U. S.
		SECURITIES AND EXCHANGE COMMISSION
		WASHINGTON, D.C. 20549

FORM 10-Q



|(X)                                                 | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
				OF SECURITIES EXCHANGE ACT OF 1934     
|--------------------------------------------------- | --------------------------------------------------------------------------------------------
|                                                    |                                                                                             
|For the
		quarterly period ended September 30, 2006
|                                                   
|OR                                                 
|                                                   
|(  )                                                | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
				SECURITIES EXCHANGE ACT OF 1934

For the
		transition period from __________ to __________

Commission
		file number  0-26016

PALMETTO
		BANCSHARES, INC.(Exact name
		of registrant as specified in its charter)

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




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.

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



Class
		 -----------------------------
		Common stock,
		$5.00 par value
			Outstanding
		at October 31, 2006
		 -------------------------------
		6,356,785




---



PALMETTO
		BANCSHARES, INC. AND SUBSIDIARYTable of
		ContentsPART I.  FINANCIAL INFORMATIONItem 1.
		Financial StatementsItem 2.
		Management's Discussion and Analysis of Financial
		Condition and Results of OperationsItem 3.
		Quantitative and Qualitative Disclosures about Market
		RiskItem 4.
		Controls and ProceduresPART II.  OTHER INFORMATIONItem 1.
		Legal ProceedingsItem 1a.
		Risk FactorsItem 2.
		Unregistered Sales of Equity Securities and Use of
		ProceedsItem 3.
		Defaults Upon Senior SecuritiesItem 4.
		Submission of Matters to a Vote of Security HoldersItem 5.
		Other InformationItem 6.
		ExhibitsSIGNATURES


1

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PALMETTO BANCSHARES, INC. AND SUBSIDIARYConsolidated Balance Sheets(dollars
		in thousands, except common and per share data)September
		30,
		
		December 31,2006
		
		2005(unaudited)ASSETSCash and cash equivalentsCash and due from
		banks
		$
		33,876
		
		36,978Federal funds sold
		6,662
		
		998Total cash and cash
		equivalents
		40,538
		
		37,976Federal Home Loan Bank
		("FHLB") stock, at cost
		2,599
		
		3,786Investment securities
		available for sale, at fair market value
		119,538
		
		125,988Mortgage loans held for sale
		1,334
		
		4,821Loans
		
		
		930,205
		
		866,181Less: allowance for
		loan losses
		(8,724)
		
		(8,431)Loans, net
		921,481
		
		857,750Premises and equipment, net
		24,331
		
		22,676Goodwill
		
		
		3,691
		
		3,691Other intangible assets
		139
		
		175Accrued interest receivable
		6,127
		
		5,226Other
		
		
		12,954
		
		12,926Total assets
		$
		1,132,732
		
		1,075,015LIABILITIES AND
		SHAREHOLDERS' EQUITYLiabilitiesDepositsNoninterest-bearing
		$
		146,081
		
		131,157Interest-bearing
		833,576
		
		772,226Total deposits
		979,657
		
		903,383Retail repurchase agreements
		17,468
		
		16,728Commercial paper (Master notes)
		21,887
		
		17,915Federal funds purchased
		-
		
		1,000FHLB borrowings - short-term
		-
		
		16,900FHLB borrowings - long-term
		10,000
		
		23,000Accrued interest payable
		1,514
		
		1,275Other
		
		
		5,019
		
		5,873Total liabilities
		1,035,545
		
		986,074Commitments and
		contingencies (Note 14)Shareholders' EquityCommon stock - par value
		$5.00 per share;  authorized 10,000,000shares; issued and
		outstanding 6,356,785 and 6,331,335at September 30,
		2006 and December 31, 2005, respectively
		31,784
		
		31,656Capital surplus
		
		986
		
		659Retained earnings
		65,283
		
		57,532Accumulated other
		comprehensive loss, net of tax
		(866)
		
		(906)Total shareholders' equity
		97,187
		
		88,941Total liabilities and
		shareholders' equity
		$
		1,132,732
		
		1,075,015


See Notes to
		Consolidated Interim Financial Statements.

2

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PALMETTO BANCSHARES, INC. AND SUBSIDIARYConsolidated Statements of Income(dollars
		in thousands, except common and per share data)For the
		three month periods ended September 30,2006
		
		2005Interest incomeInterest and fees
		on loans
		$
		18,033
		
		14,946Interest on investment
		securities available for sale:U.S. Government
		agencies (taxable)
		458
		
		231State and municipal
		(nontaxable)
		512
		
		549Mortgage-backed securities
		(taxable)
		212
		
		391Interest on federal
		funds sold
		317
		
		84Dividends on FHLB
		stock
		45
		
		54Total interest
		income
		19,577
		
		16,255Interest expenseInterest on
		deposits
		6,680
		
		3,815Interest on retail
		repurchase agreements
		213
		
		138Interest on
		commercial paper
		247
		
		129Interest on federal
		funds purchased
		6
		
		13Interest on FHLB
		borrowings - short-term
		-
		
		490Interest on FHLB
		borrowings - long-term
		96
		
		204Total interest
		expense
		7,242
		
		4,789Net interest income
		12,335
		
		11,466Provision for loan
		losses
		275
		
		600Net interest income
		after provision for loan losses
		12,060
		
		10,866Noninterest incomeService charges on
		deposit accounts
		2,228
		
		2,148Fees for trust and
		brokerage services
		817
		
		612Mortgage-banking
		income
		182
		
		287Investment
		securities gains
		-
		
		12Other
		
		
		909
		
		865Total noninterest
		income
		4,136
		
		3,924Noninterest expenseSalaries and other
		personnel
		5,772
		
		5,740Net occupancy
		
		733
		
		659Furniture and
		equipment
		986
		
		890Marketing and
		advertising
		488
		
		328Postage and
		supplies
		350
		
		295Telephone
		
		
		180
		
		181Professional
		services
		210
		
		218Other
		
		
		1,638
		
		1,483Total noninterest
		expense
		10,357
		
		9,794Net income before
		provision for income taxes
		5,839
		
		4,996Provision for
		income taxes
		2,038
		
		1,673Net income
		$
		3,801
		
		3,323Common Share DataNet income - basic
		$
		0.60
		
		0.53Net income -
		diluted
		0.59
		
		0.52Cash dividends
		
		0.18
		
		0.16Book value
		
		15.29
		
		13.81Weighted average common
		shares outstanding - basic
		6,356,656
		
		6,319,613Weighted average common
		shares outstanding - diluted
		6,432,546
		
		6,421,407


See Notes to
		Consolidated Interim Financial Statements.

3

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PALMETTO BANCSHARES, INC. AND SUBSIDIARYConsolidated Statements of Income(dollars
		in thousands, except common and per share data)For the
		nine month periods ended September 30,2006
		
		2005Interest incomeInterest and fees
		on loans
		$
		51,601
		
		41,936Interest on investment
		securities available for sale:U.S. Government
		agencies (taxable)
		1,497
		
		482State and municipal
		(nontaxable)
		1,505
		
		1,739Mortgage-backed securities
		(taxable)
		644
		
		1,589Interest on federal
		funds sold
		903
		
		149Dividends on FHLB
		stock
		144
		
		146Total interest
		income
		56,294
		
		46,041Interest expenseInterest on
		deposits
		17,943
		
		10,152Interest on retail
		repurchase agreements
		564
		
		334Interest on
		commercial paper
		591
		
		288Interest on federal
		funds purchased
		20
		
		78Interest on FHLB
		borrowings - short-term
		99
		
		676Interest on FHLB
		borrowings - long-term
		479
		
		680Total interest
		expense
		19,696
		
		12,208Net interest income
		36,598
		
		33,833Provision for loan
		losses
		1,325
		
		1,800Net interest income
		after provision for loan losses
		35,273
		
		32,033Noninterest incomeService charges on
		deposit accounts
		6,333
		
		5,987Fees for trust and
		brokerage services
		2,445
		
		2,163Mortgage-banking
		income
		679
		
		1,043Investment
		securities gains
		3
		
		81Other
		
		
		2,738
		
		2,431Total noninterest
		income
		12,198
		
		11,705Noninterest expenseSalaries and other
		personnel
		17,256
		
		16,312Net occupancy
		
		2,124
		
		1,918Furniture and
		equipment
		2,952
		
		2,695Marketing and
		advertising
		1,284
		
		851Postage and
		supplies
		1,086
		
		927Telephone
		
		
		575
		
		547Professional
		services
		690
		
		618Other
		
		
		4,724
		
		4,411Total noninterest
		expense
		30,691
		
		28,279Net income before
		provision for income taxes
		16,780
		
		15,459Provision for
		income taxes
		5,598
		
		5,178Net income
		$
		11,182
		
		10,281Common Share DataNet income - basic
		$
		1.76
		
		1.63Net income -
		diluted
		1.74
		
		1.60Cash dividends
		
		0.54
		
		0.48Book value
		
		15.29
		
		13.81Weighted average common
		shares outstanding - basic
		6,351,646
		
		6,314,431Weighted average common
		shares outstanding - diluted
		6,427,536
		
		6,418,032


See Notes to
		Consolidated Interim Financial Statements.

4

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PALMETTO BANCSHARES, INC. AND SUBSIDIARYConsolidated Statements of Changes in Shareholders' Equity and
		Comprehensive Income(dollars
		in thousands, except common and per share data)(unaudited)AccumulatedShares of
		
		
		
		
		
		
		
		othercommon
		
		Common
		
		Capital
		
		Retained
		
		comprehensivestock
		
		stock
		
		surplus
		
		earnings
		
		income
		(loss), net
		
		TotalBalance at December 31, 2004
		6,297,285
		
		$
		31,486
		
		$
		448
		
		$
		47,923
		
		$
		905
		
		$
		80,762Net income
		
		
		
		
		
		
		10,281
		
		
		
		10,281Other comprehensive
		income, net of tax:Unrealized holding losses arising during period, netof tax
		effect of $570
		
		
		
		
		
		
		
		
		(911)Less:  reclassification adjustment includedin net income, net of tax effect of $31
		
		
		
		
		
		
		
		
		(50)Net unrealized losses on securities
		
		
		
		
		
		
		
		
		
		
		(961)Comprehensive income
		
		
		
		
		
		
		
		
		
		
		9,320Cash dividend
		declared and paid ($0.48 per share)
		
		
		
		
		
		
		(3,032)
		
		
		
		(3,032)Exercise of stock options
		27,000
		
		135
		
		175
		
		
		
		
		
		310Balance at September 30, 2005
		6,324,285
		
		$
		31,621
		
		$
		623
		
		$
		55,172
		
		$
		(56)
		
		$
		87,360Balance at December 31, 2005
		6,331,335
		
		$
		31,656
		
		$
		659
		
		$
		57,532
		
		$
		(906)
		
		$
		88,941Net income
		
		
		
		
		
		
		11,182
		
		
		
		11,182Other comprehensive
		income, net of tax:Unrealized holding gains arising during period, netof tax effect of $24
		
		
		
		
		
		
		
		
		38Less:  reclassification adjustment includedin net income, net of tax effect of $1
		
		
		
		
		
		
		
		
		2Net unrealized gains on securities
		
		
		
		
		
		
		
		
		
		
		40Comprehensive income
		
		
		
		
		
		
		
		
		
		
		11,222Cash dividend
		declared and paid ($0.54 per share)
		
		
		
		
		
		
		(3,431)
		
		
		
		(3,431)Compensation
		expense related to stock options
		
		
		
		
		99
		
		
		
		
		
		99Exercise of stock options
		25,450
		
		128
		
		228
		
		
		
		
		
		356Balance at September 30, 2006
		6,356,785
		
		$
		31,784
		
		$
		986
		
		$
		65,283
		
		$
		(866)
		
		$
		97,187


See Notes to
	Consolidated Interim Financial Statements.

5

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PALMETTO BANCSHARES,
		INC. AND SUBSIDIARYConsolidated Statements of Cash Flows(in
		thousands)For the
		nine month periods ended September 30,2006
		
		2005(unaudited)Cash flows from
		operating activitiesNet income
		$
		11,182
		
		10,281Adjustments to reconcile net
		income to net cashprovided by operating
		activitiesDepreciation and
		amortization
		1,991
		
		2,465Investment securities gains
		(3)
		
		(12)Provision for loan losses
		1,325
		
		1,800Origination of mortgage
		loans held for sale
		(32,356)
		
		(55,343)Proceeds from sale of
		mortgage loans held for sale
		36,213
		
		58,398Gain on sale of mortgage
		loans
		(370)
		
		(836)Increase in accrued interest
		receivable
		(901)
		
		(304)Increase in accrued interest
		payable
		239
		
		101Compensation expense related
		to stock options
		99
		
		-Increase in other assets,
		net
		(303)
		
		(2,189)(Decrease) increase in other
		liabilities, net
		(879)
		
		146Net cash provided by
		operating activities
		16,237
		
		14,507Cash flows from
		investing activitiesPurchase of investment
		securities available for sale
		(14,832)
		
		(46,986)Proceeds from maturities of
		investment securities available for sale
		12,700
		
		790Proceeds from sales of
		investment securities available for sale
		4,129
		
		49,257Proceeds from calls of
		investment securities available for sale
		458
		
		2,052Principal paydowns on
		mortgage-backed securities available for sale
		4,065
		
		12,242Redemption (purchase) of
		FHLB stock
		1,187
		
		(933)Net increase in loans
		outstanding
		(65,210)
		
		(74,048)Purchases of premises and
		equipment, net
		(3,183)
		
		(1,989)Net cash used in investing
		activities
		(60,686)
		
		(59,615)Cash flows from
		financing activitiesNet increase in deposit
		accounts
		76,274
		
		47,075Net increase in retail
		repurchase agreements
		740
		
		476Net increase in commercial
		paper
		3,972
		
		1,052Decrease in federal funds
		purchased
		(1,000)
		
		-Net increase (decrease) in
		FHLB borrowings
		(29,900)
		
		16,400Proceeds from stock option
		activity
		356
		
		310Dividends paid
		
		(3,431)
		
		(3,032)Net cash provided by
		financing activities
		47,011
		
		62,281Net increase in cash
		and cash equivalents
		2,562
		
		17,173Cash and cash
		equivalents, beginning of the period
		37,976
		
		33,445Cash and cash
		equivalents, end of the period
		$
		40,538
		
		50,618Supplemental
		InformationCash paid during the
		period for:Interest expense
		$
		19,935
		
		12,107Income taxes
		
		5,960
		
		5,142Supplemental
		schedule of non-cash investing and financing transactionsChange in unrealized loss on
		investment securities availablefor sale, net of income tax
		$
		40
		
		(961)Loans transferred to other
		real estate owned, at fair market value
		154
		
		1,050Loans charged-off
		1,166
		
		1,232


See Notes to
		Consolidated Interim Financial Statements.

6

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PALMETTO BANCSHARES, INC. AND
SUBSIDIARYNotes 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 32 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.

While the Company's chief
decision-makers monitor the revenue streams of the Company's various products
and services, the identifiable segments are not material, and operations are
managed and financial performance is evaluated on a Company-wide basis.
Accordingly, all of the Company's financial service operations are considered
by management to be aggregated in one reportable operating segment.

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 nine month periods ended
September 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 prior
period reclassifications within the Consolidated Balance Sheets and
Consolidated Statements of Income.



7

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Concentrations of Credit
RiskThe Company makes
loans to individuals and small to
medium-sized businesses for various personal and commercial purposes primarily in the Upstate.  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).

September 30, 2006Outstanding
	
	balance
  
  As a percentage of
	
	total equity
  
  As a percentage of
	
	total loansLoans secured by:Commercial and industrial
  nonmortgage instruments
  $
  121,519
  
  125
  %
  13
  %Residential mortgage
  instruments
  177,263
  
  182
  
  19Nonresidential mortgage
  instruments
  523,277
  
  538
  
  56December 31, 2005Outstanding
	
	balance
  
  As a percentage of
	
	total equity
  
  As a percentage of
	
	total loansLoans secured by:Commercial and industrial
  nonmortgage instruments
  $
  143,334
  
  161
  %
  17
  %Residential mortgage
  instruments
  167,693
  
  189
  
  19Nonresidential 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 September 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
PronouncementsThe following is a summary of
recent authoritative pronouncements that could impact the accounting,
reporting, and / or disclosure of financial information by the Company.



8

---

In February 2006, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards  ("SFAS") No. 155, "Accounting for Certain Hybrid Financial Instruments-an amendment of FASB Statements No. 133 and 140." This Statement amends SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," and SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." This Statement resolves issues addressed in SFAS No. 133 Implementation Issue No. D1, "Application of Statement 133 to Beneficial Interests in Securitized Financial Assets." SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity's first fiscal year that begins after September 15, 2006. The Company has concluded that the adoption of SFAS No. 155 will not have a material impact on the Company's financial position and results of operations upon adoption.

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

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

In
September 2006, the FASB issued SFAS No. 157, "Fair Value
Measurements." SFAS No. 157 defines fair value, establishes a framework
for measuring fair value in generally accepted accounting principles, and
expands disclosures about fair value measurements. SFAS No. 157 is effective
for the Company on January 1, 2008 and is not expected to have a significant
impact on the Company's financial position and results of operations upon
adoption.

In
September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for
Defined Benefit Pension and Other Postretirement Plans," which amends SFAS No.
87, "*Employers' Accounting for Pensions,"*
and SFAS No. 106, "*Employers' Accounting for Postretirement Benefits
Other Than Pensions,"* to require recognition of the overfunded or
underfunded status of pension and other postretirement benefit plans on the
balance sheet. Under SFAS No. 158, gains and losses, prior service costs and
credits, and any remaining transition amounts under SFAS No. 87 and SFAS No.
106 that have not yet been recognized through net periodic benefit cost will be
recognized in accumulated other comprehensive income, net of tax effects, until
they are amortized as a component of net periodic cost. The measurement date -
the date at which the benefit obligation and plan assets are measured - is
required to be the company's fiscal year-end. SFAS No. 158 is effective for
publicly held companies for fiscal years ending after December 15, 2006, except
for the measurement date provisions, which are effective for fiscal years
ending after December 15, 2008. The Company is currently evaluating the impact
that the adoption of SFAS No. 158 will have on its financial position, results
of operations, and cash flows.





9

---

In
September 2006, the FASB ratified the consensuses reached by the FASB's Emerging Issues Task Force ("EITF")
relating to EITF No. 06-4 "Accounting for the Deferred Compensation and
Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance
Arrangements." 
EITF 06-4 addresses employer
accounting for endorsement split-dollar life insurance arrangements that
provide a benefit to an employee that extends to postretirement periods should
recognize a liability for future benefits in accordance with SFAS No. 106, or
Accounting Principles Board ("APB") Opinion No. 12, "*Omnibus Opinion-1967."*EITF 06-4 is
effective for fiscal years beginning after December 15, 2006. Entities should
recognize the effects of applying this Issue through either (a) a change in
accounting principle through a cumulative-effect adjustment to retained
earnings or to other components of equity or net assets in the statement of
financial position as of the beginning of the year of adoption or (b) a change
in accounting principle through retrospective application to all prior periods. 
The Company does not believe the adoption
of EITF 06-4 will have a material impact on its financial position, results of
operations, and cash flows.

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

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

2.       
CASH AND
CASH EQUIVALENTS

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

September 30,
  December 31,2006
  2005Cash working funds
  $
  8,113
  8,377Noninterest-earning demand
  deposits in other banks
  16,742
  18,911In-transit funds
  9,021
  9,690Federal funds sold
  6,662
  998Total cash and cash
  equivalents
  $
  40,538
  37,976


Liability management continues to be critical to enhancing the Company's profitability. The balance in costs between asset-based and liability-based liquidity and which funding alternatives are most effective are factors the Company considers with regard to its liquidity and funds management.  The increase in cash and cash equivalents during the first nine 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.   The Company expects to use excess balances of cash and cash equivalents to fund future interest-earning asset.



10

---

The average outstanding
federal funds sold for the nine month periods ended September 30, 2006 and 2005
was $23.9 million and $6.6 million, respectively.  The maximum amount of
federal funds sold at any month-end during the nine month periods ended
September 30, 2006 and 2005 was $45.5 million and $9.5 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 September 30, 2006
and December 31, 2005, the Federal Reserve required that the Company maintain
$9.4 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).

September 30, 2006Amortized
	
	cost
  
  Gross
	
	unrealized 
	gains
  
  Gross
	
	unrealized 
	losses
  
  Fair market
	
	valueInvestment securities
  available for saleU.S. Government agencies
  $
  43,491
  
  -
  
  (264)
  
  43,227State and municipal
  57,903
  
  120
  
  (884)
  
  57,139Mortgage-backed securities
  19,551
  
  16
  
  (395)
  
  19,172Total investment securities
  available for sale
  $
  120,945
  
  136
  
  (1,543)
  
  119,538December 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 securities
  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 nine month period ended September 30, 2006.

During the quarter ended
September 30, 2006, the Company had no sales of investment securities available
for sale compared with realized gains of $68 thousand and realized losses
amounting to $56 thousand during the same quarter of 2005.  During the nine
month period ended September 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 $451 thousand and
realized losses amounting to $370 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 September 30, 2006
(dollars in thousands).



11

---

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 securities
  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.  At September 30, 2006, all mortgage backed securities
were rated by Standard and Poor's as "A" or higher with 70% being rated "AAA." 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.

Investment securities available for sale with an aggregate
carrying value totaling $71.9 million and $104.9 million at September 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. The decline in pledged securities between these
periods was the result of a diversification of assets pledged to secure public
deposits, securities sold under agreements to repurchase, and for other
purposes as required or permitted by law.  At September 30, 2006, of its
approximately $191 million available credit based on qualifying loans to serve
as collateral against short-term or long-term borrowings from the FHLB, the
Company employed $79.0 million in a letter of credit used to secure public
deposits as required or permitted by law. No such line of credit was employed
at December 31, 2005.

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).





12

---

September 30, 2006
  
  December 31, 2005Total
  
  % of total
  
  Total
  
  % of totalCommercial business
  $
  104,730
  
  11.3
  %
  90,345
  
  10.5Commercial real estate
  579,486
  
  62.8
  
  561,574
  
  65.1Installment
  20,979
  
  2.3
  
  18,677
  
  2.2Installment real estate
  62,090
  
  6.7
  
  55,682
  
  6.5Indirect
  39,784
  
  4.3
  
  30,481
  
  3.5Credit line
  1,951
  
  0.2
  
  2,022
  
  0.2Prime access
  53,771
  
  5.8
  
  54,296
  
  6.3Residential mortgage
  46,352
  
  5.0
  
  34,453
  
  4.0Bankcards
  11,223
  
  1.2
  
  11,744
  
  1.4Business manager
  337
  
  -
  
  230
  
  -Other
  1,789
  
  0.2
  
  2,059
  
  0.2Loans in process
  7,106
  
  0.8
  
  3,857
  
  0.4Deferred loan fees and costs
  607
  
  0.1
  
  761
  
  0.1Loans
  930,205
  
  100.7
  
  866,181
  
  100.4Mortgage loans held for sale
  1,334
  
  0.2
  
  4,821
  
  0.6Total loans, gross
  931,539
  
  100.9
  
  871,002
  
  101.0Allowance for loan losses
  (8,724)
  
  (0.9)
  
  (8,431)
  
  (1.0)Total loans, net
  $
  922,815
  
  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 $310.0 million and $304.2 million at September 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 $80 thousand and $220 thousand for
the three month periods ended September 30, 2006 and 2005, respectively, and
$370 thousand and $836 thousand for the nine month periods ended September 30,
2006 and 2005, respectively.

During the nine months ended September 30, 2006, the
Company introduced business credit scoring and began placing an emphasis on
small commercial credits.  Management believes that these changes resulted in
an increase in commercial business loans as a percentage of the total
portfolio.

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

During the first nine months of 2006, the Company's
indirect lending portfolio increased by $9.3 million, or 30.5%.  Management attributes this indirect loan growth to a
new program offered by the Company that targets high credit scoring consumers
at competitive rates. The goal of this program is to introduce the Company and
its products to reputable automobile dealers.  Once introduced, the Company's goal
is to continue to build and maintain relationships with these dealers and their
customers.

During
the first nine months of 2006, prime access loans declined as a percentage of the total loan portfolio. 
Management attributes this decline to the conversion of prime access loans to
fixed rate second mortgages during the rising rate environment that has been
experienced since the second quarter of 2004.

The increase in residential mortgage loans and the
decrease in mortgage loans held for sale during the first nine months of 2006
is the result of an increase in retained residential mortgage loans during the
period.

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).

September 30,
  
  December 31,2006
  
  2005Nonaccrual loans
  $
  6,921
  
  9,913Loans past due 90 days and
  still accruing (1)
  94
  
  207$
  7,015
  
  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. During the third quarter of 2006, this loan was paid in full.  After
taking into consideration the removal of this loan from nonaccrual status
during the first nine months of 2006, activity within the nonaccrual loan
portfolio has resulted in a relatively unchanged balance 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 September 30, 2006. The following table
summarizes nonaccrual loan trends over
the twelve month period ended September 30, 2006 after adjusting the nonaccrual
loan balance for the special circumstance loan remaining in nonaccrual status
at September 30, 2006 (in thousands).

September 30,
  
  December 31,
  
  September 30,2006
  
  2005
  
  2005Nonaccrual loans
  $
  6,921
  
  $
  9,913
  
  2,703Less: remaining loan(s)
  discussed above
  (3,903)
  
  (7,177)
  
  -Adjusted nonaccrual loans
  $
  3,018
  
  $
  2,736
  
  2,703Ending loans (1)
  $
  930,205
  
  $
  866,181
  
  845,320Nonaccrual loans as a
  percentage of loans (1)
  0.32
  %
  0.32
  
  0.32(1)
  Calculated using loans
  excluding mortgage loans held for sale, net of unearned, excluding the
  Allowance


As a percentage of total
loans, nonaccrual loan remained relatively unchanged over the nine and twelve
month periods ended September 30, 2006 after adjusting for the special
circumstance loans discussed herein.

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 periods
  
  For the nine month periodsended September 30,
  
  ended September 30,2006
  
  2005
  
  2006
  
  2005Allowance, beginning of
  period
  $
  8,879
  
  8,051
  
  8,431
  
  7,619Provision for loan losses
  275
  
  600
  
  1,325
  
  1,800Loans charged-off
  (454)
  
  (374)
  
  (1,166)
  
  (1,232)Loan recoveries
  24
  
  79
  
  134
  
  169Net loans charged-off
  (430)
  
  (295)
  
  (1,032)
  
  (1,063)Allowance, end of period
  $
  8,724
  
  8,356
  
  $
  8,724
  
  8,356


14

---

As
of September 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 nine
month periods ended September 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).

September 30,
  December 31,2006
  2005Land
  $
  6,302
  5,856Buildings
  16,685
  15,552Leasehold improvements
  2,844
  2,775Furniture and equipment
  17,633
  16,578Software
  3,140
  2,858Bank automobiles
  824
  816Premises and equipment,
  gross
  47,428
  44,435Accumulated depreciation and
  amortization
  (23,097)
  (21,759)Premises and equipment, net
  $
  24,331
  22,676


During the first nine months
of 2006, real estate was purchased in conjunction with the expansion of the
Bank's Montague banking office in Greenwood County and the construction of the
Bank's permanent Boiling Springs banking office in Spartanburg County.  The
Montague banking office expansion contributed $188 thousand toward the increase
in buildings during the first nine months of 2006.  The Boiling Springs banking
office construction contributed $781 thousand and $228 thousand to buildings
and furniture and equipment, respectively, during the same period.

The Bank entered into an additional lease in
2005, and therefore additional leasehold improvements, in conjunction with the
move of the Bank's banking office on East Blackstock Road in Spartanburg, South
Carolina to W.O. Ezell Boulevard in Spartanburg, South Carolina.  The Bank also
entered into an additional lease during 2006 with regard to the banking office
used temporarily during the construction of the new Boiling Springs banking office
opened in 2006. The upfitting of this temporary facility contributed to the
increase in leasehold improvements during the first nine months of 2006.

Contributing
to the increase in furniture and equipment was the addition of new ATMs during
the first nine months of 2006.  See Note 14 contained herein for discussion
regarding the addition of three ATMs at nonretail office locations during the
first nine months of 2006.  Additionally, during the same period, one ATM was
added at an existing banking office location and another was added in
conjunction with the opening of the Bank's new Boiling Springs banking office.

The table set forth below
summarizes the activity impacting accumulated depreciation for the periods
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 of Income. Depreciation balances were impacted during
the period by the activity discussed herein.

15

---

For the three month periods
  
  For the nine month periodsended September 30,
  
  ended September 30,2006
  
  2005
  
  2006
  
  2005Accumulated depreciation,
  beginning of period
  $
  22,710
  
  20,932
  
  21,759
  
  20,089DepreciationBuildings
  111
  
  107
  
  343
  
  316Leasehold improvements
  43
  
  31
  
  124
  
  115Furniture and equipment
  248
  
  250
  
  743
  
  733Software
  62
  
  61
  
  197
  
  194Bank automobiles
  43
  
  38
  
  119
  
  113Total depreciation
  507
  
  487
  
  1,526
  
  1,471Disposals
  (120)
  
  (6)
  
  (188)
  
  (147)Accumulated depreciation,
  end of period
  $
  23,097
  
  21,413
  
  23,097
  
  21,413


Although the Bank also
entered into an additional lease during 2006 with regard to the banking office
used temporarily during the construction of the new Boiling Springs banking
office opened in 2006, any additional related depreciation expenses were, for
the most part, offset by the year-end 2005 expiration of the similar lease with
regard to the temporary banking office used during the Easley banking office
construction.

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 $310.0 million and $304.2 million at September 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 Company's mortgage-servicing rights portfolio for the
periods indicated (in thousands).



For the three month
  
  For the nine monthperiods ended September 30,
  
  periods ended September 30,2006
  
  2005
  
  2006
  
  2005Mortgage-servicing rights
  portfolio, net ofvaluation allowance,
  beginning of period
  $
  2,673
  
  2,548
  
  2,626
  
  2,316Capitalized
  mortgage-servicing rights
  68
  
  239
  
  306
  
  765Mortgage-servicing rights
  portfolio amortization
  (167)
  
  (215)
  
  (457)
  
  (552)Change in mortgage-servicing
  rights valuation allowance
  11
  
  40
  
  110
  
  83Mortgage-servicing rights
  portfolio, net ofvaluation allowance, end of
  period
  $
  2,585
  
  2,612
  
  2,585
  
  2,612


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

The aggregate fair market value of mortgage-servicing rights at September
30, 2006, December 31, 2005, and September 30, 2005 was $3.5 million, $3.1
million, and $3.0 million, respectively.

The decline in
mortgage-servicing rights capitalized is primarily due to the lower level of
mortgage loan sales during the three and nine month periods ended September 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.

16

---

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 nine
month period ended September 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 rights portfolio.  As interest rates have risen
since 2004, refinancing activity has continued to slow.  As such,
mortgage-servicing rights amortization 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 rights 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 rights portfolio,
allowing the Company to recover a portion of previously recorded impairment
reserves through the mortgage-servicing rights valuation allowance. The increase in mortgage-servicing fees during the
nine month period ended September 30, 2006 compared with the same period of
2005 is the result of an increase in mortgage loans serviced for others
totaling $8.9 million between the periods noted as fees earned are directly
correlated to the portfolio serviced.

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

For the three month
  
  For the nine monthperiods ended September 30,
  
  periods ended September 30,2006
  
  2005
  
  2006
  
  2005Valuation allowance,
  beginning of period
  $
  15
  
  89
  
  114
  
  132Aggregate additions charged
  and reductions credited to operations
  (11)
  
  (40)
  
  (110)
  
  (83)Valuation allowance, end of
  period
  $
  4
  
  49
  
  4
  
  49


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 rights 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 rights portfolio not to be indicative of future financial
condition or results of operations or that would cause future financial
condition or results of operations to differ material from these projections.
However, amortization expense is calculated based on current available
information regarding loan payments and prepayments and could change in future
periods based on changes in volume of prepayments and other economic factors.

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

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).



|                          |                         | September 30, |       | December 31, |       | September 30, |      
|------------------------- | ----------------------- | ------------- | ----- | ------------ | ----- | ------------- | -----
|                          |                         | 2006          |       | 2005         |       | 2005          |      
|Goodwill                  | $                       | 3,691         |       | 3,691        |       | 3,691         |      
|Customer list intangibles | 139                     |               | 175   |              | 211   |              
|                          | Total intangible assets | $             | 3,830 |              | 3,866 |               | 3,902
|                          |                         |               |       |              |       |               |      

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 nine month         
|--------------------------------- | --------------------------- | --- | ---------------------------
|                                  | periods ended September 30, |     | periods ended September 30,
|                                  | 2006                        |     | 2005                       
|Balance, at beginning of
  period | $                           | 151 |                            
|Less: amortization                | (12)                        |     | (36)                       
|Balance, at end of period         | $                           | 139 |                            
|                                  |                             |     |                            

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

|                                   | September 30, |       | December 31, |       | September 30, |      
|---------------------------------- | ------------- | ----- | ------------ | ----- | ------------- | -----
|                                   | 2006          |       | 2005         |       | 2005          |      
|Customer list intangibles,
  gross | $             | 1,779 |              | 1,779 |               | 1,779
|Less: accumulated
  amortization   | (1,640)       |       | (1,604)      |       | (1,568)       |      
|Customer list intangibles,
  net   | $             | 139   |              | 175   |               | 211  
|                                   |               |       |              |       |               |      

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 nine month periods ended September 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).

September 30,
  
  December 31,
  
  September 30,2006
  
  2005
  
  2005Real estate acquired in
  settlement of loans
  $
  771
  
  1,954
  
  2,003Repossessed automobiles
  acquired in settlement of loans
  347
  
  167
  
  180Total property acquired
  in settlement of loans
  $
  1,118
  
  2,121
  
  2,183


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 nine month  
|------------------------------------------------------------------ | ------------------------------------------------------ | ------------------- | --------------------------- | ----- | ---------------------------
|                                                                   |                                                        |                     | periods ended September 30, |       | periods ended September 30,
|                                                                   |                                                        |                     | 2006                        |       | 2005                       
|Real estate acquired in
  settlement of loans, beginning of period | $                                                      | 728                 |                             | 2,323 |                            
|                                                                   | Add: New real estate
  acquired in settlement of loans | 72                  |                             | 534   |                            
|                                                                   | Less: Sales / recoveries of
  real estate acquired in  |                     |                             |       |                            
|                                                                   |                                                        | settlement of loans | (29)                        |       | (829)                      
|                                                                   | Less: Provision charged to
  expense                   | -                   |                             | (25)  |                            
|Real estate acquired in
  settlement of loans, end of period       | $                                                      | 771                 |                             | 2,003 |                            
|                                                                   |                                                        |                     |                             |       |                            

18

---

Levels of real estate
acquired in settlement of loans decreased from December 31, 2005 to September
30, 2006. Management believes that the main factor contributing to this decline
has been the portfolio trend of recent years that is not believed to
necessarily be indicative of historical or future credit trends.  The following
table summarizes the Company's real estate acquired in settlement of loans
portfolio balance at the dates indicated (in thousands).

December 31, 2001
  $
  217December 31, 2002
  2,468December 31, 2003
  2,170December 31, 2004
  2,413December 31, 2005
  1,954September 30, 2006
  771


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 September 30, 2006.

9.       
DEPOSITS

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

September 30, 2006
  
  December 31, 2005Total
  
  % of total
  
  Total
  
  % of totalTransaction deposit accounts
  $
  429,948
  
  43.9
  %
  351,629
  
  38.9Money market deposit
  accounts
  127,500
  
  13.0
  
  111,380
  
  12.4Savings deposit accounts
  45,217
  
  4.6
  
  45,360
  
  5.0Time deposit accounts
  376,993
  
  38.5
  
  395,014
  
  43.7Total traditional deposit
  accounts
  $
  979,658
  
  100.0
  %
  903,383
  
  100.0




10.    
FEDERAL HOME LOAN BANK BORROWINGS

At September 30, 2006, of its approximately $191 million available
credit based on qualifying loans to serve as collateral against short-term or
long-term borrowings from the FHLB, the Company employed $10.0 million in
borrowings, all of which was determined to be long-term when employed, and
employed $79.0 million in a letter of credit used to secure public deposits as
required or permitted by law.

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



September 30, 2006Long-term
  Short-term
  TotalBorrowing balance
  outstanding
  $      10,000
  -
  10,000Interest rate
  3.85%
  -
  3.85
  (1)Maturity date
  6/14/2007
  OvernightDecember 31, 2005Long-term
  Short-term
  TotalBorrowing balance
  outstanding
  $      13,000
  10,000
  16,900
  39,900Interest rate
  3.27%
  3.85
  4.44
  3.91
  (1)Maturity date
  6/14/2006
  6/14/2007
  Overnight(1) Represents weighted
  average rate at the dates indicated.




19

---



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

At and for the nine month
  
  At and for the year endedperiods ended September 30,
  
  December 31,2006
  
  2005
  
  2005Short-term FHLB
  borrowingsAmount outstanding at
  period-end
  $
  -
  
  39,400
  
  16,900Average amount outstanding
  during period
  2,861
  
  26,504
  
  26,745Maximum amount outstanding
  at any month-end
  10,900
  
  51,400
  
  51,400Rate paid at period-end
  -
  %
  4.16
  
  4.44Weighted average rate paid
  during the period
  4.63
  
  3.41
  
  3.59Long-term FHLB borrowingsAmount outstanding at
  period-end
  $
  10,000
  
  23,000
  
  23,000Average amount outstanding
  during period
  17,810
  
  27,705
  
  26,145Maximum amount outstanding
  at any month-end
  23,000
  
  30,000
  
  30,000Rate paid at period-end
  3.85
  %
  3.52
  
  3.52Weighted average rate paid
  during the period
  3.60
  
  3.28
  
  3.38




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
September 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 nine month   |        | At and for the year ended |       
|------------------------------ | ------------------------------------------------------------------------------------------------------------------------------------- | --------------------------- | ------ | ------------------------- | ------
|                               |                                                                                                                                       | periods ended September 30, |        | December 31,              |       
|                               |                                                                                                                                       | 2006                        |        | 2005                      |       
|Retail repurchase
  agreements |                                                                                                                                       |                             |        |                           |       
|                               | Amount outstanding at
  period-end                                                                                                    | $                           | 17,468 |                           | 16,873
|                               | Average amount outstanding
  during period                                                                                            | 18,492                      |        | 21,060                    |       
|                               | Maximum amount outstanding
  at any month-end                                                                                         | 23,344                      |        | 20,981                    |       
|                               | Rate paid at period-end *                                                                                                             | 3.63                        | %      | 2.13                      |       
|                               | Weighted average rate paid
  during the period                                                                                        | 4.08                        |        | 2.12                      |       
|                               |                                                                                                                                       |                             |        |                           |       
|Commercial paper               |                                                                                                                                       |                             |        |                           |       
|                               | Amount outstanding at
  period-end                                                                                                    | $                           | 21,887 |                           | 18,103
|                               | Average amount outstanding
  during period                                                                                            | 19,630                      |        | 18,433                    |       
|                               | Maximum amount outstanding
  at any month-end                                                                                         | 22,104                      |        | 21,877                    |       
|                               | Rate paid at period-end *                                                                                                             | 3.81                        | %      | 2.31                      |       
|                               | Weighted average rate paid
  during the period                                                                                        | 4.03                        |        | 2.09                      |       
|                               |                                                                                                                                       |                             |        |                           |       
|Federal funds purchased        |                                                                                                                                       |                             |        |                           |       
|                               | Amount outstanding at
  period-end                                                                                                    | $                           | -      |                           | -     
|                               | Average amount outstanding
  during period                                                                                            | 584                         |        | 3,820                     |       
|                               | Maximum amount outstanding
  at any month-end                                                                                         | 3,000                       |        | 13,320                    |       
|                               | Rate paid at period-end                                                                                                               | -                           | %      | -                         |       
|                               | Weighted average rate paid
  during the period                                                                                        | 4.58                        |        | 2.73                      |       
|                               |                                                                                                                                       |                             |        |                           |       
|*                              | 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 September 30, 2006,
the Company had unused short-term lines of credit at correspondent banks
totaling $40 million (which were accessible at the Company's option).



20

---

12.    
EMPLOYEE BENEFIT PLANS

Postretirement Benefits

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

For the three month periods
  
  For the nine month periodsended September 30,
  
  ended September 30,2006
  
  2005
  
  2006
  
  2005Service cost
  $
  141
  
  209
  
  423
  
  696Interest cost
  165
  
  237
  
  495
  
  794Expected return on plan
  assets
  (229)
  
  (354)
  
  (687)
  
  (1,169)Amortization of prior
  service cost
  3
  
  3
  
  9
  
  11Amortization of loss
  20
  
  35
  
  60
  
  113Postretirement benefit
  expense
  $
  100
  
  130
  
  300
  
  445


The Company expects to contribute $1.2 million to the
plan during 2006. During the three month periods ended September 30, 2006 and
2005, $308 thousand and $300 thousand was contributed, respectively. During the
nine month periods ended September 30, 2006 and 2005, $925 thousand and $923
thousand was contributed, respectively.

Stock Option PlanSince 1987, the Company has adopted several plans
pursuant to which the Company's Board of Directors may grant incentive and
nonincentive stock options to certain key employees and directors of the
Company. The Board determines the option price and term of the options on the
grant date.  The option price must be at least 100% of fair market value as of
the grant date, and the term of the options shall not be greater than 10 years.
Because the Company's common stock is not traded on an established market, the
fair market value is determined by an annual independent valuation. The only
stock option plan currently in effect is the Palmetto Bancshares, Inc. 1997
Stock Compensation Plan.  This plan originally provided for the issuance of
175,000 common shares, which were doubled in conjunction with the 2000 stock
split. During the 2003 Annual Meeting of Shareholders, the shareholders of the
Company voted to amend the Palmetto Bancshares, Inc. 1997 Stock Compensation
Plan to increase the number of shares of common stock of the Company subject to
the 1997 Stock Compensation Plan by 100,000 shares.

As of September 30, 2006,
429,200 options, net of cancellations, had been granted that expire at various
dates through December 31, 2015. Of these, 242,335 remained outstanding at
September 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
September 30, 2006, there were 20,800 remaining options available for grant
under this plan.

Adoption of SFAS No. 123 (R)Prior to January 1, 2006, the Company accounted for its 1997 Stock Compensation Plan under the recognition and
measurement provisions of APB No. 25, "Accounting
for Stock Issued to Employees," as permitted by SFAS No. 123, "Accounting
for Stock-Based Compensation"and SFAS No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure." For the three and nine
months ended September 30, 2005, no stock-based employee compensation cost was
recognized in the Consolidated Statements of Income for options granted as all
options granted under those plans had an exercise price equal to the market
value of the underlying common stock on the date of grant. Effective January 1,
2006, the Company adopted the fair value recognition provisions of SFAS No.
123(R), "Share-Based Payment,"using the modified prospective transition
method. Under that transition method, compensation cost recognized in fiscal
year 2006 includes compensation cost for all share-based payments vesting
during 2006 that were granted prior to, but not yet vested as of January 1,
2006, based on the grant-date fair value estimated in accordance with the
original provisions of SFAS No. 123, and compensation cost for all share-based
payments vesting during 2006 that were granted subsequent to January 1, 2006,
based on the grant-date fair value estimated in accordance with the provisions
of SFAS No. 123(R). Results for prior periods have not been restated.



21

---



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

For the three month periods
 ended September 30,
  
  For the nine month periods 
	ended September 30,2006
  
  2005
  
  2006
  
  2005Net income, as reported
  $
  3,801
  
  3,323
  
  11,182
  
  10,281Add: stock-based
  compensation expense included in reportednet income, net of related
  tax effects
  29
  
  -
  
  66
  
  -Deduct:
  stock-based compensation expense determined under fair marketvalue based method for all
  awards, net of related tax effects
  (29)
  
  (26)
  
  (66)
  
  (77)Pro forma net
  income including stock-based compensation expensebased on fair market value
  method
  $
  3,801
  
  3,297
  
  11,182
  
  10,204Common Share DataNet income - basic, as
  reported
  $
  0.60
  
  0.53
  
  1.76
  
  1.63Net income - basic, pro
  forma
  0.60
  
  0.52
  
  1.76
  
  1.62Net income - diluted, as
  reported
  $
  0.59
  
  0.52
  
  1.74
  
  1.60Net income - diluted, pro
  forma
  0.59
  
  0.51
  
  1.74
  
  1.59


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

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

Expected
Volatility. As noted in the Company's Annual Report on Form 10-K for the year
ended December 31, 2005, the Company is
closely held, and there is no established public trading market for the
Company's stock.  The Company's Secretary facilitates stock trades of the
Company's common stock by matching willing buyers and sellers that contact her
with their intent.  However, trades can be and are made that are not
facilitated through the Secretary between willing buyers and sellers of which
the Company may have no record.  Additionally, many of these transactions do
not constitute arm's length transactions as many of the transactions are
between buyers and sellers with relationships that may lead to a sale at a
price other than fair market value.  The Company believes that many trades are
between buyers and sellers that are family members, that are family members of
Company employees, or that are members of the community who may be willing to
pay a premium for the stock of a company headquartered in their community.
Because of these factors, the Company does not believe that the prices at which
the trades recorded by its Secretary are transacted can be considered fair
market value, and, as a result, annually, a third party fair market valuation
is performed by an external third party on a minority block of the outstanding
common shares of Palmetto Bancshares, Inc. for use in conjunction with stock
options. The
Company uses this fair market valuation of the common stock in
determining an estimated volatility factor when using the Black-Scholes
option-pricing formula to determine the fair value of options granted.

22

---

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

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

The following table
summarizes the stock-based awards granted by the Company, the fair market value of each award granted
as estimated on the date of grant using the Black-Scholes option-pricing model,
and the weighted average assumptions used for such grants for the periods
indicated. No stock-based awards were granted by the Company during the three
month periods ended September 30, 2006 and 2005.



For awards granted during the 
	nine month periods
  ended September 30,2006
  
  2005Awards granted
  15,000
  
  33,000Dividend yields
  2.7
  
  2.4Expected
  volatility
  5
  
  16Risk-free interest rate
  4
  
  4Expected term
  (years)
  10
  
  9Vesting period
  (years)
  5
  
  5


Stock Option Compensation ExpenseThe
compensation cost that has been charged against pretax net income for stock
options was $45 thousand and $99 thousand for the three and nine months ended
September 30, 2006, respectively. The total income tax benefit recognized in
the Consolidated Statements of
Income with regard to this compensation cost was $16 thousand and $33
thousand for the three and nine months ended September 30, 2006, respectively. Management
estimated that forfeitures would not be significant and is recognizing
compensation costs for all equity awards.

At September 30, 2006, based on options outstanding at
that time, the total compensation cost related to nonvested stock option awards
granted under the Company's stock option plans but not yet recognized was $286
thousand. Stock option compensation expense is recognized on a straight-line
basis over the vesting period of the option. This cost is expected to be
recognized over a remaining period of 4.25 years.

23

---

Stock Option ActivityThe 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
  (4,000)
  
  13.50Exercised
  (27,000)
  
  11.43Outstanding at September 30,
  2005
  259,835
  
  $
  16.44Outstanding at December 31,
  2005
  252,785
  
  $
  16.63Granted
  15,000
  
  27.30Forfeited / Cancelled
  -
  
  -Exercised
  (25,450)
  
  13.97Outstanding at September 30,
  2006
  242,335
  
  $
  17.57


Cash received from stock option exercises under the
Company's stock option plan for the nine months ended September 30, 2006 and
2005 was $356 thousand and $309 thousand, respectively.

401(k) Retirement PlanDuring the three month
periods ended September 30, 2006 and 2005, the Company made matching
contributions to employee 401(k) retirement plans totaling $73 thousand and $70
thousand, respectively. During the nine month periods ended September 30, 2006
and 2005, the Company made matching contributions to employee 401(k) retirement
plans totaling $207 thousand and $212 thousand, respectively.

13.    
NET INCOME PER COMMON SHARE

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

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

For the three month periods 
	ended September 30,
  
  For the nine month periods 
	ended September 30,2006
  
  2005
  
  2006
  
  2005Weighted average common
  shares outstanding - basic
  6,356,656
  
  6,319,613
  
  6,351,646
  
  6,314,431Dilutive impact resulting
  from potential common share issuances
  75,890
  
  101,794
  
  75,890
  
  103,601Weighted average common
  shares outstanding - diluted
  6,432,546
  
  6,421,407
  
  6,427,536
  
  6,418,032Common Share DataNet income - basic
  $
  0.60
  
  0.53
  
  1.76
  
  1.63Net income - diluted
  0.59
  
  0.52
  
  1.74
  
  1.60


24

---

At September 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
September 30, 2006 and 2005, respectively.  The Company paid cash dividends of
$0.54 and $0.48 per share for the nine month periods ended September 30, 2006
and 2005, respectively.

14.    
COMMITMENTS AND CONTINGENCIES

The Company's significant contractual obligations and
commitments at December 31, 2005 are included in the Annual Report on Form 10-K
for the year ended December 31, 2005.

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 $164 thousand during the three month
periods ended September 30, 2006 and 2005,
respectively. For the nine month periods ended September 30, 2006 and 2005,
such payments totaled $555 thousand and $483 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.

In
conjunction with the Company's 100th anniversary celebration on
September 21st, the Company announced its plan to relocate its
headquarters to downtown Greenville in 2008. Tentative plans project
construction of the new leased facility to begin in 2007 with a projected
completion date in 2008.  Management is currently completing negotiations of a
build-to-suit ground and building lease with the property owner.

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

Home equity loans
  $
  48,897Credit cards
  44,620Commercial real estate
  development
  86,470Other unused lines of credit
  62,705Total contractual
  obligations
  $
  242,692


GuaranteesAt
September 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 September 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 September 30, 2006.

25

---

Other Off-Balance Sheet ArrangementsAt September 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 September 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
$2.2 million at September 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 September 30, 2006.

16.    
DIVIDEND RESTRICTIONS AND
REGULATORY CAPITAL REQUIREMENTS

At
September 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 September
30, 2006, there have been no events or conditions that management believes
would change these categories.



Actual
  
  For capital adequacy purposes
  
  To be well capitalized under 
	prompt corrective action
 provisionsamount
  
  ratio
  
  amount
  
  ratio
  
  amount
  
  ratioAt September 30, 2006Total capital to
  risk-weighted assetsCompany
  
  
  $
  102,688
  
  10.12 %
  
  81,137
  
  8.00
  
  n/a
  
  n/aBank
  
  
  101,468
  
  10.00
  
  81,137
  
  8.00
  
  101,422
  
  10.00Tier 1 capital to
  risk-weighted assetsCompany
  
  
  93,964
  
  9.26
  
  40,569
  
  4.00
  
  n/a
  
  n/aBank
  
  
  92,744
  
  9.14
  
  40,569
  
  4.00
  
  60,853
  
  6.00Tier 1 capital to average
  assetsCompany
  
  
  93,964
  
  8.41
  
  44,715
  
  4.00
  
  n/a
  
  n/aBank
  
  
  92,744
  
  8.29
  
  44,731
  
  4.00
  
  55,913
  
  5.00At September 30, 2005Total capital to
  risk-weighted assetsCompany
  
  
  $
  91,608
  
  10.29 %
  
  71,255
  
  8.00
  
  n/a
  
  n/aBank
  
  
  90,803
  
  10.19
  
  71,255
  
  8.00
  
  89,068
  
  10.00Tier 1 capital to
  risk-weighted assetsCompany
  
  
  83,252
  
  9.35
  
  35,627
  
  4.00
  
  n/a
  
  n/aBank
  
  
  82,447
  
  9.26
  
  35,627
  
  4.00
  
  53,441
  
  6.00Tier 1 capital to average
  assetsCompany
  
  
  83,252
  
  7.91
  
  42,098
  
  4.00
  
  n/a
  
  n/aBank
  
  
  82,447
  
  7.83
  
  42,110
  
  4.00
  
  52,637
  
  5.00


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

26

---

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
nine month periods ended September 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.  In
addition, certain statements in future filings by the Company with the
Securities and Exchange Commission, 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.  Actual events or results may differ materially as a result of
risks and uncertainties facing the Company, including, without limitation,
those described in the Company's Annual Report on Form 10-K for the year ended
December 31, 2005 and other risks referenced from time to time in subsequent
documents the Company files with the Securities and Exchange Commission. 
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 rights portfolio, past acquisitions, and
income taxes to be its most critical accounting policies due to the valuation
techniques used and the sensitivity of these financial statement amounts to the
methods, assumptions, and estimates underlying these balances.  Accounting for
these critical areas requires a significant degree of judgment that could be
subject to revision as newer information becomes available.







27

---

COMPANY OVERVIEW

Palmetto Bancshares, Inc. is a regional financial services
holding company headquartered in Laurens, South Carolina and organized in 1982
under the laws of South Carolina. Through its wholly owned subsidiary, The
Palmetto Bank (the "Bank"), Palmetto Bancshares, Inc. engages in the
general banking business through 32 retail banking offices in the upstate South
Carolina markets of Laurens, Greenville, Spartanburg, Greenwood, Anderson,
Cherokee, Abbeville, Pickens, and Oconee counties (the "Upstate").  In addition
to retail offices, at September 30, 2006, the Bank had 37 automatic teller
machine ("ATM") locations (including seven at nonretail office locations) and
five-limited service offices located in retirement centers in the Upstate.
Additionally, as noted in 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. The Bank celebrated the grand
opening of its Boiling Springs banking office on October 16, 2006. Prior to
this grand opening, the Bank was operating in a temporary location.  The Bank
was organized and chartered under South Carolina law in 1906. Throughout this
report, the "Company" shall refer to Palmetto Bancshares, Inc. and
its subsidiary, the Bank, which includes its brokerage subsidiary, Palmetto
Capital, Inc. ("Palmetto Capital"), except where the
context requires otherwise.

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

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

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

The Company is subject to competition from other
financial institutions and operating results, like those of other financial
institutions operating in South Carolina, are significantly influenced by local
and state economic conditions, including, but not limited to, the strength of
the real estate market. In addition, both the fiscal and regulatory policies of
the federal and state government and regulatory authorities that govern
financial institutions and market interest rates impact the Company's financial condition and results of operations.



28

---

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

The
Company's strategy is to be recognized as the Upstate's premier independent
community banking organization, and the Company believes that there are
opportunities for internal loan and deposit growth because our operations are
located in some of the strongest growth markets in the Upstate.  The Company
plans to position itself to take full advantage of these markets. To this end,
in conjunction with the Company's 100th anniversary celebration on
September 21st, the Company announced its plan to relocate its
headquarters to downtown Greenville in 2008. Tentative plans project
construction of the new leased facility to begin in 2007 with a projected
completion date in 2008.  Management is currently completing negotiations of a
build-to-suit ground and building lease with the property owner.  At an
estimated cost of $12.5 million, the 42,000
square foot, classical bank design will be located at the corner of East
North and Church Streets.  Despite the position of being in some of the best
growth markets in South Carolina, the Company faces the risk of being
particularly sensitive to changes in the state and local economies. If the economy weakens, it could cause loan demand to
decline and also impact the Company's core deposit growth.

















29

---

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.

Overview

PALMETTO BANCSHARES, INC. AND SUBSIDIARYConsolidated Balance Sheets(dollars in thousands, except common and per share
  data)September 30,
  
  December 31,
  
  Dollar
  
  Percent2006
  
  2005
  
  Variance
  
  Variance(unaudited)ASSETSCash and cash equivalentsCash and due from banks
  $
  33,876
  
  36,978
  
  (3,102)
  
  (8.4)
  %Federal funds sold
  6,662
  
  998
  
  5,664
  
  567.5Total cash and cash
  equivalents
  40,538
  
  37,976
  
  2,562
  
  6.7Federal Home Loan Bank
  ("FHLB") stock, at cost
  2,599
  
  3,786
  
  (1,187)
  
  (31.4)Investment securities
  available for sale, at fair market value
  119,538
  
  125,988
  
  (6,450)
  
  (5.1)Mortgage loans held for sale
  1,334
  
  4,821
  
  (3,487)
  
  (72.3)Loans
  
  
  930,205
  
  866,181
  
  64,024
  
  7.4Less allowance for loan
  losses
  (8,724)
  
  (8,431)
  
  (293)
  
  3.5Loans, net
  921,481
  
  857,750
  
  63,731
  
  7.4Premises and equipment, net
  24,331
  
  22,676
  
  1,655
  
  7.3Goodwill
  
  
  3,691
  
  3,691
  
  -
  
  -Other intangible assets
  139
  
  175
  
  (36)
  
  (20.6)Accrued interest receivable
  6,127
  
  5,226
  
  901
  
  17.2Other assets
  
  12,954
  
  12,926
  
  28
  
  0.2Total assets
  $
  1,132,732
  
  1,075,015
  
  57,717
  
  5.4
  %LIABILITIES AND
  SHAREHOLDERS' EQUITYLiabilitiesDepositsNoninterest-bearing
  $
  146,081
  
  131,157
  
  14,924
  
  11.4
  %Interest-bearing
  833,576
  
  772,226
  
  61,350
  
  7.9Total deposits
  979,657
  
  903,383
  
  76,274
  
  8.4Retail repurchase agreements
  17,468
  
  16,728
  
  740
  
  4.4Commercial paper (Master
  notes)
  21,887
  
  17,915
  
  3,972
  
  22.2Federal funds purchased
  -
  
  1,000
  
  (1,000)
  
  (100.0)FHLB borrowings - short-term
  -
  
  16,900
  
  (16,900)
  
  (100.0)FHLB borrowings - long-term
  10,000
  
  23,000
  
  (13,000)
  
  (56.5)Accrued interest payable
  1,514
  
  1,275
  
  239
  
  18.7Other liabilities
  5,019
  
  5,873
  
  (854)
  
  (14.5)Total liabilities
  1,035,545
  
  986,074
  
  49,471
  
  5.0Shareholders' EquityCommon stock
  31,784
  
  31,656
  
  128
  
  0.4Capital surplus
  986
  
  659
  
  327
  
  49.6Retained earnings
  65,283
  
  57,532
  
  7,751
  
  13.5Accumulated other
  comprehensive loss, net of tax
  (866)
  
  (906)
  
  40
  
  (4.4)Total shareholders' equity
  97,187
  
  88,941
  
  8,246
  
  9.3Total liabilities and
  shareholders' equity
  $
  1,132,732
  
  1,075,015
  
  57,717
  
  5.4
  %


During
the first nine months of 2006 net cash inflows resulting from the growth in
deposits, retail repurchase agreements, and commercial paper totaling $81.0
million coupled with net cash inflows from purchases, sales, maturities, calls,
and paydowns within the investment securities portfolio totaling $6.5 million
were used to fund loan growth during the period of $60.5 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 September
30, 2006 over December 31, 2005.

30

---

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

|                                                     |                                   | September 30, | December 31, |        |  | 
|---------------------------------------------------- | --------------------------------- | ------------- | ------------ | ------ |  | 
|                                                     |                                   | 2006          | 2005         |        |  | 
|Cash working funds                                   | $                                 | 8,113         | 8,377        |        |  | 
|Noninterest-earning demand
  deposits in other banks | 16,742                            | 18,911        |              |        | 
|In-transit funds                                     | 9,021                             | 9,690         |              |        | 
|Federal funds sold                                   | 6,662                             | 998           |              |        | 
|                                                     | Total cash and cash
  equivalents | $             | 40,538       | 37,976 |  | 
|                                                     |                                   |               |              |        |  | 

As interest rates continue to rise, liability management continues to be critical to enhancing the Company's profitability. The balance in costs between asset-based and liability-based liquidity and which funding alternatives are most effective are factors the Company considers with regard to its liquidity and funds management.  The increase in cash and cash equivalents during the first nine 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.   The Company expects to use the excess balances of cash and cash equivalents to fund future interest-earning asset growth.

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 September 30, 2006 was in compliance with this requirement.

Investment
Securities Available For SaleInvestment securities available for sale totaled
$119.5 million at September 30, 2006, a decrease of $6.5 million, or 5.1%, when
compared with December 31, 2005.  Average balances of available for sale
investment securities decreased to $117.1 million during the three months ended
September 30, 2006 from $127.0 million during the same period of 2005. Average
balances of available for sale investment securities decreased to $121.3
million during the first nine months of 2006 from $135.6 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).

September 30, 2006
  
  December 31, 2005Total
  
  % of total
  
  Total
  
  % of totalU.S. Government agencies
  $
  43,227
  
  36.2
  %
  49,960
  
  39.7State and municipal
  57,139
  
  47.8
  
  56,006
  
  44.4Mortgage-backed securities
  19,172
  
  16.0
  
  20,022
  
  15.9Total investment securities
  available for sale
  $
  119,538
  
  100.0
  %
  125,988
  
  100.0Total investment securities
  available for sale as a percentage of total assets
  10.6
  %
  
  11.7


Investment securities
available for sale as a percentage of total assets declined from December 31,
2005 to September 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 fund loan growth and repay borrowings during the nine
months ended September 30, 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 nine month periods ended September 30, 2006.

31

---

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).

September 30, 2006
  
  December 31, 2005Amortized cost
  
  Fair market value
  
  Amortized cost
  
  Fair market valueU.S. Government agencies
  $
  43,491
  
  43,227
  
  50,257
  
  49,960State and municipal
  57,903
  
  57,139
  
  56,766
  
  56,006Mortgage-backed securities
  19,551
  
  19,172
  
  20,438
  
  20,022Total investment securities
  available for sale
  $
  120,945
  
  119,538
  
  127,461
  
  125,988


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.

LoansGeneral. 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 the
Upstate.

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

September 30, 2006
  
  December 31, 2005Total
  
  % of total
  
  Total
  
  % of totalCommercial and industrial
  $
  121,519
  
  13.1
  %
  143,334
  
  16.5Real estate - 1 - 4 family
  177,263
  
  19.0
  
  167,693
  
  19.3Real estate - construction
  22,430
  
  2.4
  
  29,731
  
  3.4Real estate - other
  523,277
  
  56.2
  
  458,154
  
  52.6General consumer
  70,055
  
  7.5
  
  55,008
  
  6.3Credit line
  4,753
  
  0.5
  
  4,465
  
  0.5Bankcards
  11,223
  
  1.2
  
  11,744
  
  1.3Others
  1,019
  
  0.1
  
  873
  
  0.1Total loans
  $
  931,539
  
  100.0
  %
  871,002
  
  100.0


The Company emphasizes
growth in loans secured by real estate as such loans are typically less risky
than loans secured by collateral other than real estate or unsecured loans. 
The loan portfolio secured by real estate comprised 75.3% of the Company's loan
portfolio at December 31, 2005 compared with 77.6% of the Company's loan portfolio
at September 30, 2006.  The majority of the growth in loans secured by real
estate was offset by a decline in loans, as a percentage of the loan portfolio,
secured by commercial and industrial security other than real estate.

32

---

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).

September 30, 2006
  
  December 31, 2005Total
  
  % of total
  
  Total
  
  % of totalCommercial business
  $
  104,730
  
  11.3
  %
  90,345
  
  10.5Commercial real estate
  579,486
  
  62.8
  
  561,574
  
  65.1Installment
  20,979
  
  2.3
  
  18,677
  
  2.2Installment real estate
  62,090
  
  6.7
  
  55,682
  
  6.5Indirect
  39,784
  
  4.3
  
  30,481
  
  3.5Credit line
  1,951
  
  0.2
  
  2,022
  
  0.2Prime access
  53,771
  
  5.8
  
  54,296
  
  6.3Residential mortgage
  46,352
  
  5.0
  
  34,453
  
  4.0Bankcards
  11,223
  
  1.2
  
  11,744
  
  1.4Business manager
  337
  
  -
  
  230
  
  -Other
  1,789
  
  0.2
  
  2,059
  
  0.2Loans in process
  7,106
  
  0.8
  
  3,857
  
  0.4Deferred loan fees and costs
  607
  
  0.1
  
  761
  
  0.1Loans
  930,205
  
  100.7
  
  866,181
  
  100.4Mortgage loans held for sale
  1,334
  
  0.2
  
  4,821
  
  0.6Total loans, gross
  931,539
  
  100.9
  
  871,002
  
  101.0Allowance for loan losses
  (8,724)
  
  (0.9)
  
  (8,431)
  
  (1.0)Total loans, net
  $
  922,815
  
  100.0
  %
  862,571
  
  100.0


At September 30, 2006, the
Company's net loan portfolio approximated $922.8 million, or 81.5%, of the
Company's total assets compared with $862.6 million, or 80.2%, at December 31,
2005. Mortgage loans held for sale decreased $3.5 million from December 31,
2005 to September 30, 2006.

During the nine months ended September 30, 2006, the
Company introduced business credit scoring and began placing an emphasis on
small commercial credits.  Management believes that these changes resulted in
an increase in commercial business loans as a percentage of the total
portfolio.

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

During the first nine months of 2006, the Company's
indirect lending portfolio increased by $9.3 million, or 30.5%.  Management attributes this indirect loan growth to a
new program offered by the Company that targets high credit scoring consumers
at competitive rates. The goal of this program is to introduce the Company and
its products to reputable automobile dealers.  Once introduced, the Company's
goal is to continue to build and maintain relationships with these dealers and
their customers.

During
the first nine months of 2006, prime access loans declined as a percentage of the total loan portfolio. 
Management attributes this decline to the conversion of prime access loans to
fixed rate second mortgages during the rising rate environment that has been
experienced since the second quarter of 2004.

The increase in residential mortgage loans and the
decrease in mortgage loans held for sale during the first nine months of 2006
is the result of an increase in retained residential mortgage loans during the
period.

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.

33

---

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

September 30, 2006Special 
	mention
  
  Substandard
  
  Doubtful
  
  Loss
  
  TotalCommercial and industrial
  $
  379
  
  974
  
  958
  
  -
  
  2,311Real estate - 1 - 4 family
  32
  
  5,029
  
  372
  
  -
  
  5,433Real estate - construction
  -
  
  -
  
  -
  
  -
  
  -Real estate - other
  347
  
  8,265
  
  518
  
  -
  
  9,130General consumer
  -
  
  289
  
  55
  
  -
  
  344Credit line
  5
  
  38
  
  1
  
  -
  
  44Total classified assets
  $
  763
  
  14,595
  
  1,904
  
  -
  
  17,262Total classified assets as a percentage of loans (1)
  
  1.9%December 31, 2005Special 
	mention
  
  Substandard
  
  Doubtful
  
  Loss
  
  TotalCommercial and industrial
  $
  230
  
  2,925
  
  851
  
  -
  
  4,006Real estate - 1 - 4 family
  1,147
  
  4,023
  
  239
  
  -
  
  5,409Real estate - construction
  -
  
  -
  
  -
  
  -
  
  -Real estate - other
  82
  
  11,400
  
  58
  
  -
  
  11,540General consumer
  25
  
  287
  
  68
  
  -
  
  380Credit line
  6
  
  54
  
  1
  
  1
  
  62Total classified assets
  $
  1,490
  
  18,689
  
  1,217
  
  1
  
  21,397Total classified assets as a percentage of loans (1)
  
  2.5%(1)
  Calculated using loans
  excluding mortgage loans held for sale, net of unearned, excluding the Allowance


As a percentage of loans
excluding mortgage loans held for sale, classified assets declined from 2.5% at
December 31, 2005 to 1.9% at September 30, 2006. The decline within substandard real estate -
other from December 31, 2005 to September 30, 2006 resulted from the payoff of
a loan during the third quarter of 2006 that was classified as substandard at
December 31, 2005.  See Note 4 contained
within Part I, Item
1 of this Quarterly Report on Form 10-Q
for further discussion regarding this classified asset reduction.

Management
is aware of no material relationships or specific events or trends that led to
the decrease in classified assets during the first nine 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.

34

---

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

September 30,
  
  December 31,2006
  
  2005Nonaccrual loans
  $
  6,921
  
  9,913Total nonperforming loans
  6,921
  
  9,913Real estate acquired in
  settlement of loans
  771
  
  1,954Repossessed automobiles
  acquired in settlement of loans
  347
  
  167Total nonperforming assets
  $
  8,039
  
  12,034Loans past due 90 days and
  still accruing (1)
  $
  94
  
  207Ending loans (2)
  $
  930,205
  
  866,181Nonaccrual loans as a
  percentage of loans (2)
  0.74
  %
  1.14Nonperforming assets as a
  percentage oftotal assets
  0.71
  %
  1.12(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


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

September 30, 2006
  
  
  December 31, 2005Total
  
  % of total
  
  
  Total
  
  % of totalReal estate
  $
  6,332
  
  91.5
  %
  
  9,165
  
  92.4Commercial and industrial
  479
  
  6.9
  
  
  631
  
  6.4Credit cards
  -
  
  -
  
  
  -
  
  -Other consumer
  110
  
  1.6
  
  
  117
  
  1.2Total nonaccrual loans
  $
  6,921
  
  100.0
  %
  
  9,913
  
  100.0


The
decline in nonaccrual loans from December 31, 2005 to September 30, 2006 was primarily
the result of the removal of a loan in nonaccrual status and subsequent payoff
of a loan during the nine months ended September 30, 2006.  See Note 4 contained within Part I, Item 1 of this Quarterly
Report on Form 10-Q for further
discussion regarding this classified asset reduction and 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 nine monthperiods ended September 30,
  
  periods ended September 30,2006
  
  2005
  
  2006
  
  2005Real estate acquired in
  settlement of loans, beginning of period
  $
  728
  
  2,323
  
  1,954
  
  2,413Add: New real estate
  acquired in settlement of loans
  72
  
  534
  
  154
  
  1,050Less: Sales / recoveries of
  real estate acquired insettlement of loans
  (29)
  
  (829)
  
  (1,150)
  
  (1,226)Less: Provision charged to
  expense
  -
  
  (25)
  
  (187)
  
  (234)Real estate acquired in
  settlement of loans, end of period
  $
  771
  
  2,003
  
  771
  
  2,003


35

---

Levels of real estate
acquired in settlement of loans decreased from December 31, 2005 to September
30, 2006. Management believes that the main factor contributing to this decline
has been the portfolio trend of recent years that is not believed to
necessarily be indicative of historical or future credit trends.  The following
table summarizes the Company's real estate acquired in settlement of loans
portfolio balance at the dates indicated (in thousands).

|December 31, 2001  | $     | 217 | 
|------------------ | ----- | --- | 
|December 31, 2002  | 2,468 |    
|December 31, 2003  | 2,170 |    
|December 31, 2004  | 2,413 |    
|December 31, 2005  | 1,954 |    
|September 30, 2006 | 771   |    
|                   |       |     | 
|                   |       |     | 

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 September 30, 2006.

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.

Nonperforming commercial
loans are reviewed for impairment, and impairment is measured in accordance
with SFAS No. 114, "Accounting by Creditors for Impairment of a Loan, an
amendment of FASB Statements No. 5 and 15," and assigned specific reserves, if
necessary.  At September 30, 2006, impaired loans amounted to approximately
$4.2 million for which $936 thousand was included in the Allowance.  During the
first nine months of 2006, the average recorded investment in impaired loans
was approximately $7.3 million. At December 31, 2005, impaired loans amounted
to approximately $7.4 million for which $670 thousand was included in the
Allowance.  The
decline in impaired loans from December 31, 2005 to September 30, 2006 was
primarily the result of the payoff of an impaired loan during the nine months
ended September 30, 2006.  See Note 4
contained within Part
I, Item 1 of this Quarterly Report on Form 10-Q for further discussion regarding this classified asset reduction and
the Company's loans in nonaccrual status.  Management
believes that the impaired loans at September 30, 2006 were recorded at or
below fair market value. Because impaired loans are generally classified as
nonaccrual, no interest income is recognized on such loans subsequent to being
placed in nonaccrual status.

As of September 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 September 30, 2006 and 2005 were immaterial when considered
individually, or in the aggregate, with regard to the Company's Consolidated
Financial Statements.

Management believes that
because the Company's loan portfolio is closely monitored, and that 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 LossesThe Allowance totaled $8.7
million and $8.4 million, at September 30, 2006 and December 31, 2005,
respectively representing 0.94% and 0.97% of loans, calculated using loans
excluding mortgage loans held for sale, net of unearned income, excluding
allowance for loan losses.



36

---

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 nine month
  
  At and for the yearperiods ended September 30,
  
  periods ended September 30,
  
  ended December 31,2006
  
  2005
  
  2006
  
  2005
  
  2005Allowance balance, beginning
  of period
  $
  8,879
  
  8,051
  
  8,431
  
  7,619
  
  7,619Provision for loan losses
  275
  
  600
  
  1,325
  
  1,800
  
  2,400Loans charged-offCommercial and industrial
  104
  
  45
  
  318
  
  228
  
  244Real estate - 1 - 4 family
  107
  
  83
  
  147
  
  207
  
  415Real estate - construction
  -
  
  -
  
  -
  
  -
  
  -Real estate - other
  44
  
  35
  
  144
  
  81
  
  242Consumer
  199
  
  211
  
  557
  
  716
  
  891Total loans charged-off
  454
  
  374
  
  1,166
  
  1,232
  
  1,792RecoveriesCommercial and industrial
  2
  
  31
  
  31
  
  34
  
  35Real estate - 1 - 4 family
  1
  
  -
  
  14
  
  -
  
  -Real estate - construction
  -
  
  -
  
  -
  
  -
  
  -Real estate - other
  2
  
  1
  
  5
  
  35
  
  35Consumer
  19
  
  47
  
  84
  
  100
  
  134Total recoveries
  24
  
  79
  
  134
  
  169
  
  204Net loans charged-off
  430
  
  295
  
  1,032
  
  1,063
  
  1,588Allowance balance, end of
  period
  $
  8,724
  
  8,356
  
  8,724
  
  8,356
  
  8,431Average loans (1)
  $
  905,222
  
  843,827
  
  882,357
  
  819,711
  
  828,545Ending loans (1)
  930,205
  
  845,320
  
  930,205
  
  845,320
  
  866,181Net loans charged-offs to
  average loans (1)
  0.19
  %
  0.14
  
  0.16
  
  0.17
  
  0.19Allowance for loan losses to
  ending loans (1)
  0.94
  
  0.99
  
  0.94
  
  0.99
  
  0.97(1)
  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.

September 30,
  
  December 31,2006
  
  2005Total allowance
  
  % of loans 
	to total loans
  
  Total allowance
  
  % of loans 
	to total loansCommercial and industrial
  $
  1,201
  
  13.1
  %
  1,897
  
  16.5Real estate - 1 - 4 family
  1,528
  
  19.0
  
  1,267
  
  19.3Real estate - construction
  23
  
  2.4
  
  26
  
  3.4Real estate - other
  2,725
  
  56.2
  
  2,044
  
  52.6General consumer
  1,754
  
  7.5
  
  2,153
  
  6.3Credit line
  158
  
  0.5
  
  130
  
  0.5Bankcards
  355
  
  1.2
  
  310
  
  1.3Others
  980
  
  0.1
  
  604
  
  0.1Total
  $
  8,724
  
  100.0
  %
  8,431
  
  100.0


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.  The fluctuations
within the allocation of the Allowance from December 31, 2005 to September 30,
2006 are primarily the result of changes in previous loss experience ratios and
portfolio balances. The increase in Allowance allocation with regard to loans
secured by one to four family real estate is primarily the result of a shift of
approximately $1 million of classified one to four family real estate assets
from special mention to substandard which are generally reserved for at higher
loss percentages.

37

---

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 September 30, 2006.

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 nine month periods ended September 30, 2005
with the same periods of 2006.

Total net loans charged-off
totaled $430 thousand during the three month period ended September 30, 2006 up
from $295 thousand during the same period of 2005. When comparing the nine
month periods ended September 30, 2006 and 2005, net loans charged-off declined
$31 thousand to $1.0 million for the nine month period ended September 30,
2006.  For the nine month period ended September 30, 2006, net loans charged-off
as a percentage of average loans, excluding mortgage loans held for sale,
declined to 0.16% from 0.17% for the nine month period ended September 30,
2005. 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.  ANY SPECIFIC REASONS

The Allowance as a percentage
of loans excluding those held for sale declined from 0.97% at December 31, 2005
to 0.94% at September 30, 2006. Supporting this decline was the improvement in
credit quality key performance indicators between the periods.  As noted above,
for the nine month period ended September 30, 2006, net loans charged-off as a
percentage of average loans, excluding mortgage loans held for sale, declined
to 0.16% from 0.17% for the nine month period ended September 30, 2005.  As
noted in Loans contained herein, classified assets as a percentage of loans
excluding those held for sale declined from 2.5% to 1.9% from December 31, 2005
to September 30, 2006.  At September 30, 2006, the Allowance as a percentage of
classified assets totaled 50.5%, up from coverage of 39.4% at December 31,
2006. When comparing the same periods, nonaccrual loans as a percentage of
loans excluding those held for sale declined from 1.14% to 0.74% and real
estate and personal property acquired in settlement of loans as a percentage of
loans excluding those held for sale declined from 0.24% to 0.12%.

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 herein, management believes that the Allowance at
September 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).

September 30, 2006
  
  December 31, 2005Total
  
  % of total
  
  Total
  
  % of totalTransaction deposit accounts
  $
  429,948
  
  43.9
  %
  351,629
  
  38.9Money market deposit
  accounts
  127,500
  
  13.0
  
  111,380
  
  12.4Savings deposit accounts
  45,217
  
  4.6
  
  45,360
  
  5.0Time deposit accounts
  376,993
  
  38.5
  
  395,014
  
  43.7Total traditional deposit
  accounts
  $
  979,658
  
  100.0
  %
  903,383
  
  100.0




38

---

Total
traditional deposit accounts increased $76.3 million from December 31, 2005 to
September 30, 2006. At
September 30, 2006, traditional deposit accounts as a percentage of liabilities
were 94.6% compared with 91.6% at December 31, 2005.  The percentage of funding provided by traditional
deposit accounts has increased during the first nine 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 $94.3 million during the first nine months of 2006, or 18.5%.  The increase
in core traditional deposit accounts during the first nine months of 2006 was
primarily a result of  pricing adjustments, expansion of the Company's
geographic market area, quality customer service, the Company's reputation in
the communities served, and additional marketing efforts directed toward
several existing deposit products.  Also specifically contributing to the
growth in money market deposit accounts over the periods presented was a
deposit of approximately $14 million from one entity during the first nine
months of 2006 and an increase in money market funds by the Bank's trust
department of approximately $12 million during the period.

Time deposit accounts decreased by $18.0 million during
the first nine months of 2006. Promotional
certificate of deposit accounts offered beginning during 2004 began to mature
during the first nine months 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.

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 $94.3 million during the first nine months
of 2006 while higher-cost time deposit accounts decreased by $18.0 million
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 nine month
  
  For the year endedperiods ended September 30,
  
  periods ended September 30,
  
  December 31,2006
  
  2005
  
  2006
  
  2005
  
  2005Average cost of core deposit
  accounts
  2.42
  %
  1.06
  
  2.06
  
  0.81
  
  0.94Average cost of time deposit
  accounts
  4.07
  
  3.05
  
  3.89
  
  2.91
  
  2.99Average cost of total
  traditional deposit accounts
  3.18
  
  2.04
  
  2.94
  
  1.88
  
  1.98


BorrowingsBorrowings decreased $26.2 million at September
30, 2006 when compared with year-end 2005.  Borrowings
as a percentage of total liabilities were approximately 4.8% and 7.7% at
September 30, 2006 and December 31, 2005, respectively. The following table
summarizes the Company's borrowings composition at the dates indicated (dollars
in thousands).

September 30, 2006
  
  December 31, 2005Total
  
  % of total
  
  Total
  
  % of totalRetail repurchase agreements
  $
  17,468
  
  35.4
  %
  16,728
  
  22.1Commercial paper
  21,887
  
  44.3
  
  17,915
  
  23.7Federal funds purchased
  -
  
  -
  
  1,000
  
  1.3FHLB borrowings - short-term
  -
  
  -
  
  16,900
  
  22.4FHLB borrowings - long-term
  10,000
  
  20.3
  
  23,000
  
  30.5Total borrowings
  $
  49,355
  
  100.0
  %
  75,543
  
  100.0


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 represent unsecured overnight
borrowings, and short-term FHLB borrowings represent secured 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 September 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 in long-term FHLB advances in June 2006.

39

---

At September 30, 2006, of its approximately $191 million
available credit based on qualifying loans to serve as collateral against
short-term or long-term borrowings from the FHLB, the Company employed $10.0
million in borrowings, all of which was determined to be long-term when
employed, and employed $79.0 million in a letter of credit used to secure
public deposits as required or permitted by law.

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
September 30, 2006 that would require prepayment of any of the Company's FHLB
advances.

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

For the three month
  
  For the nine month
  
  For the yearperiods ended September 30,
  
  periods ended September 30,
  
  ended December 31,2006
  
  2005
  
  2006
  
  2005
  
  2005Retail repurchase agreements
  4.43
  %
  2.65
  
  4.08
  
  2.12
  
  2.38Commercial paper
  4.37
  
  2.56
  
  4.03
  
  2.09
  
  2.33Federal funds purchased
  3.56
  
  3.52
  
  4.58
  
  2.73
  
  2.71FHLB borrowings - short-term
  -
  
  7.70
  
  4.63
  
  3.41
  
  3.59FHLB borrowings - long-term
  3.81
  
  3.31
  
  3.60
  
  3.28
  
  3.38


Borrowing rates paid during the three and nine month
periods ended September 30, 2006 increased from those paid for the year ended
December 31, 2005 and those paid for the three and nine month periods ended
September 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 nine month periods ended September 30, 2006 are attributed to these
increasing rates.

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 prior period 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 ResourcesThe Company's primary source of capital has been the retention of
net income. In order to ensure adequate levels of capital, an ongoing
assessment is conducted of projected sources and uses of capital in conjunction
with projected increases in assets and the level of risk.

Average shareholders' equity
was $93.6 million for the nine month period ended September 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 $84.7 million for the nine month period ended September 30, 2005, or
8.2% of average assets.

Total shareholders' equity
increased from $88.9 million at December 31, 2005 to $97.2 million at September
30, 2006. The Company's capital ratio of total shareholders' equity to total
assets was 8.6% at September 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 and a slight increase in accumulated other
comprehensive income.  These increases were offset by an increase in cash
dividends when comparing the nine month period ended September 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 nine month
period ended September 30, 2006.

40

---

The Company and the Bank are
required to meet regulatory capital requirements that currently include several
measures of capital.  At September 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 September 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.

The Company has
risk management policies and systems which attempt to monitor and limit
exposure to interest rate risk. Specifically, the Company manages its exposure
to fluctuations in interest rates through policies established by its Asset /
Liability Committee and approved by its Board of Directors. The primary goal of
the Asset / Liability Committee is to monitor and limit exposure to interest rate
risk through implementation of various strategies. While the Asset / Liability
Committee considers these strategies to ultimately position the balance sheet
to minimize fluctuations in income associated with interest rate risk, it also
monitors the Company's liquidity and capital positions to ensure that its
strategies result in adequate positions of such other measures. The Company's primary source of capital has been the
retention of net income. In order to ensure adequate levels of capital, an
ongoing assessment is conducted of projected sources and uses of capital in
conjunction with projected increases in assets and the level of risk.

During the first nine months
of 2006, the Company's cash dividend payout ratio was 30.68% 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 nine months of 2005 was 29.49%. Cash
dividends per common share for the first nine months of 2006 totaled $0.54, an
increase of 12.5% over dividends per common share during the same period of
2005 of
$0.48.

DISCLOSURES REGARDING
MARKET RISK

The Company evaluated the results of its net interest income
simulation prepared as of September 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 a falling interest rate environment, net interest margin would
likely increase and during an increasing interest rate environment, net
interest margin would likely decrease.

Net Interest Income SimulationAs
of September 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
  
  $
  50,020
  
  (8.15)
  %
  4.79
  %
  (0.43)Up 100 basis points
  
  52,292
  
  (3.98)
  
  5.01
  
  (0.21)BASE CASE
  
  54,458
  
  -
  
  5.22
  
  -Down 100 basis points
  
  56,328
  
  3.43
  
  5.40
  
  0.18Down 200 basis points
  
  58,109
  
  6.70
  
  5.57
  
  0.35


The
simulation results as of September 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 3.43%
increase in net interest income over the subsequent 12 month period while an
upward movement in interest rates of 100 basis points would result in a 3.98%
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 18 basis point increase in net interest margin, assuming all other
variables remained unchanged. Conversely, a 100 basis point increase in
interest rates would result in a 21 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.



41

---

LIQUIDITY

General

The 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 60% of
the investment securities portfolio was pledged to secure public deposits as of
September 30, 2006 as compared with 83% at December 31, 2005.  Of the Company's
$119.5 million available for sale investment securities balance at September
30, 2006, $47.6 million was available as a liquidity source. The decline in
pledged securities between these periods was the result of a diversification of
assets pledged to secure public deposits, securities sold under agreements to
repurchase, and for other purposes as required or permitted by law as noted
below with regard to the FHLB line of credit.

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 September 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
September 30, 2006, of its approximately $191 million available credit based on
qualifying loans to serve as collateral against short-term or long-term
borrowings from the FHLB, the Company employed $10.0 million in borrowings, all
of which was determined to be long-term when employed, and employed $79.0 million
in a letter of credit used to secure public deposits as required or permitted
by law leaving a balance of approximately $102 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.

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 nine month period ended September 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 September 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 $164 thousand during the three month
periods ended September 30, 2006 and 2005,
respectively. For the nine month periods ended September 30, 2006 and 2005,
such payments totaled $555 thousand and $483 thousand, respectively.  Such
payments are included in Occupancy Expense in the Consolidated Statements of
Income.



42

---

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.

In
conjunction with the Company's 100th anniversary celebration on
September 21st, the Company announced its plan to relocate its
headquarters to downtown Greenville in 2008. Tentative plans project
construction of the new leased facility to begin in 2007 with a projected
completion date in 2008.  Management is currently completing negotiations of a
build-to-suit ground and building lease with the property owner.

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 September
30, 2006.

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

At
September 30, 2006, the holding company had $21.9 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 nine month
  
  For the yearperiods ended September 30,
  
  periods ended September 30,
  
  ended December 31,2006
  
  2005
  
  2006
  
  2005
  
  2005Commercial paper
  4.37
  %
  2.56
  
  4.03
  
  2.09
  
  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 September 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 nine 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.

OFF-BALANCE SHEET ARRANGEMENTS

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

43

---

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

Home equity loans
  $
  48,897Credit cards
  44,620Commercial real estate
  development
  86,470Other unused lines of credit
  62,705Total contractual
  obligations
  $
  242,692


GuaranteesAt
September 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 September 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 September 30, 2006.

Other Off-Balance Sheet ArrangementsAt September 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 September 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
$2.2 million at September 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 September 30, 2006.





44

---

QUARTERLY HIGHLIGHTS

(dollars in thousands,
  except common and per share data)At and for the three monthperiods ended September 30,
  
  
  
  Percent2006
  
  2005
  
  Variance
  
  Variance(unaudited)SUMMARY OF OPERATIONSInterest income
  $
  19,577
  
  16,255
  
  3,322
  
  20.4
  %Interest expense
  7,242
  
  4,789
  
  2,453
  
  51.2Net interest income
  12,335
  
  11,466
  
  869
  
  7.6Provision for loan losses
  275
  
  600
  
  (325)
  
  (54.2)Net interest income after
  provision for loan losses
  12,060
  
  10,866
  
  1,194
  
  11.0Noninterest income
  4,136
  
  3,924
  
  212
  
  5.4Noninterest expense
  10,357
  
  9,794
  
  563
  
  5.7Income before provision for
  income taxes
  5,839
  
  4,996
  
  843
  
  16.9Provision for income taxes
  2,038
  
  1,673
  
  365
  
  21.8Net income
  $
  3,801
  
  3,323
  
  478
  
  14.4
  %COMMON SHARE DATANet income:Basic
  $
  0.60
  
  0.53
  
  0.07
  
  13.2
  %Diluted
  0.59
  
  0.52
  
  0.07
  
  13.5Cash dividends
  0.18
  
  0.16
  
  0.02
  
  12.5Book value
  15.29
  
  13.81
  
  1.48
  
  10.7Outstanding shares
  6,356,785
  
  6,324,285
  
  32,500
  
  0.5Weighted average outstanding
  - basic
  6,356,656
  
  6,319,613
  
  37,043
  
  0.6Weighted average outstanding
  - diluted
  6,432,546
  
  6,421,407
  
  11,139
  
  0.2Dividend payout ratio
  30.10
  %
  30.45
  
  (0.35)
  
  (1.1)PERIOD-END BALANCESAssets
  $
  1,132,732
  
  1,064,950
  
  67,782
  
  6.4
  %Investment securities
  available for sale, at fair market value
  119,538
  
  124,412
  
  (4,874)
  
  (3.9)Loans (1)
  931,539
  
  848,824
  
  82,715
  
  9.7Deposits and other
  borrowings
  1,029,012
  
  971,898
  
  57,114
  
  5.9Shareholders' equity
  97,187
  
  87,360
  
  9,827
  
  11.2AVERAGE BALANCESAssets
  $
  1,121,939
  
  1,056,607
  
  65,332
  
  6.2
  %Interest-earning assets
  1,050,577
  
  991,599
  
  58,978
  
  5.9Investment securities
  available for sale, at fair market value
  117,062
  
  126,987
  
  (9,925)
  
  (7.8)Loans (1)
  907,834
  
  849,638
  
  58,196
  
  6.8Deposits and other
  borrowings
  890,765
  
  832,124
  
  58,641
  
  7.0Shareholders' equity
  95,837
  
  86,929
  
  8,908
  
  10.2SIGNIFICANT OPERATING RATIOS
  BASED ON EARNINGSReturn on average assets
  1.34
  %
  1.25
  
  0.09
  
  7.2
  %Return on average
  shareholders' equity
  15.74
  
  15.17
  
  0.57
  
  3.8Net interest margin
  4.66
  
  4.59
  
  0.07
  
  1.5(1) Calculated using loans
  including mortgage loans held for sale, net of unearned, excluding the
  allowance for loan losses


45

---

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.

Overview

PALMETTO BANCSHARES, INC. AND SUBSIDIARYConsolidated Statements of Income(dollars in thousands, except common and per share
  data)For the three month periodsended September 30,
  
  Dollar
  
  Percent2006
  
  2005
  
  Variance
  
  Variance(unaudited)Interest incomeInterest and fees on loans
  
  $
  18,033
  
  14,946
  
  3,087
  
  20.7
  %Interest on investment
  securities available for sale
  1,182
  
  1,171
  
  11
  
  0.9Interest on federal funds
  sold
  
  317
  
  84
  
  233
  
  277.4Dividends on FHLB stock
  
  45
  
  54
  
  (9)
  
  (16.7)Total interest income
  
  19,577
  
  16,255
  
  3,322
  
  20.4Interest expenseInterest on deposits
  
  6,680
  
  3,815
  
  2,865
  
  75.1Interest on retail
  repurchase agreements
  213
  
  138
  
  75
  
  54.3Interest on commercial
  paper
  
  247
  
  129
  
  118
  
  91.5Interest on federal funds
  purchased
  6
  
  13
  
  (7)
  
  (53.8)Interest on FHLB borrowings
  - short-term
  -
  
  490
  
  (490)
  
  (100.0)Interest on FHLB borrowings
  - long-term
  96
  
  204
  
  (108)
  
  (52.9)Total interest expense
  7,242
  
  4,789
  
  2,453
  
  51.2Net interest income
  12,335
  
  11,466
  
  869
  
  7.6Provision for loan losses
  
  275
  
  600
  
  (325)
  
  (54.2)Net interest income after
  provision for loan losses
  12,060
  
  10,866
  
  1,194
  
  11.0Noninterest incomeService charges on deposit
  accounts
  2,228
  
  2,148
  
  80
  
  3.7Fees for trust and brokerage
  services
  817
  
  612
  
  205
  
  33.5Mortgage-banking income
  
  182
  
  287
  
  (105)
  
  (36.6)Investment securities gains
  
  -
  
  12
  
  (12)
  
  (100.0)Other
  
  
  
  909
  
  865
  
  44
  
  5.1Total noninterest income
  4,136
  
  3,924
  
  212
  
  5.4Noninterest expenseSalaries and other personnel
  
  5,772
  
  5,740
  
  32
  
  0.6Net occupancy
  
  733
  
  659
  
  74
  
  11.2Furniture and equipment
  
  986
  
  890
  
  96
  
  10.8Marketing and advertising
  
  488
  
  328
  
  160
  
  48.8Postage and supplies
  
  350
  
  295
  
  55
  
  18.6Telephone
  
  
  180
  
  181
  
  (1)
  
  (0.6)Professional services
  
  210
  
  218
  
  (8)
  
  (3.7)Other
  
  
  
  1,638
  
  1,483
  
  155
  
  10.5Total noninterest expense
  10,357
  
  9,794
  
  563
  
  5.7Net income before provision
  for income taxes
  5,839
  
  4,996
  
  843
  
  16.9Provision for income taxes
  
  2,038
  
  1,673
  
  365
  
  21.8Net income
  
  $
  3,801
  
  3,323
  
  478
  
  14.4
  %Common Share DataNet Income - basic
  
  $
  0.60
  
  0.53
  
  0.07
  
  13.2
  %Net Income - diluted
  
  0.59
  
  0.52
  
  0.07
  
  13.5Cash dividends
  
  0.18
  
  0.16
  
  0.02
  
  12.5Book value
  
  
  15.29
  
  13.81
  
  1.48
  
  10.7Weighted average common
  shares outstanding - basic
  6,356,656
  
  6,319,613Weighted average common
  shares outstanding - diluted
  6,432,546
  
  6,421,407


Net Interest IncomeNet interest income for the
three month period ended September 30, 2006 increased $869 thousand, or 7.6%,
to $12.3 million from $11.5 million for the three month period ended September
30, 2005. During the third 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 89 basis points to 7.39% during the three
month period ended September 30, 2006 from 6.50% during the three month period
ended September 30, 2005. The average cost of interest-bearing liabilities
increased 97 basis points to 3.25% during the three month period ended
September 30, 2006 from 2.28% during the three month period ended September 30,
2005. Net interest income for the three month period ended September 30, 2006
was $12.3 million, and the net yield on interest-earning assets was 4.66%.
Average interest-earning assets increased $59.0 million over the same periods,
while interest-bearing liabilities increased $52.6 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.

46

---

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

For the three month periods ended September 30,2006
  
  2005Average
  Income/
  Yield/
  
  Average
  Income/
  Yield/Balance
  Expense
  Rate
  
  Balance
  Expense
  RateASSETSInterest-earnings assetsLoans, net of unearned (1)
  $
  907,834
  $
  18,033
  7.88
  %
  $
  849,638
  $
  14,946
  6.98
  %Investment securities
  available for sale, nontaxable (2)
  56,255
  512
  3.61
  
  59,559
  549
  3.66Investment securities
  available for sale, taxable (2)
  60,807
  670
  4.37
  
  67,428
  622
  3.66Federal funds sold
  23,083
  317
  5.45
  
  10,687
  84
  3.12Nontaxable
  loans (3)
  
  -
  #DIV/0!
  
  -
  -
  #DIV/0!FHLB stock
  2,598
  45
  6.87
  
  4,287
  54
  5.00Total interest-earning
  assets
  1,050,577
  19,577
  7.39
  
  991,599
  16,255
  6.50Noninterest-earning assetsCash and due from banks
  32,861
  
  
  
  30,635Allowance for loan losses
  (8,869)
  
  
  
  (8,134)Premises and equipment, net
  24,068
  
  
  
  22,665Goodwill
  3,688
  
  
  
  3,688Other intangible assets
  148
  
  
  
  231Accrued interest receivable
  5,731
  
  
  
  4,574Other
  13,735
  
  
  
  11,349Total noninterest-earning
  assets
  71,362
  
  
  
  65,008Total assets
  $
  1,121,939
  
  
  
  $
  1,056,607LIABILITIES AND
  SHAREHOLDERS' EQUITYLiabilitiesInterest-bearing liabilitiesTransaction and money market
  deposit accounts
  $
  401,439
  $
  2,684
  2.65
  %
  $
  323,120
  $
  956
  1.17
  %Savings deposit accounts
  45,749
  39
  0.34
  
  50,063
  38
  0.30Time deposit accounts
  385,448
  3,957
  4.07
  
  367,040
  2,821
  3.05Total interest-bearing
  deposits
  832,636
  6,680
  3.18
  
  740,223
  3,815
  2.04Retail repurchase agreements
  19,059
  213
  4.43
  
  20,698
  138
  2.65Commercial paper
  22,402
  247
  4.37
  
  20,011
  129
  2.56Federal funds purchased
  668
  6
  3.56
  
  1,465
  13
  3.52FHLB borrowings - short-term
  --
  --
  --
  
  25,243
  490
  7.70FHLB borrowings - long-term
  10,000
  96
  3.81
  
  24,484
  204
  3.31Total interest-bearing
  liabilities
  884,765
  7,242
  3.25
  
  832,124
  4,789
  2.28Noninterest-bearing
  liabilitiesNoninterest-bearing deposits
  134,141
  
  
  
  131,739Accrued interest payable
  2,370
  
  
  
  1,524Other
  4,826
  
  
  
  4,291Total noninterest-bearing
  liabilities
  141,337
  
  
  
  137,554Total liabilities
  1,026,102
  
  
  
  969,678Shareholders' equity
  95,837
  
  
  
  86,929Total liabilities and
  shareholders' equity
  $
  1,121,939
  
  
  
  $
  1,056,607NET INTEREST INCOME / NET
  YIELD ONINTEREST-EARNING ASSETS
  
  $
  12,335
  4.66
  %
  
  $
  11,466
  4.59
  %(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.


47

---

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 September 30, 2006 to the
three month period ended September 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.

For the three month period ended September 30, 2006
  	
	compared with the three month period ended September 30, 2005Volume
  
  Rate
  
  TotalInterest-earnings assetsLoans, net of unearned
  $
  1,070
  
  2,017
  
  3,087Investment securities
  available for sale
  (51)
  
  62
  
  11Federal funds sold
  142
  
  91
  
  233FHLB stock
  (188)
  
  179
  
  (9)Total interest-earning
  assets
  $
  973
  
  2,349
  
  3,322Interest-bearing liabilitiesInterest-bearing deposits
  $
  525
  
  2,340
  
  2,865Retail repurchase agreements
  (10)
  
  85
  
  75Commercial paper
  17
  
  101
  
  118Federal funds purchased
  (7)
  
  -
  
  (7)FHLB borrowings - short-term
  (245)
  
  (245)
  
  (490)FHLB borrowings - long-term
  (145)
  
  37
  
  (108)Total interest-bearing
  liabilities
  $
  135
  
  2,318
  
  2,453NET INTEREST INCOME
  $
  838
  
  31
  
  869


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 $275
thousand and $600 thousand for the three month periods ended September 30, 2006
and 2005, respectively. The Allowance at September 30, 2006, December 31, 2005,
and September 30, 2005 was $8.7 million, $8.4 million, and $8.4 million,
respectively and represented 0.94%, 0.97%, and 0.99% of loans less mortgage
loans held for sale and unearned at September 30, 2006, December 31, 2005, and
September 30, 2005, respectively.

The decline in the provision
for loan losses during the third quarter of 2006 when compared with the third
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 increased during the three month period ended September 30, 2006 when compared with the same period of 2005 from $295 thousand, or 0.14% of average loans excluding mortgage loans held for sale and unearned amounts to $430 thousand, or 0.19% of average loans excluding mortgage loans held for sale and unearned amounts. Management does not believe that the increase in net loans charged-off during the three month period ended September 30, 2006 over the same period of 2005 was an indication of declining credit quality.   Instead, it is believed that the increase is the result of lower than historical net loans charged-off during the 2005 quarter as net loans charged-off for the year ended December 31, 2005 amounted to 0.19% of average loans excluding mortgage loans held for sale.

As discussed in Financial
Condition, Allowance for Loan Losses, the Allowance as a
percentage of loans excluding those held for sale declined from 0.97% at
December 31, 2005 to 0.94% at September 30, 2006. Supporting this decline was
the improvement in credit quality key performance indicators between the
periods.  Classified assets as a percentage of loans excluding those held for
sale declined from 2.5% to 1.9% from December 31, 2005 to September 30, 2006. 
At September 30, 2006, the Allowance as a percentage of classified assets
totaled 50.5%, up from coverage of 39.4% at December 31, 2006. When comparing
the same periods, nonaccrual loans as a percentage of loans excluding those
held for sale declined from 1.14% to 0.74% and real estate and personal
property acquired in settlement of loans as a percentage of loans excluding
those held for sale declined from 0.24% to 0.12%.

48

---

Also a factor in the
provision for loan losses for the three month period ended September 30, 2006
was an increase of the total loan portfolio excluding mortgage loans held for
sale of $41.1 million during the period.

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 September 30, 2006 totaled $4.1
million, up $212 thousand compared with the third quarter of 2005. The primary
fluctuations within noninterest income when comparing the three month period
ended September 30, 2005 to the same period of 2006 included an increase in
fees from trust and brokerage services offset slightly by a decline in
mortgage-banking income of $105 thousand.

Net fees from trust and brokerage services include fees
earned through the Bank's subsidiary, Palmetto Capital and the Bank's trust
department. At September 30, 2005, assets under Palmetto Capital's management
totaled $152.8 million as compared with the assets under management at
September 30, 2006 of $164.6 million. At September 30, 2005, assets under the
trust department's management totaled $279.6 million as compared with the
assets under management at September 30, 2006 of $300.9 million. The increase
in fees earned correlates to the level of assets under management. Levels of
assets under management are a function of the flow of money into and out of the
fund, as well as the change in market valuation.

The
Company sells most of its residential mortgage loans it originates in the
secondary market with servicing rights retained. At September 30, 2006, the
mortgage-servicing rights portfolio for loans sold had an aggregate principal
balance of $310.0 million compared with $301.1 million at September 30,
2005. Mortgage-banking income decreased
$105 thousand, or 36.6%, during the third 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 monthperiods ended September 30,2006
  2005Mortgage-servicing fees
  $
  193
  187Gain on sale of mortgage
  loans
  80
  220Mortgage-servicing rights
  amortization, impairment, and recoveries
  (157)
  (175)Other mortgage-banking
  income
  66
  55Total mortgage-banking
  income
  $
  182
  287


The
decrease in mortgage-banking income when comparing the three month period ended
September 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.

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.

Noninterest ExpenseNoninterest expense for the
three month period ended September 30, 2006 increased $563 thousand, or 5.7%,
to $10.4 million from $9.8 million during the three month period ended
September 30, 2005. The primary contributors to this increase were increases in
furniture and equipment, marketing and advertising, and other noninterest
expenses.

49

---



Furniture and equipment
expense increased $257 thousand during the three month period ended September
30, 2006 compared with the same period of 2005.  This increase was the result
of changes in several accounts, none of which constituted material
fluctuations.

Marketing and advertising expense increased $160
thousand during the three month period ended September 30, 2006 compared with
the same period of 2005.  Impacting this increase were costs associated with
the Company's 100-year anniversary celebration.

Other noninterest expense
increased $155 thousand during the three month period ended September 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
$2.0 million for the three month period ended September 30, 2006, compared with
$1.7 million for the three month period ended September 30, 2005.  The
Company's effective tax rate was 35.0% and 33.5%, respectively, during the two
periods based on permanent differences.











50

---

YEAR-TO-DATE HIGHLIGHTS

(dollars in thousands,
  except common and per share data)At and for the nine monthperiods ended September 30,
  
  
  
  Percent2006
  
  2005
  
  Variance
  
  Variance(unaudited)SUMMARY OF OPERATIONSInterest income
  $
  56,294
  
  46,041
  
  10,253
  
  22.3
  %Interest expense
  19,696
  
  12,208
  
  7,488
  
  61.3Net interest income
  36,598
  
  33,833
  
  2,765
  
  8.2Provision for loan losses
  1,325
  
  1,800
  
  (475)
  
  (26.4)Net interest income after
  provision for loan losses
  35,273
  
  32,033
  
  3,240
  
  10.1Noninterest income
  12,198
  
  11,705
  
  493
  
  4.2Noninterest expense
  30,691
  
  28,279
  
  2,412
  
  8.5Income before provision for
  income taxes
  16,780
  
  15,459
  
  1,321
  
  8.5Provision for income taxes
  5,598
  
  5,178
  
  420
  
  8.1Net income
  $
  11,182
  
  10,281
  
  901
  
  8.8
  %COMMON SHARE DATANet income:Basic
  $
  1.76
  
  1.63
  
  0.13
  
  8.1
  %Diluted
  1.74
  
  1.60
  
  0.14
  
  8.6Cash dividends
  0.54
  
  0.48
  
  0.06
  
  12.5Book value
  15.29
  
  13.81
  
  1.48
  
  10.7Outstanding shares
  6,356,785
  
  6,324,285
  
  32,500
  
  0.5Weighted average outstanding
  - basic
  6,351,646
  
  6,314,431
  
  37,215
  
  0.6Weighted average outstanding
  - diluted
  6,427,536
  
  6,418,032
  
  9,504
  
  0.1Dividend payout ratio
  30.69
  %
  29.50
  
  1.19
  
  4.0PERIOD-END BALANCESAssets
  $
  1,132,732
  
  1,064,950
  
  67,782
  
  6.4
  %Investment securities
  available for sale, at fair market value
  119,538
  
  124,412
  
  (4,874)
  
  (3.9)Loans (1)
  931,539
  
  848,824
  
  82,715
  
  9.7Deposits and other
  borrowings
  1,029,012
  
  971,898
  
  57,114
  
  5.9Shareholders' equity
  97,187
  
  87,360
  
  9,827
  
  11.2AVERAGE BALANCESAssets
  $
  1,108,037
  
  1,036,788
  
  71,249
  
  6.9
  %Interest-earning assets
  1,033,776
  
  971,403
  
  62,373
  
  6.4Investment securities
  available for sale, at fair market value
  121,312
  
  135,598
  
  (14,286)
  
  (10.5)Loans (1)
  885,480
  
  824,792
  
  60,688
  
  7.4Deposits and other
  borrowings
  874,566
  
  818,152
  
  56,414
  
  6.9Shareholders' equity
  93,584
  
  84,657
  
  8,927
  
  10.5SIGNIFICANT OPERATING RATIOS
  BASED ON EARNINGSReturn on average assets
  1.35
  %
  1.33
  
  0.02
  
  1.8
  %Return on average
  shareholders' equity
  15.98
  
  16.24
  
  (0.26)
  
  (1.6)Net interest margin
  4.73
  
  4.66
  
  0.07
  
  1.5(1) Calculated using loans
  including mortgage loans held for sale, net of unearned, excluding the
  allowance for loan losses


51

---

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 SUBSIDIARYConsolidated Statements of Income(dollars in thousands, except common and per share
  data)For the nine month periodsended September 30,
  
  Dollar
  
  Percent2006
  
  2005
  
  Variance
  
  Variance(unaudited)Interest incomeInterest and fees on loans
  
  $
  51,601
  
  41,936
  
  9,665
  
  23.0
  %Interest on investment
  securities available for sale
  3,646
  
  3,810
  
  (164)
  
  (4.3)Interest on federal funds
  sold
  
  903
  
  149
  
  754
  
  506.0Dividends on FHLB stock
  
  144
  
  146
  
  (2)
  
  (1.4)Total interest income
  
  56,294
  
  46,041
  
  10,253
  
  22.3Interest expenseInterest on deposits
  
  17,943
  
  10,152
  
  7,791
  
  76.7Interest on retail
  repurchase agreements
  564
  
  334
  
  230
  
  68.9Interest on commercial
  paper
  
  591
  
  288
  
  303
  
  105.2Interest on federal funds
  purchased
  20
  
  78
  
  (58)
  
  (74.4)Interest on FHLB borrowings-short-term
  
  99
  
  676
  
  (577)
  
  (85.4)Interest on FHLB borrowings-long-term
  
  479
  
  680
  
  (201)
  
  (29.6)Total interest expense
  19,696
  
  12,208
  
  7,488
  
  61.3Net interest income
  36,598
  
  33,833
  
  2,765
  
  8.2Provision for loan losses
  
  1,325
  
  1,800
  
  (475)
  
  (26.4)Net interest income after
  provision for loan losses
  35,273
  
  32,033
  
  3,240
  
  10.1Noninterest incomeService charges on deposit
  accounts
  6,333
  
  5,987
  
  346
  
  5.8Fees for trust and brokerage
  services
  2,445
  
  2,163
  
  282
  
  13.0Mortgage-banking income
  
  679
  
  1,043
  
  (364)
  
  (34.9)Investment securities gains
  
  3
  
  81
  
  (78)
  
  (96.3)Other
  
  
  
  2,738
  
  2,431
  
  307
  
  12.6Total noninterest income
  12,198
  
  11,705
  
  493
  
  4.2Noninterest expenseSalaries and other personnel
  
  17,256
  
  16,312
  
  944
  
  5.8Net occupancy
  
  2,124
  
  1,918
  
  206
  
  10.7Furniture and equipment
  
  2,952
  
  2,695
  
  257
  
  9.5Marketing and advertising
  
  1,284
  
  851
  
  433
  
  50.9Postage and supplies
  
  1,086
  
  927
  
  159
  
  17.2Telephone
  
  
  575
  
  547
  
  28
  
  5.1Professional services
  
  690
  
  618
  
  72
  
  11.7Other
  
  
  
  4,724
  
  4,411
  
  313
  
  7.1Total noninterest expense
  30,691
  
  28,279
  
  2,412
  
  8.5Net income before provision
  for income taxes
  16,780
  
  15,459
  
  1,321
  
  8.5Provision for income taxes
  
  5,598
  
  5,178
  
  420
  
  8.1Net income
  
  $
  11,182
  
  10,281
  
  901
  
  8.8
  %Common Share DataNet Income - basic
  
  $
  1.76
  
  1.63
  
  
  
  8.0
  %Net Income - diluted
  
  1.74
  
  1.60
  
  
  
  8.8Cash dividends
  
  0.54
  
  0.48
  
  
  
  12.5Book value
  
  
  15.29
  
  13.81
  
  
  
  10.7Weighted average common
  shares outstanding - basic
  6,351,646
  
  6,314,431Weighted average common
  shares outstanding - diluted
  6,427,536
  
  6,418,032


Net Interest IncomeNet interest income for the
nine month period ended September 30, 2006 increased $2.8 million, or 8.2%, to
$36.6 million from $33.8 million for the nine month period ended September 30,
2005. During the first nine 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 94 basis points to 7.28% during the nine
month period ended September 30, 2006 from 6.34% during the nine month period
ended September 30, 2005. The average cost of interest-bearing liabilities
increased 102 basis points to 3.01% during the nine month period ended
September 30, 2006 from 1.99% during the nine month period ended September 30,
2005. Net interest income for the nine month period ended September 30, 2006
was $36.6 million, and the net yield on interest-earning assets was 4.73%.
Average interest-earning assets increased $62.4 million over the same periods,
while interest-bearing liabilities increased $56.4 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.

52

---

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

For the nine month periods ended September 30,2006
  
  2005Average
  Income/
  Yield/
  
  Average
  Income/
  Yield/Balance
  Expense
  Rate
  
  Balance
  Expense
  RateASSETSInterest-earnings assetsLoans, net of unearned (1)
  $
  885,480
  $
  51,601
  7.79
  %
  $
  824,792
  $
  41,936
  6.80
  %Investment securities
  available for sale, nontaxable (2)
  55,409
  1,505
  3.63
  
  62,463
  1,739
  3.72Investment securities
  available for sale, taxable (2)
  65,903
  2,141
  4.34
  
  73,135
  2,071
  3.79Federal funds sold
  23,941
  903
  5.04
  
  6,555
  149
  3.04FHLB stock
  3,043
  144
  6.33
  
  4,458
  146
  4.38Total interest-earning
  assets
  1,033,776
  56,294
  7.28
  
  971,403
  46,041
  6.34Noninterest-earning assetsCash and due from banks
  37,238
  
  
  
  30,962Allowance for loan losses
  (8,716)
  
  
  
  (7,896)Premises and equipment, net
  23,529
  
  
  
  22,458Goodwill
  3,688
  
  
  
  3,688Other intangible assets
  158
  
  
  
  268Accrued interest receivable
  5,298
  
  
  
  4,466Other
  13,066
  
  
  
  11,439Total noninterest-earning
  assets
  74,261
  
  
  
  65,385Total assets
  $
  1,108,037
  
  
  
  $
  1,036,788LIABILITIES AND
  SHAREHOLDERS' EQUITYLiabilitiesInterest-bearing liabilitiesTransaction and money market
  deposit accounts
  $
  377,519
  $
  6,429
  2.28
  %
  $
  303,867
  $
  2,027
  0.89
  %Savings deposit accounts
  46,007
  112
  0.33
  
  48,377
  107
  0.30Time deposit accounts
  391,663
  11,402
  3.89
  
  368,386
  8,018
  2.91Total interest-bearing
  deposits
  815,189
  17,943
  2.94
  
  720,630
  10,152
  1.88Retail repurchase agreements
  18,492
  564
  4.08
  
  21,060
  334
  2.12Commercial paper
  19,630
  591
  4.03
  
  18,433
  288
  2.09Federal funds purchased
  584
  20
  4.58
  
  3,820
  78
  2.73FHLB borrowings - short-term
  2,861
  99
  4.63
  
  26,504
  676
  3.41FHLB borrowings - long-term
  17,810
  479
  3.60
  
  27,705
  680
  3.28Total interest-bearing
  liabilities
  874,566
  19,696
  3.01
  
  818,152
  12,208
  1.99Noninterest-bearing
  liabilitiesNoninterest-bearing deposits
  133,317
  
  
  
  128,900Accrued interest payable
  2,189
  
  
  
  1,378Other
  4,381
  
  
  
  3,701Total noninterest-bearing
  liabilities
  139,887
  
  
  
  133,979Total liabilities
  1,014,453
  
  
  
  952,131Shareholders' equity
  93,584
  
  
  
  84,657Total liabilities and
  shareholders' equity
  $
  1,108,037
  
  
  
  $
  1,036,788NET INTEREST INCOME / NET
  YIELD ONINTEREST-EARNING ASSETS
  
  $
  36,598
  4.73
  %
  
  $
  33,833
  4.66
  %(1)
  Calculated including
  mortgage loans held for sale.  Nonaccrual loans are included in average
  balances for yield computations.  The effect of foregone
  interest income as a result of loans on nonaccrual was not considered in the
  above analysis.  All loans and deposits are domestic.(2)
  The average balances for
  investment securities include the unrealized gain or loss recorded for
  available for sale securities.


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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 nine month period ended September 30, 2006 to the
nine month period ended September 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.

For the nine month period ended September 30, 2006
  compared with the nine month period ended September 30, 2005Volume
  
  Rate
  
  TotalInterest-earnings assetsLoans, net of unearned
  $
  3,237
  
  6,428
  
  9,665Investment securities
  available for sale
  (484)
  
  320
  
  (164)Federal funds sold
  604
  
  150
  
  754FHLB stock
  5
  
  (7)
  
  (2)Total interest-earning
  assets
  $
  3,362
  
  6,891
  
  10,253Interest-bearing liabilitiesInterest-bearing deposits
  $
  1,474
  
  6,317
  
  7,791Retail repurchase agreements
  (35)
  
  265
  
  230Commercial paper
  20
  
  283
  
  303Federal funds purchased
  101
  
  (159)
  
  (58)FHLB borrowings - short-term
  (961)
  
  384
  
  (577)FHLB borrowings - long-term
  (275)
  
  74
  
  (201)Total interest-bearing
  liabilities
  $
  324
  
  7,164
  
  7,488NET INTEREST INCOME
  $
  3,038
  
  (273)
  
  2,765


Provision for Loan LossesThe provision for loan losses
was $1.3 million and $1.8 million for the nine month periods ended September
30, 2006 and 2005, respectively.

The decline in the provision
for loan losses during the nine months ended September 30, 2006 when compared
with the same period of 2005 was impacted by the same factors as those
discussed in Quarterly Net Income Review, Provision for Loan Losses with the following
differences.

Net loans charged-off decreased during the nine month period ended September 30, 2006 when compared with the same period of 2005 from $1.1 million, or 0.17% of average loans excluding mortgage loans held for sale and unearned amounts to $1.0 thousand, or 0.16% of average loans excluding mortgage loans held for sale and unearned amounts.

Also a factor in the
provision for loan losses for the nine month period ended September 30, 2006
was an increase of the total loan portfolio excluding mortgage loans held for
sale of $64.0 million during the period.

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 nine month period ended September 30, 2006 totaled $12.2
million, up $493 thousand compared with the same period of 2005. The primary
fluctuations within noninterest income when comparing the nine month period
ended September 30, 2005 to the same period of 2006 included increases in service
charges on deposit accounts of $346 thousand, fees for trust and brokerage
services totaling $282 thousand, and other noninterest income totaling $307
thousand offset by a decline in mortgage-banking income of $364 thousand.

Service charges on deposit accounts
comprise a significant component of noninterest income and comprised 51.9% of
noninterest income during the nine months ended September 30, 2006 compared
with 51.1% of noninterest income for the same period of 2005. Service charges
on deposit accounts increased $346 thousand, or 5.8% 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 nine months ended September 30, 2005 to the same period of
2006 as well as to enhancements offered with regard to the Company's existing
overdraft program beginning during the third quarter of 2006.

54

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Fees for trust and brokerage
services increased $282 thousand from the nine month period ended September 30,
2005 to the same period of 2006. This increase was impacted by the same factors
as those discussed in Quarterly Net Income Review, Noninterest Income.

Mortgage-banking
income decreased $364 thousand, or 34.9%, during the nine month period ended
September 30,2006 with the same period of 2005.  The following table summarizes
the components of mortgage-banking income for the periods indicated (in
thousands).

For the nine monthperiods ended September 30,2006
  2005Mortgage-servicing fees
  $
  580
  527Gain on sale of mortgage
  loans
  370
  836Mortgage-servicing rights
  amortization, impairment, and recoveries
  (429)
  (469)Other mortgage-banking
  income
  158
  149Total mortgage-banking income
  $
  679
  1,043


The
decrease in mortgage-banking income when comparing the nine month period ended
September 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 rights amortization,
impairment, and recoveries and an increase in mortgage-servicing fees.

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 nine month periods ended September
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 nine
month period ended September 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 rights portfolio.  As interest rates have risen
since 2004, refinancing activity has continued to slow.  As such,
mortgage-servicing rights amortization 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 rights 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 rights portfolio,
allowing the Company to recover a portion of previously recorded impairment
reserves through the mortgage-servicing rights valuation allowance. The increase in mortgage-servicing fees during the
nine month period ended September 30, 2006 compared with the same period of
2005 is the result of an increase in mortgage loans serviced for others
totaling $8.9 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 $307 thousand during the nine month period ended September 30, 2006
over the same period of 2005. This increase was the result of changes in
several accounts, none of which constituted material fluctuations.



55

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Noninterest ExpenseNoninterest expense for the
nine month period ended September 30, 2006 increased $2.4 million, or 8.5%, to
$30.7 million from $28.3 million during the nine month period ended September
30, 2005. The primary contributors to this increase were increases in salaries
and other personnel and marketing and advertising expense.

Comprising
56.2% of noninterest expense during the nine month period ended September 30,
2006 and 57.7% of noninterest expense during the nine month period ended
September 30, 2005, salaries and other personnel expense increased between the
periods by $944 thousand to $17.3 million from $16.3 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 Boiling Springs office during 2006.  The Company also continued to experience increasing
medical insurance premiums during the first nine 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 $246 thousand
over these periods. Full time equivalent employees increased from 378 at
September 30, 2005 to 407 at September 30, 2006.

Marketing and advertising
expense increased $433 thousand during the first nine months of 2006 compared
with the same period of 2005 primarily as a result of additional marketing
efforts directed toward the reintroduction of several existing deposit products
and expenses relating to the Company's 100-year anniversary celebration.

Provision for Income TaxesIncome tax expense totaled
$5.6 million for the nine month period ended September 30, 2006, compared with
$5.2 million for the nine month period ended September 30, 2005.  The Company's
effective tax rate was 33.4% and 33.5%, respectively, during the two periods
based on permanent 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.









56

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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 September 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 the Company's 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 third 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.







57

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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

None

Item 5.  Other Information

None.

Item 6.  Exhibits

21.1         Subsidiaries of Registrant

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.



58

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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 Patterson L. Leon Patterson
 Chairman and Chief Executive Officer

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

Dated:  
November 9, 2006









59