.8              
|Time
  deposit accounts         |                                      | 394,413       |         | 40.8             
|                                | Total
  traditional deposit accounts | $             | 966,277 |                  
|                                |                                      |               |         |                  

Total
traditional deposit accounts increased $62.9 million from December 31, 2005 to
June 30, 2006. Management does not believe that its dependence on traditional
deposit account funding changed materially from December 31, 2005 to June 30,
2006.  At June 30,
2006, traditional deposit accounts as a percentage of liabilities were 94.5%
compared with 91.6% at December 31, 2005.  The
percentage of funding provided by traditional deposit accounts has increased
during the first six months of 2006, and accordingly, the Company has not had
to rely as heavily on alternative funding sources from which to fund a portion
of loan demand.

Core traditional deposit
accounts, which include transaction, money market, and savings accounts, grew
by $63.5 million during the first six months of 2006, or 12.5%.  The increase
in core traditional deposit accounts during the first six months of 2006 was
primarily a result of the Company's continued ability to attract traditional
deposit accounts through pricing adjustments, expansion of its geographic
market area, level of quality customer service, and through the Company's
reputation in the communities served. This growth in core traditional deposit
accounts was enhanced by additional marketing efforts directed toward several
existing deposit products.  Additionally, the growth in money market deposit
accounts over the periods presented was due primarily to a deposit of
approximately $14 million in public funds from one entity.

Time deposit accounts decreased by $601 thousand during
the first six months of 2006. Promotional
certificate of deposit accounts offered beginning during the fourth quarter of
2004 began to mature during the first half of 2006.  The Bank has successfully
retained a large portion of these maturing funds.  The decline in time deposit
accounts during this period is due in large part to the funds that the Bank was
unable to retain.

Although deposit growth is a
top priority of the Company, such growth is not dependent on targeted programs,
and management does not believe the Company will lose deposits if it does not
continue to offer targeted programs.

35

---



The Company's increase in
core traditional deposit accounts results from its efforts to enhance the deposit mix by working to attract lower-cost
deposit accounts. As noted above, core
traditional deposit accounts grew by $63.5 million during the first six months
of 2006 while higher-cost time deposit accounts decreased by $601 thousand
during the same period. The table set forth below summarizes the Company's
weighted average deposit costs for the periods indicated.

|                                                     |      |   | For the three month   |  | For the six month     |  | For the year      
|---------------------------------------------------- | ---- | - | --------------------- |  | --------------------- |  | ------------------
|                                                     |      |   | period ended June 30, |  | period ended June 30, |  | ended December 31,
|                                                     |      |   | 2006                  |  | 2005                  |  | 2006              
|Average
  cost of core deposit accounts              | 2.05 | % | 0.77                  |  | 1.87                  |  | 0.67              
|Average
  cost of time deposit accounts              | 3.91 |   | 2.91                  |  | 3.80                  |  | 2.84              
|Average
  cost of total traditional deposit accounts | 2.95 |   | 1.86                  |  | 2.82                  |  | 1.80              
|                                                     |      |   |                       |  |                       |  |                   

BorrowingsBorrowings decreased $25.5 million at June 30,
2006 when compared with year-end 2005.  Borrowings
as a percentage of total liabilities were approximately 4.5% and 7.7% at June
30, 2006 and December 31, 2005, respectively. The following table summarizes
the Company's borrowings composition at the dates indicated (dollars in
thousands).

|                               |                    | June 30, 2006 |        | December 31, 2005
|------------------------------ | ------------------ | ------------- | ------ | -----------------
|                               |                    |               | Total  |                  
|Retail
  repurchase agreements | $                  | 17,961        |        | 35.9             
|Commercial
  paper             |                    | 22,104        |        | 44.1             
|Federal
  funds purchased      |                    | -             |        | -                
|FHLB
  borrowings              |                    | 10,000        |        | 20.0             
|                               | Total
  borrowings | $             | 50,065 |                  
|                               |                    |               |        |                  

Short
and long-term borrowings are a source of funding that the Company utilizes
depending on the current level of deposits, the desirability of raising
deposits through market promotions, the Company's unused FHLB borrowing
capacity, and the availability of collateral to secure FHLB borrowings. Federal funds purchased and short-term FHLB borrowings
represent unsecured overnight borrowings. These borrowings are an important
source of funding to the Company as they allow the Company to meet funding
needs without relying on increasing deposits on a short-term basis. The decrease in borrowings at
June 30, 2006 when compared with December 31, 2005 resulted from the Company's
ability to meet its funding needs during the period with funds generated
through deposit account growth and other liquidity avenues as well the maturity
of $13.0 million long-term FHLB advances
in June 2006.

At June 30, 2006, of its approximately $185 million available
credit based on qualifying loans to serve as collateral against short-term or
long-term borrowings from the FHLB, the Company employed $10.0 million in
borrowings, all of which was determined to be long-term when employed, and
employed $19.0 million in a letter of credit used to secure public deposits as
required or permitted by law.

FHLB
advances with fixed interest rates are subject to a prepayment fee in the event
of full or partial repayment prior to maturity or the expiration of any interim
interest rate period.  Management was not aware of any circumstances at June
30, 2006 that would require prepayment of any of the Company's FHLB advances.

36

---



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

|                               |      |   | For the three month   |  | For the six month     |  | For the year      
|------------------------------ | ---- | - | --------------------- |  | --------------------- |  | ------------------
|                               |      |   | period ended June 30, |  | period ended June 30, |  | ended December 31,
|                               |      |   | 2006                  |  | 2005                  |  | 2006              
|Retail
  repurchase agreements | 4.11 | % | 2.10                  |  | 3.89                  |  | 1.86              
|Commercial
  paper             | 4.05 |   | 2.05                  |  | 3.81                  |  | 1.82              
|Federal
  funds purchased      | 5.28 |   | 2.94                  |  | 5.22                  |  | 2.61              
|FHLB
  borrowings              | 3.41 |   | 2.22                  |  | 3.72                  |  | 2.36              
|                               |      |   |                       |  |                       |  |                   

Borrowing rates paid during the three and six month
periods ended June 30, 2006 increased from those paid for the year ended
December 31, 2005 and those paid for the three and six month periods ended June
30, 2005. The primary reason for the
changes in the yields paid on interest-bearing liabilities has been the action
of the Federal Reserve Open Market Committee. Since the second quarter of 2004,
the federal funds rate has increased from 1.0% to 5.25% in a series of
seventeen moves.  The increases in the Company's borrowings costs during the
three and six month periods ended June 30, 2006 are attributed to these
increasing rate trends.

During the first quarter of
2006, due to the nature of the account, the Company began classifying its
interest bearing overnight investment account at the Federal Home Loan Bank as
federal funds sold.  Prior to 2006, this account had been classified within the
cash and due from banks financial statement line item.  As such, this change
resulted in reclassifications within the Consolidated Balance Sheets and
Consolidated Statements of Income.

See Note 10 and Note 11 contained
within Part I, Item
1 of this Quarterly Report on Form 10-Q
for a further discussion regarding the Company's borrowings.

Capital Resources
Average shareholders' equity
was $92.4 million for the six month period ended June 30, 2006, or 8.4% of
average assets. Average shareholders' equity was $85.8 million for the year
ended December 31, 2005, or 8.2% of average assets. Average shareholders'
equity was $83.5 million for the six month period ended June 30, 2005, or 8.1%
of average assets.

Total shareholders' equity
increased from $88.9 million at December 31, 2005 to $93.6 million at June 30,
2006. The Company's capital ratio of total shareholders' equity to total assets
was 8.4% at June 30, 2006 compared with 8.3% at December 31, 2005. During 2006,
shareholders' equity was increased through the retention of net income and
stock option activity.  These increases were offset by an increase in cash
dividends and a decline in accumulated other comprehensive income when
comparing the six month period ended June 30, 2006 with the year ended December
31, 2005.  See Consolidated Statements of Changes in Shareholders' Equity and
Comprehensive Income contained within Part I, Item 1 of this Quarterly Report on Form 10-Q for a further discussion regarding the changes in
stockholders' equity during the six month period ended June 30, 2006.

The Company and the Bank are
required to meet regulatory capital requirements that currently include several
measures of capital.  At June 30, 2006, the Company and the Bank were each categorized as well
capitalized under the regulatory framework for prompt corrective action. See Note 16 contained within Part I, Item 1 of this Quarterly
Report on Form 10-Q for further
discussion regarding the Bank's and the Company's capital regulatory
requirements. At June 30, 2006, there were no conditions or events
of which management was aware that would materially change the Company's or the
Bank's status.

During the first six months
of 2006, the Company's cash dividend payout ratio was 30.99% compared with a
payout ratio of 30.27% for the year ended December 31, 2005. The Company's cash
dividend payout ratio during the first six months of 2005 was 29.04%. Cash
dividends per common share for the first six months of 2006 totaled $0.36, an
increase of 12.5% over dividends per common share during the same period of
2005 of
$0.32.

DISCLOSURES REGARDING
MARKET RISK

The Company evaluated the results of its net interest income
simulation prepared as of June 30, 2006 for interest rate risk management
purposes. Overall, the model results indicate that the Company's interest rate
risk sensitivity is within limits set by the Company's guidelines and the Company's balance
sheet is liability sensitive. A liability sensitive balance sheet suggests that
in falling interest rate environment, net interest margin would increase and
during an increasing interest rate environment, net interest margin would
decrease.

37

---



Net Interest Income SimulationAs
of June 30, 2006, the following table summarizes forecasted net interest income
and net interest margin using a base market rate and the estimated change to
the base scenario given upward and downward movement in interest rates of 100
basis points and 200 basis points (dollars in thousands).

|Interest rate scenario  |   | Adjusted net 
	interest income |  | Percentage change
	
	from base |   | Net interest 
	margin |   | Net interest 
	margin 
	change 
	(in
  basis points)
|----------------------- | - | ------------------------------ |  | ------------------------------ | - | --------------------- | - | ----------------------------------------------------
|Up 200
  basis points   | $ | 52,368                         |  | (5.55)                         | % | 5.02                  | % | (0.29)                                              
|Up 100
  basis points   |   | 53,960                         |  | (2.68)                         |   | 5.17                  |   | (0.14)                                              
|BASE
  CASE             |   | 55,445                         |  | -                              |   | 5.31                  |   | -                                                   
|Down
  100 basis points |   | 56,647                         |  | 2.17                           |   | 5.43                  |   | 0.12                                                
|Down
  200 basis points |   | 57,758                         |  | 4.17                           |   | 5.53                  |   | 0.22                                                
|                        |   |                                |  |                                |   |                       |   |                                                     

The
simulation results as of June 30, 2006 indicate the Company's interest rate
risk position was liability sensitive as the simulated impact of an downward
movement in interest rates of 100 basis points would result in a 2.17% increase
in net interest income over the subsequent 12 month period while an upward movement
in interest rates of 100 basis points would result in a 2.68% decrease in net
interest income over the next 12 months. The simulation results indicate that a
100 basis point downward shift in interest rates would result in a 12 basis
point increase in net interest margin, assuming all other variables remained
unchanged. Conversely, a 100 basis point increase in interest rates would cause
a 14 basis point decrease in net interest margin. The projected negative impact
on the Company's net interest income for the twelve month period does not
exceed the 20% threshold prescribed by the Asset - Liability Committee's
policy.

LIQUIDITY

GeneralThe
investment securities portfolio is also an avenue for liquidity through
scheduled maturities, sales of investment securities, and prepayment of
principal on mortgage-backed securities.  Approximately 94% of the investment
securities portfolio was pledged to secure public deposits as of June 30, 2006
as compared with 83% at December 31, 2005.  Of the Company's $118.2 million
available for sale investment securities balance at June 30, 2006, $9.3 million
was available as a liquidity source.

Each of
the Company's sources of liquidity is
subject to various uncertainties beyond the control of the Company. As a measure
of protection, the Company has back-up sources of funds available. If needed, alternative funding sources have been arranged through
federal funds lines at correspondent banks and through the Federal Reserve
Discount Window.  At June 30, 2006, the Company had unused short-term lines of
credit at correspondent banks totaling of $40 million (which were accessible at
the Company's option).

In addition to these unused short-term lines of credit, the
Company may utilize borrowings from the FHLB to fund increases in
interest-earning assets in times of declines in alternative funding sources. At
June 30, 2006, of its approximately $185 million available credit based on
qualifying loans to serve as collateral against short-term or long-term
borrowings from the FHLB, the Company employed $10.0 million in borrowings, all
of which was determined to be long-term when employed, and employed $19.0
million in a letter of credit used to secure public deposits as required or
permitted by law leaving a balance of approximately $156 million available as a
liquidity source, if needed.

See Note 10 contained within Part I, Item 1 of this Quarterly
Report on Form 10-Q and Financial
Condition, Borrowings for a further discussion regarding the Company's FHLB
borrowings.

38

---



See
Consolidated
Statements of Cash Flows contained within
Part I, Item 1 of
this Quarterly Report on Form 10-Q for a
discussion regarding the factors impacting liquidity for the six month period ended June 30, 2006.

BorrowingsOf the $30.0 million in long-term FHLB borrowings advanced in
June 2004, an additional $13.0 million matured in June 2006 leaving a remaining
balance of $10.0 million in long-term borrowings with the FHLB at June 30,
2006.

See Note 10 and Note 11
contained within Part
I, Item 1 of this Quarterly Report on Form 10-Q and Financial Condition, Borrowings for a further discussion regarding
the Company's borrowings.

Lease AgreementsLease
payments for rental commitments under noncancelable ground and building
operating leases totaled $188 thousand and $160 thousand during the three month
periods ended June 30, 2006 and 2005,
respectively. For the six month periods ended June 30, 2006 and 2005, such
payments totaled $367 thousand and $319 thousand, respectively.  Such payments
are included in Occupancy Expense in the Consolidated Statements of Income.

During the first quarter of 2006, the Bank completed
negotiations with a third party with regard to the sublease of its previous
Blackstock Road banking office location. Also during the first quarter of 2006,
the Bank entered into a one year lease
agreement with regard to the banking office used temporarily during the
construction of the new Boiling Springs banking office to be opened in 2006.

Four
of five ground lease agreements that will house automatic teller machines were
executed during the first quarter of 2006. Three of these ground leases
commenced during the second quarter of 2006.  One of the ground leases will
commence during the third quarter of 2006, and the final ground lease is expected
to be commenced by the end of 2006. All five ground lease agreements have
original five year terms (from commencement date) each with two five year
option terms.  All of these ground leases are located in market areas in which
the Company currently serves.

Lending CommitmentsSee
Note 14 contained within Part I, Item 1 of this Quarterly Report on Form 10-Q and Off-Balance Sheet Arrangements, Lending Commitments for a discussion of
the potential impact on liquidity of the Company's lending commitments at June
30, 2006.

Palmetto BancsharesAt June
30, 2006, the holding company had $22.1 million in commercial paper compared
with a balance of $17.9 million at December 31, 2005. The table set forth below summarizes the Company's
weighted average borrowing costs with respect to commercial paper for the
periods indicated.

For the three month
  
  For the six month
  
  For the yearperiod ended June 30,
  
  period ended June 30,
  
  ended December 31,2006
  
  2005
  
  2006
  
  2005
  
  2005Commercial
  paper
  4.05
  %
  2.05
  
  3.81
  
  1.82
  
  2.33


Potential
sources of the holding company's payment for periodic stock purchases and
dividends include dividends from the Bank and funds received through stock
option exercises. At June 30, 2006, the holding company had cash reserves of
$1.2 million compared with $875 thousand at December 31, 2005.  The increase
between the two periods resulted primarily from the receipt of funds in
conjunction with stock option transactions during the first six months of 2006.

CONTINGENCIES

During the second quarter of 2006, as a result of a software upgrade, the Company experienced a temporary delay in check processing and electronic check processing.  Although management is not currently able to estimate the impact that this delay will have on the Company's financial condition and results of operations, it does not believe that the impact will be material to the financial statements taken as a whole.

39

---



OFF-BALANCE SHEET ARRANGEMENTS

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

Lending CommitmentsThe following table
summarizes the Company's contractual commitments to extend credit at June 30,
2006 (in thousands).

|Home
  equity loans                  | $                               | 47,786
|------------------------------------ | ------------------------------- | ------
|Credit
  cards                       |                                 | 45,231
|Commercial
  real estate development |                                 | 52,729
|Other
  unused lines of credit       |                                 | 55,142
|                                     | Total
  contractual obligations | $     
|                                     |                                 |       

GuaranteesAt June
30, 2006, the Company recorded no liability for the current carrying amount of
the obligation to perform as a guarantor, and no contingent liability was
considered necessary as such amounts were not considered material. The maximum
potential amount of undiscounted future payments related to standby letters of
credit at June 30, 2006 was $6.0 million.  Past experience indicates that these
standby letters of credit will expire unused. However, through its various sources
of liquidity, the Company believes that it has the necessary resources
available to meet these obligations should the need arise.  Additionally, the
Company does not believe that the current fair market value of such guarantees
was material at June 30, 2006.

Other Off-Balance Sheet ArrangementsAt June 30, 2006, the Company
had no interest in nonconsolidated special purpose entities nor was it involved
in other off-balance sheet contractual relationships, unconsolidated related
entities that have off-balance sheet arrangements, or transactions that could
result in liquidity needs (other than those discussed herein).

Derivative
ActivitiesAt June 30, 2006, the
Company's derivative instruments consisted of forward sales commitments
relating to the Company's commitments to originate certain residential loans
held for sale.

Outstanding commitments on
mortgage loans not yet closed (primarily single-family loan commitments)
amounted to approximately $2.5 million at June 30, 2006.  The fair market value
of derivative assets related to commitments to originate such residential loans
held for sale and forward sales commitments was not significant at June 30,
2006.

40

---



QUARTERLY HIGHLIGHTS

(dollars
  in thousands, except common and per share data)At and for the three monthperiod ended June 30,
  
  
  
  Percent2006
  
  2005
  
  Variance
  
  Variance(unaudited)SUMMARY
  OF OPERATIONSInterest
  income
  $
  18,769
  
  15,497
  
  3,272
  
  21.1
  %Interest
  expense
  
  6,601
  
  3,943
  
  2,658
  
  67.4Net
  interest income
  
  12,168
  
  11,554
  
  614
  
  5.3Provision
  for loan losses
  
  525
  
  600
  
  (75)
  
  (12.5)Net
  interest income after provision for loan losses
  
  11,643
  
  10,954
  
  689
  
  6.3Noninterest
  income
  
  4,080
  
  4,016
  
  64
  
  1.6Noninterest
  expense
  
  10,189
  
  9,635
  
  554
  
  5.7Income
  before provision for income taxes
  
  5,534
  
  5,335
  
  199
  
  3.7Provision
  for income taxes
  
  1,803
  
  1,788
  
  15
  
  0.8Net income
  $
  3,731
  
  3,547
  
  184
  
  5.2
  %COMMON
  SHARE DATANet
  income:Basic
  $
  0.59
  
  0.56
  
  0.03
  
  5.4
  %Diluted
  
  0.58
  
  0.55
  
  0.03
  
  5.5Cash
  dividends
  
  0.18
  
  0.16
  
  0.02
  
  12.5Book
  value
  
  14.73
  
  13.49
  
  1.24
  
  9.2Outstanding
  shares
  
  6,356,635
  
  6,317,285
  
  39,350
  
  0.6Weighted
  average outstanding - basic
  
  6,354,888
  
  6,314,043
  
  40,845
  
  0.6Weighted
  average outstanding - diluted
  
  6,429,759
  
  6,420,995
  
  8,764
  
  0.1Dividend
  payout ratio
  
  30.67
  %
  28.49
  
  2.18
  
  7.6PERIOD-END
  BALANCESAssets
  $
  1,116,073
  
  1,052,002
  
  64,071
  
  6.1
  %Investment
  securities available for sale, at fair market value
  
  115,440
  
  134,121
  
  (18,681)
  
  (13.9)Loans
  (1)
  
  892,364
  
  831,691
  
  60,673
  
  7.3Deposits
  and other borrowings
  
  1,016,342
  
  961,962
  
  54,380
  
  5.7Shareholders'
  equity
  
  93,626
  
  85,214
  
  8,412
  
  9.9AVERAGE
  BALANCESAssets
  $
  1,114,488
  
  1,046,709
  
  67,779
  
  6.5
  %Interest-earning
  assets
  
  1,034,089
  
  981,497
  
  52,592
  
  5.4Investment
  securities available for sale, at fair market value
  
  121,053
  
  138,093
  
  (17,040)
  
  (12.3)Loans
  (1)
  
  880,061
  
  833,634
  
  46,427
  
  5.6Deposits
  and other borrowings
  
  880,343
  
  829,246
  
  51,097
  
  6.2Shareholders'
  equity
  
  93,625
  
  84,401
  
  9,224
  
  10.9SIGNIFICANT
  OPERATING RATIOS BASED ON EARNINGSReturn
  on average assets
  
  1.34
  %
  1.36
  
  (0.02)
  
  (1.2)
  %Return
  on average shareholders' equity
  
  15.98
  
  16.86
  
  (0.87)
  
  (5.2)Net
  interest margin
  
  4.72
  
  4.72
  
  -
  
  -(1)
  Calculated using loans including mortgage loans held for sale, net of
  unearned, excluding the allowance for loan losses


QUARTERLY NET INCOME REVIEW

The following information is intended to supplement any
information relating to the Consolidated Statements of Income contained within
Part I, Item 1 of this Quarterly Report on Form 10-Q.

41

---



Overview

PALMETTO BANCSHARES, INC. AND
  SUBSIDIARYConsolidated Statements of
  Income(dollars in thousands, except
  common and per share data)For the three month periodended June 30,
  
  Dollar
  
  Percent2006
  
  2005
  
  Variance
  
  Variance(unaudited)Interest
  incomeInterest
  and fees on loans
  $
  17,115
  
  14,099
  
  3,016
  
  21.4
  %Interest
  on investment securities available for sale
  1,215
  
  1,305
  
  (90)
  
  (6.9)Interest
  on federal funds sold
  
  393
  
  39
  
  354
  
  907.7Dividends
  on FHLB stock
  
  46
  
  54
  
  (8)
  
  (14.8)Total
  interest income
  
  18,769
  
  15,497
  
  3,272
  
  21.1Interest
  expenseInterest
  on deposits
  
  6,030
  
  3,335
  
  2,695
  
  80.8Interest
  on retail repurchase agreements
  176
  
  110
  
  66
  
  60.0Interest
  on commercial paper
  
  206
  
  93
  
  113
  
  121.5Interest
  on federal funds purchased
  12
  
  40
  
  (28)
  
  (70.0)Interest
  on FHLB borrowings
  
  177
  
  365
  
  (188)
  
  (51.5)Total
  interest expense
  6,601
  
  3,943
  
  2,658
  
  67.4Net
  interest income
  12,168
  
  11,554
  
  614
  
  5.3Provision
  for loan losses
  
  525
  
  600
  
  (75)
  
  (12.5)Net
  interest income after provision for loan losses
  11,643
  
  10,954
  
  689
  
  6.3Noninterest
  incomeService
  charges on deposit accounts
  2,047
  
  1,992
  
  55
  
  2.8Fees
  for trust and brokerage services
  847
  
  748
  
  99
  
  13.2Mortgage-banking
  income
  
  275
  
  474
  
  (199)
  
  (42.0)Investment
  securities gains
  
  1
  
  15
  
  (14)
  
  (93.3)Other
  
  
  
  910
  
  787
  
  123
  
  15.6Total
  noninterest income
  4,080
  
  4,016
  
  64
  
  1.6Noninterest
  expenseSalaries
  and other personnel
  
  5,709
  
  5,608
  
  101
  
  1.8Net
  occupancy
  
  699
  
  659
  
  40
  
  6.1Furniture
  and equipment
  
  960
  
  920
  
  40
  
  4.3Marketing
  and advertising
  
  340
  
  261
  
  79
  
  30.3Postage
  and supplies
  
  347
  
  315
  
  32
  
  10.2Telephone
  
  
  182
  
  183
  
  (1)
  
  (0.5)Professional
  services
  
  259
  
  219
  
  40
  
  18.3Other
  
  
  
  1,693
  
  1,470
  
  223
  
  15.2Total
  noninterest expense
  10,189
  
  9,635
  
  554
  
  5.7Net
  income before provision for income taxes
  5,534
  
  5,335
  
  199
  
  3.7Provision
  for income taxes
  
  1,803
  
  1,788
  
  15
  
  0.8Net
  income
  $
  3,731
  
  3,547
  
  184
  
  5.2
  %Common
  Share DataNet
  Income - basic
  $
  0.59
  
  0.56
  
  0.03
  
  5.4
  %Net
  Income - diluted
  
  0.58
  
  0.55
  
  0.03
  
  5.5Cash
  dividends
  
  0.18
  
  0.16
  
  0.02
  
  12.5Book
  value
  
  
  14.73
  
  13.49
  
  1.24
  
  9.2Weighted
  average common shares outstanding - basic
  6,354,888
  
  6,314,043Weighted
  average common shares outstanding - diluted
  6,429,759
  
  6,420,995


Net Interest IncomeNet interest income for the
three month period ended June 30, 2006 increased $614 thousand, or 5.3%, to
$12.2 million from $11.6 million for the three month period ended June 30,
2005. During the second quarter of 2006, the Company experienced increases in
average yields on interest-earning assets consistent with the increase in the
average cost of interest-bearing liabilities. The average yield on
interest-earning assets increased 95 basis points to 7.28% during the three
month period ended June 30, 2006 from 6.33% during the three month period ended
June 30, 2005. The average cost of interest-bearing liabilities increased 110
basis points to 3.01% during the three month period ended June 30, 2006 from
1.91% during the three month period ended June 30, 2005. Net interest income
for the three month period ended June 30, 2006 was $12.2 million, and the net
yield on interest-earning assets was 4.72%. Average interest-earning assets
increased $52.6 million over the same periods, while interest-bearing
liabilities increased $51.0 million. The primary reason for the increase in the
yields earned and paid on interest-earnings assets and interest-bearing
liabilities, respectively, has been the action of the Federal Reserve Open
Market Committee. Since the second quarter of 2004, the federal funds rate has
increased from 1.0% to 5.25% in a series of seventeen moves.

42

---



The following table
summarizes the Company's average balance sheets and net interest income
analysis for the periods indicated (dollars in thousands). The Company's yield
on interest-earning assets and cost of interest-bearing liabilities shown in
the table are derived by dividing interest income and expense by the average
balances of interest-earning assets or interest-bearing liabilities.

|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              | For the three month period ended June 30, |               
|-------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | -------------------------------------------- | ------------ | ----------------------------------------- | --------------
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              | 2006                                      |               
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              |                                           | Average       
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              |                                           | Balance       
|ASSETS                                 |                                                                                                                                                                                                                                                                                                  |                                              |              |                                           |               
|Interest-earnings assets               |                                                                                                                                                                                                                                                                                                  |                                              |              |                                           |               
|                                       | Loans, net of unearned (1)                                                                                                                                                                                                                                                                       | $                                            | 880,061      |                                           | $       17,115
|                                       | Investment securities
  available for sale, nontaxable (2)                                                                                                                                                                                                                                       |                                              | 54,751       |                                           | 496           
|                                       | Investment securities
  available for sale, taxable (2)                                                                                                                                                                                                                                          |                                              | 66,302       |                                           | 719           
|                                       | Federal funds sold                                                                                                                                                                                                                                                                               |                                              | 29,869       |                                           | 393           
|                                       | FHLB stock                                                                                                                                                                                                                                                                                       |                                              | 3,106        |                                           | 46            
|                                       |                                                                                                                                                                                                                                                                                                  | Total interest-earning
  assets              |              | 1,034,089                                 |               
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              |                                           |               
|Noninterest-earning assets             |                                                                                                                                                                                                                                                                                                  |                                              |              |                                           |               
|                                       | Cash and due from banks                                                                                                                                                                                                                                                                          |                                              | 44,193       |                                           |               
|                                       | Allowance for loan losses                                                                                                                                                                                                                                                                        |                                              | (8,743)      |                                           |               
|                                       | Premises and equipment, net                                                                                                                                                                                                                                                                      |                                              | 23,432       |                                           |               
|                                       | Accrued interest receivable                                                                                                                                                                                                                                                                      |                                              | 5,049        |                                           |               
|                                       | Goodwill                                                                                                                                                                                                                                                                                         |                                              | 3,688        |                                           |               
|                                       | Other intangible assets                                                                                                                                                                                                                                                                          |                                              | 156          |                                           |               
|                                       | Other                                                                                                                                                                                                                                                                                            |                                              | 12,624       |                                           |               
|                                       |                                                                                                                                                                                                                                                                                                  | Total noninterest-earning assets             |              | 80,399                                    |               
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              |                                           |               
|                                       |                                                                                                                                                                                                                                                                                                  |                                              | Total assets | $                                         | 1,114,488     
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              |                                           |               
|LIABILITIES AND
  SHAREHOLDERS' EQUITY |                                                                                                                                                                                                                                                                                                  |                                              |              |                                           |               
|Liabilities                            |                                                                                                                                                                                                                                                                                                  |                                              |              |                                           |               
|Interest-bearing liabilities           |                                                                                                                                                                                                                                                                                                  |                                              |              |                                           |               
|                                       | Transaction and money market
  deposit accounts                                                                                                                                                                                                                                                  | $                                            | 380,615      |                                           | $      2,150  
|                                       | Savings deposit accounts                                                                                                                                                                                                                                                                         |                                              | 46,535       |                                           | 38            
|                                       | Time deposit accounts                                                                                                                                                                                                                                                                            |                                              | 393,890      |                                           | 3,842         
|                                       |                                                                                                                                                                                                                                                                                                  | Total interest-bearing
  deposits            |              | 821,040                                   |               
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              |                                           |               
|                                       | Retail repurchase agreements                                                                                                                                                                                                                                                                     |                                              | 17,196       |                                           | 176           
|                                       | Commercial paper                                                                                                                                                                                                                                                                                 |                                              | 20,401       |                                           | 206           
|                                       | Federal funds purchased                                                                                                                                                                                                                                                                          |                                              | 912          |                                           | 12            
|                                       | FHLB borrowings                                                                                                                                                                                                                                                                                  |                                              | 20,794       |                                           | 177           
|                                       |                                                                                                                                                                                                                                                                                                  | Total interest-bearing
  liabilities         |              | 880,343                                   |               
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              |                                           |               
|Noninterest-bearing
  liabilities      |                                                                                                                                                                                                                                                                                                  |                                              |              |                                           |               
|                                       | Noninterest-bearing deposits                                                                                                                                                                                                                                                                     |                                              | 134,161      |                                           |               
|                                       | Other noninterest-bearing
  liabilities                                                                                                                                                                                                                                                          |                                              | 6,359        |                                           |               
|                                       |                                                                                                                                                                                                                                                                                                  | Total noninterest-bearing
  liabilities      |              | 140,520                                   |               
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              |                                           |               
|                                       |                                                                                                                                                                                                                                                                                                  | Total liabilities                            |              | 1,020,863                                 |               
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              |                                           |               
|Shareholders' equity                   |                                                                                                                                                                                                                                                                                                  | 93,625                                       |              |                                           |               
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              |                                           |               
|                                       |                                                                                                                                                                                                                                                                                                  | Total liabilities and
  shareholders' equity | $            | 1,114,488                                 |               
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              |                                           |               
|NET INTEREST INCOME / NET
  YIELD ON   |                                                                                                                                                                                                                                                                                                  |                                              |              |                                           |               
|                                       | INTEREST-EARNING ASSETS                                                                                                                                                                                                                                                                          |                                              |              |                                           | $  12,168     
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              |                                           |               
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              |                                           |               
|(1)                                    | Calculated including
  mortgage loans held for sale.  Nonaccrual loans are included in average
  balances for yield computations.  The effect of foregone
  interest income as a result of loans on nonaccrual was not considered in the
  above analysis.  All loans and deposits are domestic.
|(2)                                    | The average balances for
  investment securities include the unrealized gain or loss recorded for
  available for sale securities.                                                                                                                                                               |                                             

The following rate / volume analysis summarizes the dollar amount of changes in interest
income and interest expense attributable to changes in volume and the amount
attributable to changes in rate when comparing the three month period ended June 30, 2006 to the three
month period ended June 30, 2005 (in thousands).  The impact of the combination of rate and volume
change has been divided equally between the rate change and volume change.

43

---



For the three months ended June
  30, 2006 compared with the three months ended June 30, 2005Volume
  
  Rate
  
  TotalInterest-earnings
  assetsLoans,
  net of unearned
  $
  817
  
  2,199
  
  3,016Investment
  securities available for sale
  
  (181)
  
  91
  
  (90)Federal
  funds sold
  
  320
  
  34
  
  354FHLB
  stock
  
  429
  
  (437)
  
  (8)Total
  interest-earning assets
  $
  1,385
  
  1,887
  
  3,272Interest-bearing
  liabilitiesInterest-bearing
  deposits
  $
  529
  
  2,165
  
  2,694Retail
  repurchase agreements
  
  (15)
  
  82
  
  67Commercial
  paper
  
  12
  
  101
  
  113Federal
  funds purchased
  
  (576)
  
  548
  
  (28)FHLB
  borrowings
  
  (90)
  
  (98)
  
  (188)Total
  interest-bearing liabilities
  $
  (140)
  
  2,798
  
  2,658NET
  INTEREST INCOME
  $
  1,525
  
  (911)
  
  614


Provision for Loan LossesThe provision for loan losses
is a charge to net income in a given period in order to maintain the Allowance
at an adequate level defined by the Company's Allowance model.   The provision
for loan losses is adjusted each month to reflect loan growth and to allow for
loans charged‐offs, recoveries, and other factors that impact
management's assessment of the adequacy of the Allowance.  Management's
objective is to maintain the Allowance at an adequate level to cover probable
losses in the portfolio.  Additions to the Allowance are based on management's
evaluation of the loan portfolio under current economic conditions, past loan
loss experience, and such other factors that, in management's judgment, deserve
consideration in estimating loan losses. The provision for loan losses was $525
thousand and $600 thousand for the three month periods ended June 30, 2006 and
2005, respectively. The Allowance at June 30, 2006, December 31, 2005, and June
30, 2005 was $8.9 million, $8.4 million, and $8.1 million, respectively and
represented 1.00%, 0.97%, and 0.97% of loans less mortgage loans held for sale
and unearned at June 30, 2006, December 31, 2005, and June 30, 2005,
respectively.

The decline in the provision
for loan losses during the second quarter of 2006 when compared with the second
quarter of 2005 was impacted by several factors, including, but not limited to,
historical levels of loans charged-off, nonperforming assets, classified
assets, and loan portfolio growth as well as management's assessment of current
economic conditions.

Net loans charged-off improved slightly during the three month period ended June 30, 2006 when compared with the same period of 2005 from $387 thousand, or 0.19% of average loans excluding mortgage loans held for sale and unearned amounts to $373 thousand, or 0.17% of average loans excluding mortgage loans held for sale and unearned amounts.

As discussed in Financial
Condition, Loans, although classified assets increased from June 30,
2005 to June 30, 2006, management believes that the increase was attributed to
the isolated loan conditions discussed in Note 4 contained within Part I, Item 1 of this Quarterly
Report on Form 10-Q rather than credit
deterioration within the loan portfolio.  When considering key performance
indicators without these two loan relationships, the balances of classified
assets declined slightly from June 30, 2005 to June 30, 2006.  After adjusting
the June 30, 2006 results for these two loan relationships, classified assets
declined $4.1 million at June 30, 2006 from June 30, 2005.

Further impacting the decline
in the provision for loan losses from the three months ended June 30, 2005 to
the same period of 2006 was a decline in other nonperforming assets, comprised
of real estate and automobiles acquired in the settlement of loans, of $1.5
million to a balance of $1.0 million at June 30, 2006.

Offsetting these factors that
resulted in a reduction to net income in order to maintain the Allowance at an
adequate level was an increase in nonaccrual loans.  As discussed above, two
loan relationships, totaling $7.2 million, were placed in nonaccrual status and
classified during the fourth quarter of 2005.  Payment was received during the
first quarter of 2006 on one of these loans (balance of approximately $3.3
million at December 31, 2005) that warranted the removal of nonaccrual status
at that time. Additionally, current payments have been received since the loan
was brought current and removed from nonaccrual status. As such, at June 30,
2006 one of these loans remained in nonaccrual status (balance of approximately
$3.9 million at June 30, 2006). After taking into consideration this isolated
loan circumstance for which management believes that the collateral is adequate
to cover the Bank's exposure, the balance of nonaccrual loans has remained
relatively unchanged since June 30, 2005.

44

---



In addition to the increase
in nonaccrual loans from the three month period ended June 30, 2005 to the same
period of 2006, the increase of the total loan portfolio of $62.3 million when
comparing the same periods also offset the factors that resulted in a reduction
to net income in order to maintain the Allowance at an adequate level.

See Note 4 contained within Part I, Item 1 of this Quarterly
Report on Form 10-Q and Financial Condition, Loans and
Financial Condition, Allowance for Loan Losses all contained herein for a further discussion regarding the Company's factors
impacting the adequacy of the Company's Allowance.

Noninterest IncomeNoninterest
income for the three month period ended June 30, 2006 totaled $4.1 million, up
$63 thousand compared with the second quarter of 2005. The primary fluctuations
within noninterest income when comparing the three month period ended June 30,
2005 to the same period of 2006 included an increase in other noninterest
income of $123 thousand and a decline in mortgage-banking income of $199
thousand.

The
Company sells most of its residential mortgage loans it originates in the
secondary market with servicing rights retained. At June 30, 2006, the
mortgage-servicing right portfolio for loans sold had an aggregate principal
balance of $312.8 million compared with $294.1 million at June 30, 2005.
Mortgage-banking income decreased $199
thousand, or 42.0%, during the second quarter of 2006 over the same period of
2005.  The following table summarizes the components of mortgage-banking income
for the periods indicated (in thousands).

|                                                                    |                                 | For the three month  
|------------------------------------------------------------------- | ------------------------------- | ---------------------
|                                                                    |                                 | period ended June 30,
|                                                                    |                                 |                      
|Mortgage-servicing
  fees                                           | $                               | 192                  
|Gain
  on sale of loans                                             |                                 | 132                  
|Mortgage-serciving
  right amortization, impairment, and recoveries |                                 | (104)                
|Processing
  fees                                                   |                                 | 27                   
|Other
  mortgage-banking income                                     |                                 | 28                   
|                                                                    | Total
  mortgage-banking income | $                    
|                                                                    |                                 |                      

The
decrease in mortgage-banking income when comparing the three month period ended
June 30, 2006 to the same period of 2005 was primarily due to decreased sales
over the periods noted resulting in lower gains on sales of mortgage loans
offset by a decline in mortgage-servicing right amortization, impairment, and
recoveries and an increase in mortgage-servicing fees. Residential mortgage
loan originations during the three month period ended June 30, 2006 were offset
by maturities, prepayments, and loan sales.

During
June 2005, the Company securitized and sold approximately $10 million of its
residential mortgage loans from the Company's retained loan portfolio. The goal of this securitization was to provide
enhanced liquidity, to improve capital ratios, and to provide growth in
revenues from mortgage-servicing activities. In addition, the Company sold approximately $4 million of residential
mortgage loans during June 2005 from the loans receivable portfolio.  These
transactions contributed to increased gains on sale of loans during the three
month period ended June 30, 2005.  Offsetting this decline in gain on sale of
mortgage loans was a decline in the amortization, impairment, and recoveries
within the mortgage-servicing right portfolio.  As interest rates have continued
to rise during 2006, refinancing activity continues to slow.  As such, the
component of mortgage-servicing right amortization, impairment, and recoveries
relative to refinancing activity (prepayment speeds) has slowed as well.  Additionally, over the last
several years the Company was required to record reserves for impairment as
declining interest rates caused the estimated fair value of its
mortgage-servicing right portfolio to fall below recorded values. Recent
increases in market interest rates for mortgage loans resulted in increases in
the estimated fair value of the Company's mortgage-servicing right portfolio,
allowing the Company to recover a portion of previously recorded impairment
reserves through the mortgage-servicing right valuation allowance. The increase in mortgage-servicing fees during the
quarter ended June 30, 2006 compared with the same quarter of 2005 is the
result of an increase in mortgage loans serviced for others totaling $18.8
million between the periods noted as fees earned are directly correlated to the
portfolio serviced.



45

---



See Note 6 contained within Part I, Item 1 of this Quarterly
Report on Form 10-Q contained herein for a further discussion regarding the Company's
mortgage-servicing rights portfolio.

Other noninterest income
increased $123 thousand during the three month period ended June 30, 2006 over
the same period of 2005. This increase was the result of changes in several
accounts, none of which constituted material fluctuations.

Noninterest ExpenseNoninterest expense for the
three month period ended June 30, 2006 increased $554 thousand, or 5.7%, to
$10.2 million from $9.6 million during the three month period ended June 30,
2005. The primary contributors to this increase were increases in salaries and
other personnel and other noninterest expense.

Comprising
56.0% of noninterest expense during the three month period ended June 30, 2006
and 58.2% of noninterest expense during the three month period ended June 30,
2005, salaries and other personnel expense increased between the periods by
increased $101 thousand to $5.7 million from $5.6 million. The majority of the
increase in salaries and other personnel expense resulted from annual merit
raises for employees and officers as well as the addition of new officer positions
including those positions created with regard to the opening of the new Easley
banking office during the third quarter of 2005 and the preparation for the
opening of the Boiling Springs temporary office during the third quarter of
2006.  The Company
also continued to experience increasing medical insurance premiums during the
second quarter of 2006 compared with the same period of 2005 due to the
increasing number of employees as well as the increasing premiums.  Medical
insurance expense increased $88 thousand over these periods. Full time
equivalent employees increased from 375 at June 30, 2005 to 399 at June 30,
2006.

Other noninterest expense
increased $223 thousand during the three month period ended June 30, 2006 over
the same period of 2005. This increase was the result of changes in several
accounts, none of which constituted material fluctuations.

Provision for Income TaxesIncome tax expense totaled
$1.8 million for the three month period ended June 30, 2006, compared with $1.8
million for the three month period ended June 30, 2005.  The Company's
effective tax rate was 32.6% and 33.5%, respectively, during the two periods
based on timing differences.





46

---





YEAR-TO-DATE HIGHLIGHTS

|(dollars
  in thousands, except common and per share data)                                                                      |                                                       |                          |        |           |       
|------------------------------------------------------------------------------------------------------------------------------- | ----------------------------------------------------- | ------------------------ | ------ | --------- | ------
|                                                                                                                                |                                                       | At and for the six month |        |           |       
|                                                                                                                                |                                                       | period ended June 30,    |        |           |       
|                                                                                                                                |                                                       |                          | 2006   |           | 2005  
|                                                                                                                                |                                                       | (unaudited)              |        |           |       
|                                                                                                                                |                                                       |                          |        |           |       
|SUMMARY
  OF OPERATIONS                                                                                                         |                                                       |                          |        |           |       
|Interest
  income                                                                                                               | $                                                     | 36,717                   |        | 29,786    |       
|Interest
  expense                                                                                                              |                                                       | 12,454                   |        | 7,419     |       
|                                                                                                                                | Net
  interest income                                 |                          | 24,263 |           | 22,367
|Provision
  for loan losses                                                                                                     |                                                       | 1,050                    |        | 1,200     |       
|                                                                                                                                | Net
  interest income after provision for loan losses |                          | 23,213 |           | 21,167
|Noninterest
  income                                                                                                            |                                                       | 8,062                    |        | 7,781     |       
|Noninterest
  expense                                                                                                           |                                                       | 20,334                   |        | 18,485    |       
|                                                                                                                                | Income
  before provision for income taxes            |                          | 10,941 |           | 10,463
|Provision
  for income taxes                                                                                                    |                                                       | 3,560                    |        | 3,505     |       
|                                                                                                                                | Net income                                            | $                        | 7,381  |           | 6,958 
|                                                                                                                                |                                                       |                          |        |           |       
|COMMON
  SHARE DATA                                                                                                             |                                                       |                          |        |           |       
|Net
  income:                                                                                                                   |                                                       |                          |        |           |       
|                                                                                                                                | Basic                                                 | $                        | 1.16   |           | 1.10  
|                                                                                                                                | Diluted                                               |                          | 1.15   |           | 1.08  
|Cash
  dividends                                                                                                                |                                                       | 0.36                     |        | 0.32      |       
|Book
  value                                                                                                                    |                                                       | 14.73                    |        | 13.49     |       
|Outstanding
  shares                                                                                                            |                                                       | 6,356,635                |        | 6,317,285 |       
|Weighted
  average outstanding - basic                                                                                          |                                                       | 6,349,099                |        | 6,311,798 |       
|Weighted
  average outstanding - diluted                                                                                        |                                                       | 6,423,970                |        | 6,418,417 |       
|Dividend
  payout ratio                                                                                                         |                                                       | 30.99                    | %      | 29.04     |       
|                                                                                                                                |                                                       |                          |        |           |       
|PERIOD-END
  BALANCES                                                                                                           |                                                       |                          |        |           |       
|Assets                                                                                                                          | $                                                     | 1,116,073                |        | 1,052,002 |       
|Investment
  securities available for sale, at fair market value                                                                |                                                       | 115,440                  |        | 134,121   |       
|Loans
  (1)                                                                                                                     |                                                       | 892,364                  |        | 831,691   |       
|Deposits
  and other borrowings                                                                                                 |                                                       | 1,016,342                |        | 961,962   |       
|Shareholders'
  equity                                                                                                          |                                                       | 93,626                   |        | 85,214    |       
|                                                                                                                                |                                                       |                          |        |           |       
|AVERAGE
  BALANCES                                                                                                              |                                                       |                          |        |           |       
|Assets                                                                                                                          | $                                                     | 1,100,971                |        | 1,026,715 |       
|Interest-earning
  assets                                                                                                       |                                                       | 1,025,236                |        | 961,138   |       
|Investment
  securities available for sale, at fair market value                                                                |                                                       | 123,472                  |        | 139,975   |       
|Loans
  (1)                                                                                                                     |                                                       | 874,118                  |        | 812,163   |       
|Deposits
  and other borrowings                                                                                                 |                                                       | 869,382                  |        | 811,051   |       
|Shareholders'
  equity                                                                                                          |                                                       | 92,439                   |        | 83,502    |       
|                                                                                                                                |                                                       |                          |        |           |       
|SIGNIFICANT
  OPERATING RATIOS BASED ON EARNINGS                                                                                |                                                       |                          |        |           |       
|Return
  on average assets                                                                                                      |                                                       | 1.35                     | %      | 1.37      |       
|Return
  on average shareholders' equity                                                                                        |                                                       | 16.10                    |        | 16.80     |       
|Net
  interest margin                                                                                                           |                                                       | 4.77                     |        | 4.69      |       
|                                                                                                                                |                                                       |                          |        |           |       
|(1)
  Calculated using loans including mortgage loans held for sale, net of
  unearned, excluding the allowance for loan losses |                                                      
|                                                                                                                                |                                                       |                          |        |           |       

47

---



YEAR-TO-DATE NET INCOME
REVIEW

The following information is intended to supplement any
information relating to the Consolidated Statements of Income contained within
Part I, Item 1 of this Quarterly Report on Form 10-Q.

Overview

|PALMETTO BANCSHARES, INC. AND SUBSIDIARY                   |                                                       
|---------------------------------------------------------- | ------------------------------------------------------
|Consolidated Statements of
  Income                        |                                                       
|(dollars in thousands, except
  common and per share data) |                                                       
|                                                           |                                                       
|                                                           |                                                       
|                                                           |                                                       
|                                                           |                                                       
|                                                           |                                                       
|Interest
  income                                          |                                                       
|                                                           | Interest
  and fees on loans                          
|                                                           | Interest
  on investment securities available for sale
|                                                           | Interest
  on federal funds sold                      
|                                                           | Dividends
  on FHLB stock                             
|                                                           |                                                       
|                                                           |                                                       
|Interest
  expense                                         |                                                       
|                                                           | Interest
  on deposits                                
|                                                           | Interest
  on retail repurchase agreements            
|                                                           | Interest
  on commercial paper                        
|                                                           | Interest
  on federal funds purchased                 
|                                                           | Interest
  on FHLB borrowings                         
|                                                           |                                                       
|                                                           |                                                       
|                                                           |                                                       
|                                                           |                                                       
|Provision
  for loan losses                                |                                                       
|                                                           |                                                       
|                                                           |                                                       
|                                                           |                                                       
|Noninterest
  income                                       |                                                       
|                                                           | Service
  charges on deposit accounts                 
|                                                           | Fees
  for trust and brokerage services               
|                                                           | Mortgage-banking
  income                             
|                                                           | Investment
  securities gains                         
|                                                           | Other                                                 
|                                                           |                                                       
|                                                           |                                                       
|Noninterest
  expense                                      |                                                       
|                                                           | Salaries
  and other personnel                        
|                                                           | Net
  occupancy                                       
|                                                           | Furniture
  and equipment                             
|                                                           | Marketing
  and advertising                           
|                                                           | Postage
  and supplies                                
|                                                           | Telephone                                             
|                                                           | Professional
  services                               
|                                                           | Other                                                 
|                                                           |                                                       
|                                                           |                                                       
|                                                           |                                                       
|                                                           |                                                       
|Provision
  for income taxes                               |                                                       
|                                                           |                                                       
|                                                           |                                                       
|                                                           |                                                       
|Common
  Share Data                                        |                                                       
|                                                           | Net
  Income - basic                                  
|                                                           | Net
  Income - diluted                                
|                                                           | Cash
  dividends                                      
|                                                           | Book
  value                                          
|                                                           |                                                       
|                                                           | Weighted
  average common shares outstanding - basic  
|                                                           | Weighted
  average common shares outstanding - diluted
|                                                           |                                                       

Net Interest IncomeNet interest income for the
six month period ended June 30, 2006 increased $1.9 million, or 8.5%, to $24.3
million from $22.4 million for the six month period ended June 30, 2005. During
the first six months of 2006, the Company experienced increases in average
yields on interest-earning assets consistent with the increase in the average
cost of interest-bearing liabilities. The average yield on interest-earning
assets increased 97 basis points to 7.22% during the six month period ended
June 30, 2006 from 6.25% during the six month period ended June 30, 2005. The
average cost of interest-bearing liabilities increased 105 basis points to
2.89% during the six month period ended June 30, 2006 from 1.84% during the six
month period ended June 30, 2005. Net interest income for the six month period
ended June 30, 2006 was 24.3 million, and the net yield on interest-earning
assets was 4.77%. Average interest-earning assets increased $64.1 million over
the same periods, while interest-bearing liabilities increased $58.3 million.
The primary reason for the increase in the yields earned and paid on
interest-earnings assets and interest-bearing liabilities, respectively, has
been the action of the Federal Reserve Open Market Committee. Since the second
quarter of 2004, the federal funds rate has increased from 1.0% to 5.25% in a
series of seventeen moves.

48

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The following table
summarizes the Company's average balance sheets and net interest income
analysis for the periods indicated (dollars in thousands). The Company's yield
on interest-earning assets and cost of interest-bearing liabilities shown in
the table are derived by dividing interest income and expense by the average
balances of interest-earning assets or interest-bearing liabilities.

|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              | For the six month period ended June 30, |               
|-------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | -------------------------------------------- | ------------ | --------------------------------------- | --------------
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              | 2006                                    |               
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              |                                         | Average       
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              |                                         | Balance       
|ASSETS                                 |                                                                                                                                                                                                                                                                                                  |                                              |              |                                         |               
|Interest-earnings assets               |                                                                                                                                                                                                                                                                                                  |                                              |              |                                         |               
|                                       | Loans, net of unearned (1)                                                                                                                                                                                                                                                                       | $                                            | 874,118      |                                         | $       33,568
|                                       | Investment securities
  available for sale, nontaxable (2)                                                                                                                                                                                                                                       |                                              | 54,979       |                                         | 993           
|                                       | Investment securities
  available for sale, taxable (2)                                                                                                                                                                                                                                          |                                              | 68,493       |                                         | 1,471         
|                                       | Federal funds sold                                                                                                                                                                                                                                                                               |                                              | 24,377       |                                         | 586           
|                                       | FHLB stock                                                                                                                                                                                                                                                                                       |                                              | 3,269        |                                         | 99            
|                                       |                                                                                                                                                                                                                                                                                                  | Total interest-earning
  assets              |              | 1,025,236                               |               
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              |                                         |               
|Noninterest-earning assets             |                                                                                                                                                                                                                                                                                                  |                                              |              |                                         |               
|                                       | Cash and due from banks                                                                                                                                                                                                                                                                          |                                              | 39,463       |                                         |               
|                                       | Allowance for loan losses                                                                                                                                                                                                                                                                        |                                              | (8,638)      |                                         |               
|                                       | Premises and equipment, net                                                                                                                                                                                                                                                                      |                                              | 23,255       |                                         |               
|                                       | Accrued interest receivable                                                                                                                                                                                                                                                                      |                                              | 5,078        |                                         |               
|                                       | Goodwill                                                                                                                                                                                                                                                                                         |                                              | 3,688        |                                         |               
|                                       | Other intangible assets                                                                                                                                                                                                                                                                          |                                              | 163          |                                         |               
|                                       | Other                                                                                                                                                                                                                                                                                            |                                              | 12,726       |                                         |               
|                                       |                                                                                                                                                                                                                                                                                                  | Total noninterest-earning
  assets           |              | 75,735                                  |               
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              |                                         |               
|                                       |                                                                                                                                                                                                                                                                                                  |                                              | Total assets | $                                       | 1,100,971     
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              |                                         |               
|LIABILITIES AND
  SHAREHOLDERS' EQUITY |                                                                                                                                                                                                                                                                                                  |                                              |              |                                         |               
|Liabilities                            |                                                                                                                                                                                                                                                                                                  |                                              |              |                                         |               
|Interest-bearing liabilities           |                                                                                                                                                                                                                                                                                                  |                                              |              |                                         |               
|                                       | Transaction and money market
  deposit accounts                                                                                                                                                                                                                                                  | $                                            | 365,361      |                                         | $      3,745  
|                                       | Savings deposit accounts                                                                                                                                                                                                                                                                         |                                              | 46,138       |                                         | 73            
|                                       | Time deposit accounts                                                                                                                                                                                                                                                                            |                                              | 394,822      |                                         | 7,445         
|                                       |                                                                                                                                                                                                                                                                                                  | Total interest-bearing
  deposits            |              | 806,321                                 |               
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              |                                         |               
|                                       | Retail repurchase agreements                                                                                                                                                                                                                                                                     |                                              | 18,204       |                                         | 351           
|                                       | Commercial paper                                                                                                                                                                                                                                                                                 |                                              | 18,221       |                                         | 344           
|                                       | Federal funds purchased                                                                                                                                                                                                                                                                          |                                              | 541          |                                         | 14            
|                                       | FHLB borrowings                                                                                                                                                                                                                                                                                  |                                              | 26,095       |                                         | 482           
|                                       |                                                                                                                                                                                                                                                                                                  | Total interest-bearing
  liabilities         |              | 869,382                                 |               
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              |                                         |               
|Noninterest-bearing
  liabilities      |                                                                                                                                                                                                                                                                                                  |                                              |              |                                         |               
|                                       | Noninterest-bearing deposits                                                                                                                                                                                                                                                                     |                                              | 132,898      |                                         |               
|                                       | Other noninterest-bearing
  liabilities                                                                                                                                                                                                                                                          |                                              | 6,252        |                                         |               
|                                       |                                                                                                                                                                                                                                                                                                  | Total noninterest-bearing
  liabilities      |              | 139,150                                 |               
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              |                                         |               
|                                       |                                                                                                                                                                                                                                                                                                  | Total liabilities                            |              | 1,008,532                               |               
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              |                                         |               
|Shareholders' equity                   |                                                                                                                                                                                                                                                                                                  | 92,439                                       |              |                                         |               
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              |                                         |               
|                                       |                                                                                                                                                                                                                                                                                                  | Total liabilities and
  shareholders' equity | $            | 1,100,971                               |               
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              |                                         |               
|NET INTEREST INCOME / NET
  YIELD ON   |                                                                                                                                                                                                                                                                                                  |                                              |              |                                         |               
|                                       | INTEREST-EARNING ASSETS                                                                                                                                                                                                                                                                          |                                              |              | $                                       | 24,263        
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              |                                         |               
|                                       |                                                                                                                                                                                                                                                                                                  |                                              |              |                                         |               
|(1)                                    | Calculated including
  mortgage loans held for sale.  Nonaccrual loans are included in average
  balances for yield computations.  The effect of foregone
  interest income as a result of loans on nonaccrual was not considered in the
  above analysis.  All loans and deposits are domestic.
|(2)                                    | The average balances for
  investment securities include the unrealized gain or loss recorded for
  available for sale securities.                                                                                                                                                               |                                             

The following rate / volume analysis summarizes the dollar amount of changes in interest
income and interest expense attributable to changes in volume and the amount
attributable to changes in rate when comparing the six month period ended June 30, 2006 to the six month
period ended June 30, 2005 (in thousands).  The
impact of the combination of rate and volume change has been divided equally
between the rate change and volume change.

49

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|                               |                                            |                                      | For the six months ended June
  30, 2006 compared with the six months ended June 30, 2005
|------------------------------ | ------------------------------------------ | ------------------------------------ | -----------------------------------------------------------------------------------------
|                               |                                            |                                      |                                                                                          
|Interest-earnings
  assets     |                                            |                                      |                                                                                          
|                               | Loans,
  net of unearned                   | $                                    | 2,164                                                                                    
|                               | Investment
  securities available for sale |                                      | (347)                                                                                    
|                               | Federal
  funds sold                       |                                      | 455                                                                                      
|                               | FHLB
  stock                               |                                      | (9)                                                                                      
|                               |                                            | Total
  interest-earning assets      | $                                                                                        
|                               |                                            |                                      |                                                                                          
|Interest-bearing
  liabilities |                                            |                                      |                                                                                          
|                               | Interest-bearing
  deposits                | $                                    | 946                                                                                      
|                               | Retail
  repurchase agreements             |                                      | (23)                                                                                     
|                               | Commercial
  paper                         |                                      | 5                                                                                        
|                               | Federal
  funds purchased                  |                                      | 432                                                                                      
|                               | FHLB
  borrowings                          |                                      | (90)                                                                                     
|                               |                                            | Total
  interest-bearing liabilities | $                                                                                        
|                               |                                            |                                      |                                                                                          
|                               |                                            | NET
  INTEREST INCOME                | $                                                                                        
|                               |                                            |                                      |                                                                                          

Provision for Loan LossesThe provision for loan losses
was $1.1 million and $1.2 million for the six month periods ended June 30, 2006
and 2005, respectively.

The decline in the provision
for loan losses during the first six months of 2006 when compared with the same
period of 2005 was impacted by the same factors impacting the second quarter of
2006 when compared with the second quarter of 2005 with the exception of net
loans charged-off.

Net loans charged-off improved during the six month period ended June 30, 2006 when compared with the same period of 2005 to $602 thousand, or 0.14% of average loans excluding mortgage loans held for sale and unearned amounts from $768 thousand, or 0.19% of average loans excluding mortgage loans held for sale and unearned amounts.

See Note 4 contained within Part I, Item 1 of this Quarterly
Report on Form 10-Q and Financial Condition, Loans and
Financial Condition, Allowance for Loan Losses all contained herein for a further discussion regarding the Company's factors
impacting the adequacy of the Company's Allowance.

Noninterest IncomeNoninterest
income for the six month period ended June 30, 2006 totaled $8.1 million, up
$280 thousand compared with the same period of 2005. The primary fluctuations
within noninterest income when comparing the six month period ended June 30,
2005 to the same period of 2006 included increases in service charges on
deposit accounts of $266 thousand and other noninterest income of $263 thousand
offset by a decline in mortgage-banking income of $259 thousand.

Service charges on deposit
accounts comprise a significant component of noninterest income and comprised
50.9% of noninterest income during the six months ended June 30, 2006 compared
with 49.3% of noninterest income for the same period of 2005. Service charges
on deposit accounts increased $266 thousand, or 6.9% when comparing the same
periods. Management believes that the increase in service charges on deposit
accounts is due, in part, to the increase in core traditional deposit accounts
when comparing the six months ended June 30, 2005 to the same period of 2006.

Mortgage-banking
income decreased $259 thousand, or 34.3%, during the six month period ended
June 30,2006 with the same period of 2005.  The following table summarizes the
components of mortgage-banking income for the periods indicated (in thousands).

50

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|                                                                    |                                 | For the six month    
|------------------------------------------------------------------- | ------------------------------- | ---------------------
|                                                                    |                                 | period ended June 30,
|                                                                    |                                 |                      
|Mortgage-servicing
  fees                                           | $                               | 387                  
|Gain
  on sale of loans                                             |                                 | 290                  
|Mortgage-serciving
  right amortization, impairment, and recoveries |                                 | (272)                
|Processing
  fees                                                   |                                 | 42                   
|Other
  mortgage-banking income                                     |                                 | 50                   
|                                                                    | Total
  mortgage-banking income | $                    
|                                                                    |                                 |                      

The
decrease in mortgage-banking income when comparing the six month period ended
June 30, 2006 to the same period of 2005 was primarily due to decreased sales
over the periods noted resulting in lower gains on sales of mortgage loans
offset by a decline in mortgage-servicing right amortization, impairment, and
recoveries and an increase in mortgage-servicing fees. Residential mortgage
loan originations during the six month period ended June 30, 2006 were offset
by maturities, prepayments, and loan sales.

See Consolidated Statements
of Cash Flows contained within Part I, Item 1 of this Quarterly Report on Form 10-Q for a further discussion of how such activities
impacted mortgage-banking income during the six month periods ended June 30,
2006 and 2005.

During
June 2005, the Company securitized and sold approximately $10 million of its
residential mortgage loans from the Company's retained loan portfolio. The goal of this securitization was to provide
enhanced liquidity, to improve capital ratios, and to provide growth in
revenues from mortgage-servicing activities. In addition, the Company sold approximately $4 million of residential
mortgage loans during June 2005 from the loans receivable portfolio.  These
transactions contributed to increased gains on sale of loans during the six
month period ended June 30, 2005.  Offsetting this decline in gain on sale of
mortgage loans was a decline in the amortization, impairment, and recoveries
within the mortgage-servicing right portfolio.  As interest rates have
continued to rise during 2006, refinancing activity continues to slow.  As
such, the component of mortgage-servicing right amortization, impairment, and
recoveries relative to refinancing activity (prepayment speeds) has slowed as
well. Additionally,
over the last several years the Company was required to record reserves for
impairment as declining interest rates caused the estimated fair value of its
mortgage-servicing right portfolio to fall below recorded values. Recent
increases in market interest rates for mortgage loans resulted in increases in
the estimated fair value of the Company's mortgage-servicing right portfolio,
allowing the Company to recover a portion of previously recorded impairment
reserves through the mortgage-servicing right valuation allowance. The increase in mortgage-servicing fees during the six
month period ended June 30, 2006 compared with the same period of 2005 is the
result of an increase in mortgage loans serviced for others totaling $18.8
million between the periods noted as fees earned are directly correlated to the
portfolio serviced.

See Note 6 contained within Part I, Item 1 of this Quarterly
Report on Form 10-Q contained herein for a further discussion regarding the Company's
mortgage-servicing rights portfolio.

Other noninterest income
increased $263 thousand during the six month period ended June 30, 2006 over
the same period of 2005. This increase was the result of changes in several
accounts, none of which constituted material fluctuations.

Noninterest ExpenseNoninterest expense for the
six month period ended June 30, 2006 increased $1.8 million, or 10.0%, to $20.3
million from $18.5 million during the six month period ended June 30, 2005. The
primary contributors to this increase were increases in salaries and other
personnel and marketing and advertising expense.

Comprising
56.5% of noninterest expense during the six month period ended June 30, 2006
and 57.2% of noninterest expense during the six month period ended June 30,
2005, salaries and other personnel expense increased between the periods by
increased $912 thousand to $20.3 million from $18.5 million. The majority of
the increase in salaries and other personnel expense resulted from annual merit
raises for employees and officers as well as the addition of new officer
positions including those positions created with regard to the opening of the
new Easley banking office during the third quarter of 2005 and the preparation
for the opening of the Boiling Springs temporary office during the third
quarter of 2006.  The
Company also continued to experience increasing medical insurance premiums
during the first six months of 2006 compared with the same period of 2005 due
to the increasing number of employees as well as the increasing premiums. 
Medical insurance expense increased $158 thousand over these periods. Full time
equivalent employees increased from 375 at June 30, 2005 to 399 at June 30,
2006.

51

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Marketing and advertising
expense increased $273 thousand during the first six months of 2006 compared
with the same period of 2005.  Impacting this increase were costs associated
with the Company's additional marketing efforts directed toward the
reintroduction of several existing deposit products. Additionally, expenses
were incurred during the first six months of 2006, and will continue to be
incurred throughout 2006, in conjunction with the Company's 100-year
anniversary celebration.

Provision for Income TaxesIncome tax expense totaled
$3.6 million for the six month period ended June 30, 2006, compared with $3.5
million for the six month period ended June 30, 2005.  The Company's effective
tax rate was 32.5% and 33.5%, respectively, during the two periods based on
timing differences.

ACCOUNTING AND REPORTING MATTERS

See Note 1 contained within Part I, Item 1 of this Quarterly
Report on Form 10-Q for a discussion of
recently issued accounting pronouncements and those adopted by the Company.

52

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Item 3.  Quantitative and
Qualitative Disclosures about Market Risk

See Disclosures Regarding
Market Risk contained within Part I, Item 2 of this Quarterly Report on Form 10-Q
for a discussion of
the information required by this item.

Item 4.  Controls and
Procedures

Our
management, Chairman and Chief Executive Officer and President and Chief
Operating Officer, has evaluated the effectiveness of the design and operation
of our disclosure controls
and procedures and the design and operation of our system of internal controls over
financial reporting as of June 30, 2006.

Evaluation
of Disclosure Controls and ProceduresAn
evaluation of the Company's disclosure controls and procedures (as defined in
Rule 13a-15(e) and Rule 15d-15(e) under the Securities Exchange Act of 1934)
was carried out under the supervision and with the participation of the
Company's Chairman and Chief Executive Officer and the Company's President and
Chief Operating Officer (Chief Accounting Officer) as of the end of the period
covered by this Quarterly Report (the "Evaluation Date"). The Company's
Chairman and Chief Executive Officer and the Company's President and Chief
Operating Officer (Chief Accounting Officer) concluded as of the Evaluation
Date that disclosure controls and procedures were effective in providing
reasonable assurance that the information required to be disclosed by the
Company in the reports it files or submits under the Securities Exchange Act of
1934 is (i) accumulated and communicated to management (including the Company's
Chairman and Chief Executive Officer and the Company's President and Chief Operating
Officer (Chief Accounting Officer)) in a timely manner, and (ii) recorded,
processed, summarized and reported within the time periods specified in the
Securities and Exchange Commission's rules and forms.

Changes
in Internal ControlsDuring the second quarter of 2006, the Company did not make any change in its internal
control over financial reporting or other factors that has materially affected,
or is reasonably likely to materially affect, its internal control over
financial reporting.

53

---





PART
II.  OTHER INFORMATION

Item 1.  Legal Proceedings

See Note 14 contained within Part I,
Item 1 of this Quarterly Report on Form 10-Q for a discussion of the information required by this item.

Item 1a. Risk Factors

There have been no material
changes from the risk factors previously disclosed in Item 1a to Part I of the
Company's Annual Report on Form 10-K for the year ended December 31, 2005.

Item 2. 
Unregistered Sales of Equity Securities and Use of Proceeds

None

Item 3. 
Defaults Upon Senior Securities

None

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

The Company's Annual
Shareholders' Meeting was held on April 18, 2006, and there were 5,375,559
shares present in person or by proxy of the 6,350,635 shares of common stock entitled
to vote at the Annual Shareholders' Meeting.

Proposal #1 - Election of
Directors.  At the meeting the following directors were elected for three year
terms ending in 2009:

|                     | Number of Votes For | Number of Votes Withheld
|-------------------- | ------------------- | ------------------------
|L. Leon Patterson    | 5,375,559           | --                      
|Sam B. Phillips, Jr. | 5,375,559           | --                      
|J. David Wasson, Jr. | 5,375,559           | --                      

On March 26, 2005, Director William S. Moore passed
away after a short illness. Mr. Moore would have been eligible for reelection
at the 2006 Annual Shareholders'
Meeting.  The resulting
vacancy will be filled in accordance with the Company's Bylaws and Articles of
Incorporation.

The
following directors' term of office continued after the meeting: W. Fred Davis, Jr., David P.
George, Jr., Michael D. Glenn, John T. Gramling, II, John D. Hopkins, Jr., E.
Keith Snead, III, Ann B. Smith, and Paul
W. Stringer.

Item 5.  Other Information

None.

Item 6.  Exhibits

31.1         L. Leon Patterson's Certification
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2         Paul W. Stringer's Certification Pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002

32            Certifications Pursuant to Section
906 of the Sarbanes-Oxley Act of 2002

The exhibits noted above have been filed with the
Securities and Exchange Commission in conjunction with this Quarterly Report on
Form 10-Q. Copies of these exhibits are available upon written request
to Lauren S. Greer, The Palmetto Bank, Post Office Box 49, Laurens, South
Carolina 29360.

54

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SIGNATURES

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



PALMETTO BANCSHARES, INC.





/s/      L. Leon PattersonL. Leon Patterson
 Chairman and Chief Executive Officer



/s/      Paul W. StringerPaul W. Stringer
 President and Chief Operating Officer
 (Chief Accounting Officer)

Dated:  
August 9, 2006







55