Table of Contents

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWashington, D.C.  20549

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FORM 10-Q

|x | QUARTERLY REPORT PURSUANT TO
  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 
|- | ------------------------------------------------------------------------------------------
|  |                                                                                           
|  | For
  the quarterly period ended September 30, 2004                                       
|  |                                                                                           
|o | TRANSITION REPORT PURSUANT TO
  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|  |                                                                                           
|  | For
  the transition period from __________ to __________                                 



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Commission File Number: 000-25081

|VAIL BANKS, INC.                                      
|------------------------------------------------------
|(Exact name of registrant as specified in its charter)



|Colorado                                                                             |  | 84-1250561                            
|------------------------------------------------------------------------------------ |  | --------------------------------------
|(State or other jurisdiction of
  incorporation or organization)                     |  | (I.R.S. Employer
  Identification No.)
|                                                                                     |  |                                       
|0015 Benchmark Road, Suite 300, P.O. Box
  6580, Avon, Colorado 81620               
|(Address of principal executive
  offices)                                          
|                                                                                    
|(970) 476-2002                                                                      
|(Registrants telephone number,
  including area code)                              
|                                                                                    
|N/A                                                                                 
|(Former name, former address
  and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.  Yes x No
o.

Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange
Act).     Yeso  No x.

Indicate the number of shares outstanding of each of the issuers
classes of common stock, as of the latest practicable date:  As of
October 31, 2004, there were 5,310,754 shares of
common stock ($1.00 par value per share) outstanding.

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VAIL BANKS, INC.

FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2004

TABLE
OF CONTENTS

|PART I     | FINANCIAL INFORMATION                                        |                                                                                        
|---------- | ------------------------------------------------------------ | ---------------------------------------------------------------------------------------
|           |                                                              |                                                                                        
|           | ITEM 1.                                                      | FINANCIAL STATEMENTS                                                                   
|           | Consolidated Balance Sheets                                  | 3                                                                                      
|           | Consolidated Statements of Income and
  Comprehensive Income | 4                                                                                      
|           | Consolidated Statements of Cash Flows                        | 6                                                                                      
|           | Notes to Unaudited Consolidated Financial
  Statements..     | 8                                                                                      
|           |                                                              |                                                                                        
|           | ITEM 2.                                                      | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
  RESULTS OF OPERATIONS
|           | Forward Looking Statements                                   | 16                                                                                     
|           | Basis of Presentation                                        | 16                                                                                     
|           | Overview                                                     | 16                                                                                     
|           | Results of Operations                                        | 17                                                                                     
|           | Financial Condition                                          | 18                                                                                     
|           | Asset Quality                                                | 19                                                                                     
|           | Liquidity                                                    | 20                                                                                     
|           | Capital Resources                                            | 22                                                                                     
|           | Recent Accounting Pronouncements                             | 22                                                                                     
|           |                                                              |                                                                                        
|           | ITEM 3.                                                      | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                             
|           |                                                              |                                                                                        
|           | ITEM 4.                                                      | CONTROLS AND PROCEDURES                                                                
|           |                                                              |                                                                                        
|PART II    | OTHER INFORMATION                                            |                                                                                        
|           |                                                              |                                                                                        
|           | ITEM 1.                                                      | LEGAL PROCEEDINGS                                                                      
|           |                                                              |                                                                                        
|           | ITEM 6.                                                      | EXHIBITS AND REPORTS ON FORM 8-K                                                       
|           |                                                              |                                                                                        
|SIGNATURES |                                                             
|           |                                                              |                                                                                        

2

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# PART I          FINANCIAL INFORMATION

## Item 1.      FINANCIAL
STATEMENTS

VAIL BANKS, INC.Consolidated Balance
SheetsSeptember 30,

December 31,(in thousands, except share data)

2004

2003ASSETS




(unaudited)Cash and due from banks
$
15,082

21,628Federal funds sold

6,230

79,280Total cash and cash equivalents

21,312

100,908Interest-bearing deposits in banks

2,000

2,000Investment securities, available for sale

132,615

76,554Investment securities, held to maturity (fair value of$302(unaudited) and $397 as of September
30, 2004 and December 31, 2003,
    respectively)

283

370Investments in bank stocks, at cost

4,411

4,371Investments in Trust I and Trust II (See Note 1)

743

—Loans held for sale

2,295

2,515Loans, net (includes related party loans of $10,687 (unaudited) and
$11,239as of September 30, 2004 and December 31, 2003,
respectively)

380,530

308,271Premises and equipment, net

38,367

38,147Interest receivable

2,305

2,134Goodwill

35,969

36,758Other intangible assets, net

169

199Other assets



3,983

3,383$
624,982

575,610LIABILITIES AND SHAREHOLDERS’ EQUITYLiabilitiesDepositsNon-interest bearing
$
108,232

101,305Interest bearing

392,065

347,210Total
deposits

500,297

448,515Federal funds purchased and securities sold under agreements to
repurchase

751

907Federal Home Loan Bank advances

33,603

39,461Guaranteed preferred beneficial interest in
Company’s subordinated debt (See Note 1)

—

24,000Subordinated notes to Trust I and Trust II (See Note 1)

24,743

—Interest payable and other liabilities

3,641

4,165Total liabilities

563,035

517,048Minority interest

2,546

703Shareholders’ equityPreferred stock – $1 par value; 2,250,000 shares authorized, no
sharesissued and outstanding at September 30, 2004 (unaudited) and December 31,
2003,
          respectively

—

—Common stock – $1 par value; 20,000,000 shares authorized,5,310,754 (unaudited) and 5,283,264 issued and outstanding at September 30,
2004
          and December 31, 2003, respectively

5,311

5,283Additional paid-in
capital

34,724

33,916Retained earnings

19,977

18,780Accumulated other
comprehensive loss, net of tax benefit of$(360)(unaudited) and $(71) at September
30, 2004 and December 31, 2003,
          respectively

(611)

(120)Total shareholders equity

59,401

57,859$
624,982

575,610


The accompanying notes
are an integral part of these unaudited consolidated financial statements.



3

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Vail Banks, Inc.
Consolidated Statements of Income and Comprehensive
Income(in thousands, except share data)

Three
months ended
September 30,

Nine
months ended
September 30,2004

2003

2004

2003(unaudited)

(unaudited)

(unaudited)

(unaudited)Interest and dividend
incomeLoans, including fees
$
6,704

6,318

18,934

19,860Investment securities

1,134

850

2,952

2,847Federal funds sold and other short-term
         investments

25

191

314

480Investments in Trust I and II (See Note 1)

19



57

Total interest and dividend income

7,882

7,359

22,257

23,187Interest expenseDeposits

1,028

1,172

3,052

3,576Short-term borrowings

105

97

307

265Long-term borrowings

235

342

750

907Federal funds purchased and securities 
           sold under agreements to repurchase

3



5

Trust preferred securities (See Note 1)



612



1,835Subordinated notes to Trust I and II (See
           Note 1)

631



1,892

Total interest expense

2,002

2,223

6,006

6,583Net interest income

5,880

5,136

16,251

16,604Provision for loan losses

323

164

524

414Net interest income after provision
                        
for loan losses

5,557

4,972

15,727

16,190Non-interest incomeGain (loss) on sale of premises and equipment

(11)



1,770

Deposit related

717

747

2,094

2,323Mortgage broker fees

756

1,299

2,334

4,083Other

781

702

1,981

2,0702,243

2,748

8,179

8,476Non-interest expenseSalaries and employee benefits

4,096

4,403

12,109

13,015Occupancy

1,000

850

2,691

2,478Furniture and equipment

608

696

1,781

2,095Amortization of intangible assets

10

19

30

56Other

1,338

1,326

3,576

3,5697,052

7,294

20,187

21,213Income before income tax expense

748

426

3,719

3,453Income tax expense

189

63

1,406

978Net income

559

363

2,313

2,475Net change in unrealized
gain/loss on
     investment securities available for sale, net
     of taxes:Unrealized holding gains
arising during
          period
          Reclassification
adjustment for gains
          included in income

987 


(564)
(140)

(491)


(579)

(179)Comprehensive income
$
1,546

(341)

1,822

1,717




4

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Vail Banks, Inc.Consolidated
Statements of Income and Comprehensive Income(Continued)



Three
months ended
 
September 30,

Nine
months ended
September
30,2004

2003

2004

2003(unaudited)

(unaudited)

(unaudited)

(unaudited)Earnings per shareBasic
$
0.11

0.07

0.46

0.47Diluted
$
0.10

0.07

0.43

0.44Weighted average common
sharesBasic

5,079,123

5,064,981

5,049,624

5,295,502Diluted

5,426,283

5,498,653

5,415,405

5,689,159


The accompanying notes
are an integral part of these unaudited consolidated financial statements.

5

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Vail Banks, Inc.Consolidated
Statements of Cash Flows(in thousands)

Nine months ended
September 30,2004

2003(unaudited)

(unaudited)Cash flows from operating activitiesNet income
$
2,313

2,475Adjustments to reconcile net income to net cash provided
by
    operating activitiesNet amortization of premiums on investment securities

666

371Provision for loan losses
Gain on sale of investment securities
Gain on sale of loans

524 
— 
—

414 
(15)
(95)Amortization of deferred loan fees

(601)

(196)(Gain) loss on sale of premises and equipment

(1,770)

17Depreciation and amortization

1,390

1,724Gain on sale of foreclosed properties

(130)

(84)Minority interest expense (income)

107

(3)Recognition of stock compensation on restricted
common stock and
     stock options

267

306Deferred income tax benefit

—

(176)Changes in operating assets and
liabilitiesLoans held for sale

220

3,385Interest receivable

(171)

(355)Other assets

403

(728)Interest payable and other
liabilities

(511)

(803)Net cash provided by operating activities

2,707

6,237Cash flows from investing activitiesPurchases of investment securities, available for sale

(80,520)

(75,312)Purchases of bank stocks

(59)

(648)Proceeds from maturities of investment
securities, held to maturity

87

259Proceeds from maturities/calls of investment
securities, available for sale
Proceeds from sales of investment securities,
available for sale

23,013 
—

35,623 
14,490Proceeds from redemption of bank stocks

19

—Net (increase) decrease in loans

(73,264)

14,255Purchases of premises and equipment

(6,086)

(1,828)Proceeds from sales of premises and equipment

8,318

78Proceeds from sales of foreclosed properties

968

2,340Net cash used by investing activities

(127,524)

(10,743)Cash flows from financing activitiesNet increase in deposits

51,782

34,373Net change in federal funds purchased and
securities sold under
     agreements to repurchase

(156)

225Net (decrease) increase in Federal Home Loan
Bank advances

(5,858)

14,961Proceeds from issuance of common stock

569

111Repurchase of common stock

—

(8,020)Payment of cash dividends on common stock

(1,116)

(1,055)Net cash provided by financing activities

45,221

40,595Net (decrease) increase in cash and cash equivalents

(79,596)

36,089Cash and cash equivalents at beginning of period

100,908

74,980Cash and cash equivalents at end of period
$
21,312

111,069


6

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Vail Banks, Inc.Consolidated Statements of Cash Flows
(Continued)(in thousands)



|                                                                                                     |   | Nine months ended
September 30,
|---------------------------------------------------------------------------------------------------- | - | -------------------------------
|                                                                                                     |   | 2004                           
|                                                                                                     |   | (unaudited)                    
|Supplemental disclosures of cash flow information                                                    |   |                                
|Cash paid during the period for:                                                                     |   |                                
|Interest expense                                                                                     | $ | 6,190                          
|Income taxes                                                                                         | $ | 1,177                          
|                                                                                                     |   |                                
|Non-cash investing and financing transactions
   Foreclosure of collateralized loans, net of reserve | $ | 1,082                          
|Net change in unrealized gain/loss on investment securities
        available for sale, net of taxes | $ | 491                            
|Reclassification of idle premises and equipment to other
assets                                      | $ | —                              
|Reclassification of other assets to premises and
equipment                                           | $ | 431                            
|Contribution of land by minority partner                                                             |   | 1,736                          
|Issuance of restricted common stock                                                                  | $ | 10                             
|Forfeiture of restricted common stock                                                                | $ | (40)                           

On January 1, 2004, the Company adopted Financial Interpretation No. 46, Consolidation
of Variable Interest Entities (FIN 46).   As a result of adoption, the Company deconsolidated its two business trusts that
had been formed in 2001 to issue trust preferred securities.   As a result, the Company added to its balance sheet a
$743,000 investment in the two trusts and $24.7 million of subordinated notes payable to the two trusts, and removed from its
balance sheet the $24 million of trust preferred securities.  In accordance with FIN 46, prior period information was not
restated.

The accompanying notes are an integral part of these unaudited consolidated
financial statements.





7

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Vail Banks, Inc.

### Notes to Unaudited
Consolidated Financial Statements

1.  ORGANIZATION
AND BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements include the accounts of Vail
Banks, Inc. (Vail Banks) and its wholly owned subsidiary, WestStar Bank (WestStar).  WestStar and Vail Banks own a combined
54.04% interest in Avon 56 Limited and approximately 70% of Glenwood/Rose L.P. (see Note 6).  All entities are collectively
referred to as “the Company.”  All significant intercompany accounts and transactions have been eliminated in
consolidation.

On August 1, 2004, First Western Mortgage Services, Inc. (First Western) was
merged into WestStar, dissolving the previously existing subsidiary relationship.  The merger did not have an impact on the
consolidated financial condition or results of operations of the Company as First Western was previously owned 100% by WestStar and
was included in the consolidated financial statements of the Company.

For prior years, the financial statements also included Vail Banks Statutory Trust
I and Vail Banks Statutory Trust II, both wholly owned subsidiaries of Vail Banks.  In January 2003, the Financial Accounting
Standards Board (FASB) issued Financial Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46). 
This interpretation of Accounting Research Bulletin No. 51, Consolidated Financial Statements (ARB 51), addresses
consolidation by business enterprises where ownership interests in an entity may vary over time.  FIN 46 requires that an
enterprise’s consolidated financial statements include only subsidiaries in which the enterprise has a controlling financial
interest.  The Company adopted FIN 46 on January 1, 2004.  As a result of adoption, the Company no longer consolidates
its two subsidiary trusts that had been formed in 2001 to issue trust preferred securities because the Company does not have
controlling financial interests over the trusts, as specifically defined by FIN 46.   The effect of this change is that
the Company now excludes the trust preferred securities issued by the subsidiary trusts from its consolidated balance sheets and
includes the subordinated debentures issued by the Company to the trusts. In accordance with FIN 46, prior period information was
not restated.   Additionally, there was no cumulative effect on retained earnings or a change in the Company’s
capital ratios as a result of this adoption.

The accompanying unaudited consolidated financial statements, which are for interim
periods, do not include all disclosures provided in the consolidated financial statements as of December 31, 2003.  These
interim unaudited consolidated financial statements and the notes thereto should be read in conjunction with the Company’s
Annual Report on Form 10-K as of and for the year ended December 31, 2003.  In the opinion of the Company,
all adjustments necessary, consisting of only normal recurring items, have been included for a fair presentation of the
accompanying unaudited consolidated financial statements.  Operating results for the three and nine months ended September 30,
2004, are not necessarily indicative of the results that may be expected for the full year.

Certain reclassifications have been made to the 2003 financial statements to
conform to the 2004 presentation.

2.  INVESTMENT SECURITIES

Investment securities consist of the following:

September 30, 2004

December 31, 2003Amortized

Fair

Amortized

Fair(in thousands)

Cost

Value

Cost

Value(unaudited)

(unaudited)Securities available for saleGovernment agencies
$
41,490

41,234

20,869

20,813State and municipal

19,880

20,015

20,282

20,277Mortgage-backed securities

67,714

67,201

31,080

31,075Agency preferred stock

4,502

4,165

4,514

4,389Total securities available
for sale
$
133,586

132,615

76,745

76,554




8

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September 30, 2004

December 31, 2003Amortized

Fair

Amortized

Fair(in thousands)

Cost

Value

Cost

Value(unaudited)

(unaudited)Securities held to maturityMortgage-backed securities
$
283

302

370

397Total securities held to
maturity
$
283

302

370

397Investments in bank stocksFederal Home Loan Bank stock
$
2,358

2,358

2,318

2,318Federal Reserve Bank stock

1,870

1,870

1,869

1,869Bankers’ Bank of the West stock

183

183

184

184$
4,411

4,411

4,371

4,371


The following table presents the components of investment income for the three and nine
months ended September 30, 2004 and 2003.

Three months ended
September 30,

Nine months ended
September 30,(in thousands)

2004

2003

2004

2003(unaudited)

(unaudited)

(unaudited)

(unaudited)Taxable interest income
$
820

502

1,998

1,907Nontaxable interest income

261

293

797

789Dividends

53

55

157

151$
1,134

850

2,952

2,847


3.  LOANS HELD FOR SALE

The mortgage broker segment sells mortgage loans to certain investors subject to
contractual recourse provisions that may obligate the Company to repurchase a mortgage loan if certain monthly payments during the
first six months after the sale of the loan are not made by the borrower.  The Company has not historically repurchased
mortgage loans and does not anticipate that future repurchases will be necessary.

4.  LOANS

Loans consist of the following:

(in thousands)

September 30,
2004

December 31,
2003(unaudited)Commercial, industrial and land
$
227,337

185,158Real estate – construction

82,436

63,844Real estate – mortgage

69,935

57,602Consumer and other

5,762

5,940385,470

312,544Less:  Allowance for loan losses
(3,742)

(3,503)Net deferred loan
fees

(1,198)

(770)Loans, Net
$
380,530

308,271




9

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As of September 30, 2004 and December 31, 2003, $286,000 and $116,000, respectively, of
deposit account overdrafts have been reclassified to loans.

In the ordinary course of business, the Company had loans receivable from directors,
executive officers and principal shareholders (holders of more than five percent of the outstanding shares of common stock) of the
Company and their affiliates as follows:

(in thousands)

2004Balance at January 1, 2004
$
11,239New loans, including renewals

467Payments

(1,019)Balance at September 30, 2004 (unaudited)
$
10,687


5.  PROVISION AND ALLOWANCE FOR LOAN LOSSES

Transactions in the allowance are summarized as follows:

(in thousands)

2004Allowance at January 1, 2004
$
3,503Loans charged off

(607)Recoveries on loans
previously charged off

322Provision for loan losses

524Allowance at September 30, 2004 (unaudited)
$
3,742


6.  PREMISES AND EQUIPMENT

On March 5, 2004, the Company sold its bank building in Vail, Colorado and is leasing
back a portion of the space.  The sale resulted in a pre-tax gain of approximately $1.7 million, all of which was recognized
at the time of sale.  The lease, which is being accounted for as an operating lease, has a term of five years with three
five-year renewal options and will require future minimum lease payments aggregating approximately $881,000.  WestStar
financed $7.9 million of the purchase price, of which $2 million was participated to another financial institution, with a loan due
in 2024 at an interest rate of 5.30%.   Commissions of $261,000 related to the sale were paid to two related
parties.

On  June 30, 2004, the Company sold the right to purchase its main bank building in
Glenwood Springs, Colorado that was replaced by a newly constructed building (see below).  The sale resulted in a pre-tax gain
of approximately $107,000, all of which was recognized at the time of sale.

On July 18, 2004, the Company entered into a partnership agreement with an investor to
construct and own a new facility in Glenwood Springs.  The Company owns approximately 70% of Glenwood/Rose L.P.  
The building construction was completed during the third quarter 2004 at a cost to the Company of approximately $4.5 million. 
WestStar has leased the main level of the building and the partnership anticipates selling or leasing the remaining portion of the
building to a third party.

7.  SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE

Securities sold under agreements to repurchase, which are classified as secured
borrowings, generally mature within one to four days from the transaction date.  At September 30, 2004 and December 31, 2003,
the carrying amount of securities sold to secure repurchase agreements was $751,000 and $907,000, respectively.  Securities
sold under agreements to repurchase are reflected at the amount of cash received in connection with the transaction.  The
Company may be required to provide additional collateral based on the fair value of the underlying securities.

8.  BORROWINGS

WestStar is a member of the Federal Home Loan Bank of Topeka (FHLB) and, as a regular part
of its business, obtains both short and long-term advances from this FHLB. Advances are collateralized primarily by FHLB stock
owned by WestStar and loans secured by certain mortgages or deeds of trust. As of September 30, 2004, the Company’s total
borrowing capacity was $135.6 million of which $33.6 million of borrowings were outstanding ($10.8 million was short-term and $22.8
million was long-term) and $24.0 million in the form of stand-by irrevocable letters of credit issued by the FHLB were pledged as
collateral for uninsured public fund deposits.

10

---

WestStar has established an unsecured, overnight federal funds line with Bankers’
Bank of the West that expires on August 31, 2005.  As of September 30, 2004, this authorized borrowing line totaled $38.2
million with no amounts outstanding.

WestStar has also established overnight federal funds lines with First Tennessee Bank,
N.A. (First Tennessee) totaling $20.0 million.  If drawn upon, $10.0 million will be a secured line and $10.0 million will be
an unsecured line.  These lines are subject to cancellation by First Tennessee at any time upon the occurrence of certain
conditions.  As of September 30, 2004, no amounts were outstanding under the lines.

9.  SHAREHOLDERS’ EQUITY

Stock Repurchase Plan

At its meeting on January 19, 2004, the Company’s Board of Directors reauthorized
the Company’s stock repurchase program that was originally approved in February 2001. Since inception of the program through
September 30, 2004, the Company has repurchased 1,535,380 shares at an average price of $12.10 per share, or approximately $19
million.  The total amount of repurchases under the program, both previously completed and allowable up to January 2005,
aggregate approximately $29 million.  During the first nine months of 2004, the Company did not repurchase any common
shares.

Restricted Stock

The Company accounts for its restricted stock grants in accordance with Accounting
Principles Board (APB) Opinion No. 25.  Accordingly, compensation expense is recorded over the vesting period of the
restricted stock equal to the value of the restricted shares using the market price of the stock on the grant
date.

Earnings Per Share

Basic earnings per share represents net income available to common shareholders divided by
the weighted-average number of common shares outstanding during the period.  Diluted earnings per share is computed similar to
basic earnings per share, except that the weighted average common shares outstanding is increased to include the number of
additional common shares that would have been outstanding if dilutive potential common shares had been issued.  Common
equivalent shares are not included where inclusion would be anti-dilutive.

The following table presents the net income and weighted average common shares outstanding
used to calculate earnings per share for the nine months ended September 30, 2004 and 2003:

September 30,(in thousands, except share data)

2004

2003(unaudited)

(unaudited)Basic earnings per share computationNet income available to common shareholders
$
2,313

2,475Weighted average shares outstanding – basic

5,049,624

5,295,502Basic earnings per share
$
0.46

0.47


11

---



September 30,(in thousands, except share data)

2004

2003(unaudited)

(unaudited)Diluted earnings per share computationNet income available to common shareholders
$
2,313

2,475Weighted average shares outstanding  basic

5,049,624

5,295,502Shares assumed issued:Stock
options

124,921

147,801Restricted
stock

240,860

245,856Weighted average shares outstanding –
diluted

5,415,405

5,689,159Diluted earnings per share
$
0.43

0.44


During the nine months ended September 30, 2004 and 2003, there were no anti-dilutive
options.

Stock Options

The Company accounts for its stock options in accordance with SFAS No. 123, Accounting
for Stock-Based Compensation, which permits entities to expense over the vesting period the fair value of stock‐based
awards as measured on the date of grant.  Alternatively, SFAS 123 allows entities to apply the provisions of APB Opinion No.
25 while disclosing pro forma net income and pro forma earnings per share for employee stock option grants made in 1995 and future
years as if the fair‐value-based method defined in SFAS 123 had been applied.  The Company has elected to apply the
accounting provisions of APB Opinion No. 25 to employee stock option grants and provide the pro forma disclosure provisions of SFAS
123.  Accordingly, stock-based compensation expense for employee option grants is not recognized in the consolidated financial
statements, as options granted under the Plan generally have an exercise price equal to the market value of the underlying common
stock on the date of grant.  However, during May 2002, approximately 20,000 stock options were granted at a strike price below
market value.  The Company recognized $2,000 and $4,000, of compensation expense during the nine months ended September 30,
2004 and 2003, respectively, related to these options.  Any non-employee stock option grants are accounted for under SFAS
123.

The fair value of each employee stock option grant was estimated on the date of grant
using the Black-Scholes option-pricing model.  The following weighted-average assumptions were used:

2004

2003(unaudited)

(unaudited)Dividend yield

**

2.0%Expected life

**

7 yearsExpected volatility

**

27.5%Risk-free interest rate

**

3.6%


** There were no stock option grants during the first nine months of 2004

Had the Company determined compensation cost based on the fair value accounting provisions
prescribed by SFAS 123 and using the assumptions listed above, the Company’s net income and earnings per share would have
been adjusted to the pro forma amounts indicated as follows:

12

---

Three months ended
September 30,

Nine months ended
September 30,(in thousands, except share data)

2004

2003

2004

2003(unaudited)

(unaudited)

(unaudited)

(unaudited)Net incomeAs reported
$
559

363

2,313

2,475Deduct:  Total stock-based employee
           compensation determined under the
           fair value method, net of tax

(61)

(20)

(99)

(161)Pro forma
$
498

343

2,214

2,314Earnings per share – basicAs reported
$
0.11

0.07

0.46

0.47Pro forma
$
0.10

0.07

0.44

0.44Earnings per share – dilutedAs reported
$
0.10

0.07

0.43

0.44Pro forma
$
0.09

0.06

0.39

0.39


On May 17, 2004, shareholders approved an amendment to the Amended and Restated Stock
Incentive Plan, as amended (the Plan) to increase the number of shares of common stock reserved for issuance under the Plan from
1,000,000 shares to 1,250,000 shares and to provide that the new total number of shares will increase on January 1st of
each year using a formula based on increases in the total number of shares outstanding.  The amendment also increased the
number of shares reserved for the grant of incentive stock options from 500,000 shares to 625,000 shares.

10.  REGULATORY MATTERS

As of September 30, 2004, the Company met all capital adequacy requirements to
which it was subject.  As of that date, the Company had Tier 1 and Total Risk-Based Capital ratios of 10.88% and 12.47%, respectively, and a Leverage ratio of 8.28%.  Regulatory
guidelines permit the Company’s trust preferred securities to be included in the calculation of Tier 1, Total Risk-Based
capital, and the Leverage Ratio, subject to certain limitations.

As of
September 30, 2004, WestStar met all capital adequacy requirements to which it was subject and exceeded the minimum ratios to be
designated as “well-capitalized.”  As of September 30, 2004, WestStar had Tier 1 and Total Risk-Based Capital
ratios of 10.63% and 11.50%, respectively, and a Leverage ratio of 8.11%.

11.  SEGMENT INFORMATION

Information about reportable segments and reconciliation of such information to
the consolidated financial statements for the nine months ended September 30 is
as follows:

13

---



Nine Months Ended September 30, 2004 (unaudited)Mortgage(in thousands)

Banking

Broker

Other

TotalCondensed income statementTotal income
$
27,989

2,406

41

30,436Total expense

21,472

2,060

3,185

26,717Income before income taxes

6,517

346

(3,144)

3,719Income taxes

2,444

109

(1,147)

1,406Net income
$
4,073

237

(1,997)

2,313Nine Months Ended September 30, 2003 (unaudited)Mortgage(in thousands)

Banking

Broker

Other

TotalCondensed income statementTotal income
$
27,582

4,078

3

31,663Total expense

21,739

3,244

3,227

28,210Income before income taxes

5,843

834

(3,224)

3,453Income taxes

1,853

306

(1,181)

978Net income
$
3,990

528

(2,043)

2,475


On August 1, 2004, First Western was merged into WestStar. 
Accordingly, income tax expense was no longer allocated to First Western after July 31, 2004.

12.  RECENT ACCOUNTING PRONOUNCEMENTS

The Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments

In November 2003, the Emerging Issues Task Force (EITF) published issue summary 03-1
(EITF 03-1), The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. EITF 03-01 addressed
an entity’s treatment of the impairment of securities when such impairment is considered other than temporary. The
preliminary summary required disclosures only related to other than temporary impairment. In March 2004, the EITF continued
its discussion and reached a consensus on the procedures for recognizing an impairment of securities considered other than
temporarily impaired. The guidance in EITF 03-1 was intended to be effective for reporting periods beginning after June 15,
2004. However, in September 2004, the FASB issued FSP EITF 03-1-1, which deferred the effective date for the measurement and
recognition provisions of EITF 03-1 until further implementation guidance could be established. Management does not believe the
provision of this standard, as currently written, will have a material impact on the results of future
operations. For the quarter ended September 30, 2004, the Company has
determined that it has the ability and intent to hold its investments classified as
available for sale for a reasonable period of time sufficient for the fair value of the securities to recover.

Application of Accounting Principles to Loan Commitments

On March 9, 2004, the Securities and Exchange Commission (SEC) issued Staff
Accounting Bulletin (SAB) No. 105, Application of Accounting Principles to Loan Commitments. SAB No. 105 requires
that when a company is recognizing and valuing a loan commitment at fair value, only differences between the guaranteed interest
rate in the loan commitment and a market interest rate should be included. Any expected future cash flows related to the customer
relationships or loan servicing should be excluded from the fair value measurement. The expected future cash flows that are
excluded from the fair-value determination include anticipated fees for servicing the funded loan, late-payment charges, other
ancillary fees, or other cash flows from servicing rights. The guidance in SAB
No. 105 is effective for mortgage-loan commitments that are accounted for as
derivatives and are entered into after March 31, 2004. The initial adoption of
this standard did not have an impact on the financial condition or the results
of operations of the Company. Management does not believe the provisions of this
standard will have a material impact on the results of future operations.

14

---

Stock Based Compensation

At its meeting held on October 13, 2004, the FASB elected to defer, for public companies,
the effective date of its proposed standard, Share-Based Payment, from fiscal years beginning after December 15, 2004, to
periods beginning after June 15, 2005.  The new standard will apply to awards granted, modified or settled in cash on or after
that date.  The proposed statement will amend FASB Statement No. 123, Accounting for Stock-Based Compensation. 
Generally, this approach is similar to that of SFAS 123. However, the Exposure Draft would require all share-based payments to
employees, including grants of employee stock options, to be recognized in the statement of income for all awards that vest based
on their fair values. Companies will be able to choose from one of three methods when transitioning to the new standard.  The
FASB expects to issue a final standard by December 31, 2004.  The Company will wait until a final standard is issued to
determine which transition method it will choose.  Accordingly, the Company has not yet evaluated the potential impact on its
future financial condition or results of operations as a result of adopting this proposed standard.

13.  SUBSEQUENT EVENTS

On October 18, 2004, the Board of Directors (Board) declared a regular
quarterly dividend of $0.07 per share payable on November 12, 2004 to shareholders of record on October 29, 2004.





15

---

## Item 2.      MANAGEMENT’S DISCUSSION AND
ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

### Forward Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning
of the Private Securities Litigation Reform Act of 1995.  These forward-looking statements include, but are not limited to,
statements about our plans, objectives, expectations and intentions and other statements contained in this report that are not
historical facts.  When used in this report, the words “expects,” “anticipates,”
“intends,” “plans,” “believes,” “seeks,” “estimates” and similar
expressions are generally intended to identify forward-looking statements.  These forward-looking statements are inherently
subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our
control.  In addition, these forward-looking statements are subject to assumptions with respect to future business strategies
and decisions that are subject to change.  Actual results may differ materially from the results discussed in these
forward-looking statements as a result of the impact of economic conditions and interest rates, loan losses, risks related to the
execution of the Company’s growth strategy, the possible loss of key personnel, factors that could affect the Company’s
ability to compete in its trade areas, changes in regulations and government policies and other factors discussed in the
Company’s filings with the Securities and Exchange Commission.  Vail Banks does not intend to update any forward-looking
statements whether written or oral, relating to matters discussed in this Quarterly Report on Form 10-Q.

### Basis of Presentation

The following discussion and analysis provides information regarding the
Companys financial condition as of September 30, 2004, and its results of
operations for the three and nine months ended September 30, 2004, in comparison
to the three and nine months ended September 30, 2003. The following discussion
should be read in conjunction with the unaudited consolidated financial
statements and related notes included elsewhere in this Quarterly Report on Form
10-Q, and in conjunction with the Companys Annual Report on Form 10-K for the
year ended December 31, 2003.

In January 2003, the Financial Accounting Standards Board (FASB) issued Financial
Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46).  This interpretation of Accounting
Research Bulletin No. 51, Consolidated Financial Statements (ARB 51), addresses consolidation by business enterprises where
ownership interests in an entity may vary over time.  FIN 46 requires that an enterprise’s consolidated financial
statements include only subsidiaries in which the enterprise has a controlling financial interest.  The Company adopted FIN 46
on January 1, 2004.  As a result of adoption, the Company deconsolidated its two business trusts that had been formed in 2001
to issue trust preferred securities because the Company does not have controlling financial interests over the trusts, as
specifically defined by FIN 46.   In accordance with FIN 46, prior period information was not restated.  
Additionally, there was no cumulative effect on retained earnings or a change in the Company’s capital ratios as a result of
this deconsolidation.

### Overview

Net income was $559,000 for the three months ended September 30, 2004, up
from $363,000 for the three months ended September 30, 2003, an increase of 54%.  Net income was $2.3 million for the nine
months ended September 30, 2004, down from $2.5 million for the nine months ended September 30, 2003, a decrease of 7%.  First
quarter 2004 revenue included a $1.7 million gain, pre-tax, on the sale of the Company’s Vail bank building.  Without
this gain, net income for the nine months ended September 30, 2004 would have been $1.6 million.

Diluted earnings per share for the three months ended September 30, 2004,
was $0.10 compared to $0.07 for the three months ended September 30, 2003, an increase of 43%.  Diluted earnings per share for
the nine months ended September 30, 2004, was $0.43 compared to $0.44 for the nine months ended September 30, 2003, a decrease of
2%.  Excluding the gain on the building sale, diluted earnings per share would have been $0.29 for the first nine months of
2004.

The annualized return on average assets was 0.37% for the three months ended
September 30, 2004 compared to 0.24% for the three months ended September 30, 2003.  The annualized return on average assets
was 0.52% for the nine months ended September 30, 2004 compared to 0.56% for the nine months ended September 30, 2003. 
Excluding the gain on the building sale, the annualized return on average assets would have been 0.35% for the first nine months of
2004.

16

---

The annualized return on average equity was 3.79% for the three months ended
September 30, 2004 compared to 2.39% for the three months ended September 30, 2003.  The annualized return on average equity
was 5.28% for the nine months ended September 30, 2004 compared to 5.21% for the nine months ended September 30, 2003. 
Excluding the gain on the building sale, the annualized return on average equity would have been 3.53% for the first nine months of
2004.

### Results of Operations

Net Interest Income.Net interest
income is the principal component of a financial institution’s income stream and represents the difference or spread between
interest and fee income generated from earning assets and the interest expense paid on deposits and borrowed funds. Fluctuations in
interest rates as well as changes in the volume and mix of earning assets and interest bearing liabilities can materially impact
net interest income.

Net interest income, on a fully tax-equivalent basis (FTE), increased by
$730,000, or 14% to $6.0 million for the three months ended September 30, 2004 from $5.3 million for the three months endedSeptember 30, 2003.  The net interest margin on an FTE basis was 4.68% for the three months ended September 30, 2004 as
compared to 4.15% for the comparable period in 2003.  This significant increase in the net interest margin was due to the
following two factors:  (1) Average loan volumes for the three months ended September 30, 2004 were $46.7 million higher, or
15%, versus the comparable period in 2003, as a result of an improving economy and resulting
increased loan demand.  For the quarter
ended September 30, 2004, average loans represented approximately 71% of average earning assets, while for the quarter ended
September 30, 2003, average loans represented only 63% of earning assets.  As loans are higher yielding components of total
earning assets than investments or federal funds, this shift in the mix of earning assets contributed to a higher overall yield on
total earning assets. (2) Average deposits increased $14.5 million, or 3%, for the third quarter of 2004 versus the comparable
period in 2003.  The majority of this growth was in lower costing core deposits (total deposits excluding certificates of
deposit).  Core deposits grew $35.1 million, or 11%, while higher costing certificates of deposit decreased $20.6 million, or
14%.   This overall growth and improved mix of deposits resulted in a 15 basis point decline in the overall cost of
deposits and contributed to the 19 basis point decline in the overall cost of interest bearing liabilities.

Net interest income, on an FTE basis decreased by $357,000, or 2% to $16.6 million for the
nine months ended September 30, 2004 from $17.0 million for the nine months ended September 30, 2003.  The net interest margin
on an FTE basis was 4.41% for the nine months ended September 30, 2004 as compared to 4.60% for the comparable period in
2003.  The decrease in net interest margin for the first nine months of 2004 as compared to the same period in 2003 was due
primarily to the following two factors:  (1) Yields on loans declined due to the competitive environment
and the 25 basis point interest rate cut implemented by the Federal Reserve during late June 2003.  Although the
Federal Reserve implemented three 25 basis point interest rate increases during 2004, these did not take effect until third quarter, and so did not have a significant impact on the net interest margin for the nine months ended September 2004.  For the first
nine months of 2004, loans (excluding loan fees) yielded 6.50% as compared to the 7.35% yield for the comparable period in
2003.  (2) Yields on securities fell as a result of the lower interest rate environment during the majority of 2004. 
Additionally, heavy prepayments during 2003 resulted in funds rolling over into lower yielding securities.  For the first nine
months of 2004, securities yielded 3.68% as compared to the 4.43% yield for the comparable period in 2003.   These
factors were partially offset by the following three items: (1) Average loan volumes for the nine months ended September 30, 2004
were $7.2 million higher, or 2%, as compared to the comparable period in 2003 as a result of an improving economy and resulting
increased loan demand.  (2) Loan fees increased $790,000, or 44%, for the nine months ended September 30, 2004 as compared to
the nine months ended September 30, 2003.  While loan yields excluding loan fees dropped 85 basis points for the nine months
ended September 30, 2004 as compared to the nine months ended September 30, 2003, loan yields including loan fees dropped only 55
basis points during the comparable periods.  (3) Deposit costs decreased 19 basis points to 0.86% for the first nine months of
2004, as compared to 1.05% for the first nine months of 2003 due to an improved mix of deposits.

Non-Interest Income.  During the
three months ended September 30, 2004, non-interest income decreased by $505,000, or 18% from the comparable quarter in
2003.   This decrease was primarily due to a $543,000 decrease in mortgage broker fees as refinancing activity
slowed.  During the nine months ended September 30, 2004, non-interest income decreased by $297,000, or 4%, as compared to the
nine months ended September 30, 2003.   This decrease was primarily due to a $1.7 million decrease in mortgage broker
fees.  Additionally, service charges on
depositsdecreased $229,000.   These decreases were partially offset by the
$1.8 million gain on the sales of the Vail bank building and the main Glenwood Springs facility during the first nine months of
2004.

17

---

Non-Interest Expense.  
Non-interest expense decreased $242,000, or 3%, from the comparable quarter in 2003.  For the nine months ended September 30,
2004, non-interest expense decreased $1.0 million, or 5%, as compared to the nine months ended September 30, 2003.  These
decreases were largely attributable to a decrease in salaries and benefits of $906,000 for the first nine months of 2004 compared
to the first nine months of 2003 and a decrease in furniture and equipment expense of $314,000 for the comparable periods,
partially offset by an increase in occupancy expense of $213,000.  Salaries and benefits decreased primarily due to:  (1)
a $967,000 decrease in mortgage incentive pay as a result of lower mortgage origination volume and (2) a $300,000 decrease in
employee insurance costs primarily due to favorable healthcare claim volumes, partially offset by (3) $653,000 of salaries and
benefits expense attributable to the new Denver Tech branch opened during third quarter 2003 compared to only $324,000 during the
comparable period during 2003 and (4) $101,000 of salaries and benefits expense attributable to the new Denver Stapleton branch
opened during third quarter 2004.  Furniture and equipment expense decreased primarily due to a decrease in depreciation and
amortization expense related to the fourth quarter 2003 write-off of $1.6 million of obsolete fixed assets.  Occupancy expense
increased primarily due to the following three factors: (1) An additional $84,000 of lease expense
was incurred during 2004 attributable to the
relocation of Vail Banks’ executive offices during June 2003.  Prior to June 30, 2003, these offices were located in a
Company owned facility, and so no rent expense was incurred.  (2) An additional $44,000 of lease expense
was incurred attributable to an
expansion of the leased space in the Avon branch. (3) An additional $66,000 of occupancy expense
was incurred attributable to the new Denver
Tech branch opened during third quarter 2003 compared to only $29,000 during the comparable period during 2003.

The efficiency ratio was 87% for the quarter ended September 30, 2004 compared to 93% for
the quarter ended September 30, 2003.  This improvement in the efficiency ratio was due to a $239,000, or 3% increase in
revenue (net interest income plus non-interest income) from third quarter 2003 to third quarter 2004, while at the same time
non-interest expenses decreased by $242,000, or 18%.   The efficiency ratio was 83% for the nine months ended September
30, 2004 compared to 85% for the nine months ended September 30, 2003.  Although revenue decreased $650,000, or 3% for the
nine months 2004 as compared to the nine months 2003, non-interest expenses decreased by over $1.0 million, or 5%.   This
greater percentage reduction in non-interest expense compared to the reduction in revenue caused the overall reduction in the
efficiency ratio for the nine months ended September 30, 2004.  Excluding the gain on the building sale, the efficiency ratio
would have been 89% for the nine months ended September 30, 2004.

Income
Taxes.The
Company’s effective income tax rate (income tax expense as a percentage of pre-tax income) was 25.3% and 37.8%, respectively,
for the three and nine months ended September 30, 2004 as compared to 14.8% and 28.3%, respectively, for the three and nine months
ended September 30, 2003.  During the third quarter 2004, tax-exempt interest from municipal securities represented a lower
percentage of pre-tax income than it did during the same period in 2003, resulting in a higher effective tax rate.  
Additionally, the effective tax rate for the nine months ended September 30, 2004 increased as a result of  income tax expense recorded as a result of the Vail building sale, which occurred during the first quarter of
2004.

Financial Condition

The Company's assets increased by $49.4 million or 9%, to $625.0 million as
of September 30, 2004, from $575.6 million as of December 31, 2003.

Federal funds sold balances decreased by $73.1 million, or 92%, to $6.2
million  as of September 30, 2004 from $79.3 million at December 31, 2003.   Investment securities increased to
$137.3 million as of September 30, 2004, compared to $81.3 million as of December 31, 2003, a 69% increase.  During this
period, the Company deployed excess liquidity from cash equivalents (which included federal funds sold) and deposit growth into
short-term investments as well as loan growth.

As of September 30, 2004, loans held for sale decreased $220,000, or 9%,
from December 31, 2003.  The ending balance of loans held for sale at any particular date is dependent on the timing of the
closing and ultimate funding of these loans by the outside investor.  Thus, an increase or decrease in the ending balance is
primarily a function of this timing and not necessarily indicative of trends in mortgage loan demand.

Gross loans increased $72.9 million, or 23%, from December 31,
2003.   This increase was due to an increase in loan demand.  The largest increase was in the commercial, industrial
and land category, with a $42.2 million, or 23% increase.  Real estate – construction loans increased $18.6 million, or
29%, and real estate – mortgage loans increased $12.3 million, or 21%

Premises and equipment increased by $220,000, or 1%, from $38.1
million as of December 31, 2003, to $38.4 million as of September 30, 2004.  This increase was mainly attributable to the
purchase of $6.1 million of premises and equipment primarily related to the construction and furnishing of a new branch facility in
Glenwood Springs, which replaces the building sold, a $1.7 million contribution
of land by a minority partner, equipment upgrades, the remodeling of branches, the purchase of land to build a new
branch facility in Fruita, Colorado, and the transfer of a $431,000 building from other assets to fixed assets.  The building
was previously used for investment purposes but now is being used to facilitate Company business.  These increases were
partially offset by the sale of the Vail bank building that had a net book value of $5.8 million, sale of the main Glenwood Springs
facility that had a net book value of approximately $740,000, and $1.4 million of depreciation and amortization
expense.

18

---

Goodwill decreased by $789,000, or 2%, from $36.8 million as of December 31,
2003 to $36.0 million as of September 30, 2004 in conjunction with the sale of the Vail bank building.

Deposits increased by $51.8 million, or 12%, from $448.5 million as of
December 31, 2003, to $500.3 million as of September 30, 2004.  The largest increases were in the money market category, with
a $30.2 million, or 29% increase, and in checking accounts, with a $16.4 million, or 9% increase.  These increases are
attributable to the Company’s continued focus on attracting new deposit relationships and expanding existing
relationships.

Federal Home Loan Bank advances decreased $5.9 million, or 15% from $39.5
million as of December 31, 2003 to $33.6 million as of September 30, 2004.  This decrease was due to repayment of maturing
advances.

### Asset Quality

Provision and Allowance for Loan Losses.Provision for loan losses expense for the three and nine months ended September 30, 2004, was $323,000 and $524,000,
respectively, compared to $164,000 and $414,000, respectively, for the three and nine months ended September 30, 2003.  The
allowance for loan losses of $3.7 million as of September 30, 2004, increased 7% from the $3.5 million level as of December 31,
2003 and represents 0.97% of total loans and 460% of non-performing loans as of September 30, 2004 as compared to 1.12% and 201%,
respectively at December 31, 2003.   During the nine months ended September 30, 2004, gross loans increased $72.9
million, or 23%, from $312.5 million at December 31, 2003 to $385.5 million at September 30, 2004, however non-performing loans
decreased $933,000, or 53%.  Additionally, loans past due 30 or more days and still accruing dropped to 0.15% of total loans
from 0.47% at December 31, 2003.  Although this benchmark, often an indicator of future loan non-performance, is at its lowest
level since December 2000, the $239,000 increase in the allowance for loan losses from December 31, 2003 reflects the
Company’s estimate of reserves required for the growing loan portfolio.

The amount of
the provision for loan losses is based on regular evaluations of the loan
portfolio, with particular attention directed toward non-performing, delinquent,
and other potential problem loans.  During these evaluations, consideration
is also given to such factors as managements evaluation of specific loans, the
level and composition of delinquent and non-performing loans, historical loan
loss experience, results of examinations by regulatory agencies, external and
internal asset review processes, the market value of collateral, the strength
and availability of guarantees, concentrations of credit and other judgmental
factors.

The following table presents, for the periods indicated, an analysis of the
allowance for loan losses and other related data.

|Allowance for Loan Losses Analysis(in
thousands) |   | Nine months ended
September 30,
|------------------------------------------------ | - | -------------------------------
|                                                 |   | 2004                           
|                                                 |   | (unaudited)                    
|Average total loans                              | $ | 335,685                        
|Total loans at end of period                     | $ | 384,272                        
|                                                 |   |                                
|Allowance at beginning of period                 | $ | 3,503                          
|Loans charged off                                |   | (607)                          
|Recoveries on loans previously charged
off       |   | 322                            
|Provision for loan losses                        |   | 524                            
|Allowance at end of period                       | $ | 3,742                          
|                                                 |   |                                
|Annualized net charge-offs to average loans      |   | 0.11%                          
|Allowance to total loans at end of period        |   | 0.97%                          



19

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Non-Performing Assets. The following table
presents information regarding non-performing assets as of the dates indicated:

Non-Performing Assets(in
thousands)

September 30,2004

2003(unaudited)

(unaudited)Nonaccrual loans
$
814

2,105Total non-performing
loans

814

2,105Foreclosed properties

606

2,496Total non-performing
assets

1,420

4,601Loans 90 days or more past due and
accruing

3

163Total risk assets
$
1,423

4,764Non-performing loans to total loans

0.21%

0.68%Non-performing assets to loan related assets

0.37%

1.46%Non-performing assets to total assets

0.23%

0.77%Risk assets to loan related assets

0.37%

1.52%


The Company believes that it has adequate collateral to recover the majority
of the balance of the nonaccrual loans.   Foreclosed properties are
recorded at the lower of cost or fair value less estimated costs to sell. 
Anticipated losses are recorded at the time of transfer from loans. 
Management is not aware of any significant adverse trends relating to the
Companys loan portfolio.

### Liquidity

Liquidity is a measure of the Company’s ability to meet its
commitments and obligations with available funds.These commitments may include paying dividends to shareholders, funding
new loans for borrowers, funding withdrawals by depositors, paying general and administrative expenses, and funding capital
expenditures.Historically, the Company's primary source of funds has been customer deposits.  Scheduled
loan repayments are a relatively stable source of funds.  Deposit inflows and unscheduled loan repayments, which are
influenced by fluctuations in the general level of interest rates, returns available on other investments, competition, economic
conditions and other factors, are relatively volatile.  Other sources of liquidity include sale or maturity of investment
securities and the ability to borrow funds.  Company borrowing may be used on a short-term basis to compensate for reductions
in other sources of funds (such as deposit inflows at less than projected levels).  Company borrowing may also be used on a
longer-term basis to support expanded lending and investing activities and to match the maturity or repricing intervals of
assets.

As of September 30, 2004, the Company had cash and cash equivalents
(including federal funds sold) of $21.3 million, interest-bearing deposits in banks of $2.0 million, and investment securities of
$137.3 million.  Approximately $132.6 million, or 97%, of the Company’s investment portfolio is classified as
available-for-sale and can be readily sold, however $64.2 million of this amount has been pledged to secure public fund deposits and
$751,000 of this amount has been sold under agreements to repurchase.  Accordingly, these pledged amountsmay not be available to meet general liquidity needs.  Based on current plans and business conditions, the Company
expects that its cash, cash equivalents, investment securities and available borrowing capacity under its credit facilities,
together with any amounts generated from operations, will be sufficient to meet the Company's liquidity requirements for the next
12 months. However, there can be no assurance that the Company will not be required to seek other financing sooner or that such
financing, if required, will be available on terms satisfactory to the Company.

Cash Flows

Net Cash from Operating Activities

During the nine-month period ended September 30, 2004, cash of $2.7 million
was provided by operating activities consisting primarily of net income of $2.3 million plus non-cash expense of $453,000 less a
net cash outflow of $59,000 from the change in operating assets and liabilities. Non-cash expense consisted primarily of $1.4
million of depreciation and amortization expense on premises, equipment and intangible assets, $666,000 of net amortization of
premiums on investment securities, a $524,000 loan loss provision, and $267,000 of stock compensation expense, partially offset by
a $1.8 million gain on the sale of premises and equipment and $601,000 of deferred loan fee amortization.  The change in
operating assets and liabilities was comprised of a decrease in interest payable and other liabilities of $511,000 and an increase
in interest receivable of $171,000, offset by a decrease in other assets of $403,000 and a decrease in loans held for sale of
$220,000.

20

---

During the nine-month period ended September 30, 2003, cash of $6.2 million
was provided by operating activities consisting primarily of net income of $2.5 million plus non-cash expenses of $2.3 million and
net decreases in operating assets and liabilities of $1.5 million. Non-cash expenses consisted primarily of $1.7 million of
depreciation and amortization expense on premises and equipment, a $414,000 loan loss provision, $371,000 of net amortization of
premiums on investment securities, and $306,000 of stock compensation, partially offset by $196,000 of deferred loan fee
amortization and $176,000 of deferred income tax benefit.  The net decrease in operating assets and liabilities was primarily
due to a $3.4 million decrease in loans held for sale offset by a $728,000 increase in other assets, a $355,000 increase in
interest receivable, and an $803,000 decrease in interest payable and other liabilities.

Net Cash from Investing Activities

During the nine-month period ended September 30, 2004, cash of $127.5
million was used for investing activities.  These outflows consisted primarily of the purchase of $80.6 million of investment
securities, a $73.3 million increase in loans and $6.1 million in purchases of premises and equipment, offset by the maturity
and/or calls of $23.1 million of investments, $8.3 million of proceeds from the sale of premises and equipment, and $968,000 of
proceeds from the sale of foreclosed properties.

During the nine-month period ended September 30, 2003, cash of $10.7 million
was used for investing activities.  These outflows consisted primarily of the purchase of $76.0 million of investment
securities and $1.8 million in purchases of premises and equipment, offset by the sale, maturity and/or calls of $50.4 million of
investment securities, a decrease in loans of $14.3 million, and $2.3 million of proceeds from sales of foreclosed
properties.

Net Cash from Financing Activities

During the nine-month period ended September 30, 2004, cash of $45.2 million
was provided by financing activities consisting primarily of an increase in deposits of $51.8 million, and $569,000 of proceeds
from the issuance of common stock, offset by the net repayment of FHLB advances of $5.9 million and the payment of dividends on
common stock of $1.1 million.

During the nine-month period ended September 30, 2003, cash of $40.6 million
was provided by financing activities consisting primarily of an increase in deposits of $34.4 million and the receipt of $15.0
million of net proceeds from FHLB advances, offset by the repurchase of $8.0 million of common stock and the payment of dividends
on common stock of $1.1 million.

Borrowings

WestStar is a member of the Federal Home Loan Bank of Topeka (FHLB) and, as a regular part
of its business, obtains both short and long-term advances from this FHLB. Advances are collateralized primarily by FHLB stock
owned by WestStar and loans secured by certain mortgages or deeds of trust. As of September 30, 2004, the Company’s total
borrowing capacity was $135.6million of which $33.6 million of borrowings were outstanding ($10.8
million was short-term and $22.8 million was long-term) and $24.0 million in the form of stand-by irrevocable letters of credit
issued by the FHLB were pledged as collateral for uninsured public fund deposits.

WestStar has established an unsecured, overnight federal funds line with Bankers’
Bank of the West that expires on August 31, 2005.  As of September 30, 2004, this authorized borrowing line totaled $38.2
million with no amounts outstanding.

Dividends

Payment of dividends is at the discretion of the Board and is determined by taking into
account the earnings, capital levels, cash requirements, and the financial condition of Vail Banks and WestStar, as well as
applicable government regulations and other relevant factors.  The principal source of Vail Banks’ income is dividends
from WestStar.  There are statutory and regulatory requirements applicable to the payment of dividends by WestStar to Vail
Banks, as well as by Vail Banks to its shareholders.  Due to the high volume of dividends relative to earnings paid in earlier
years, beginning in 2004, any dividend payments from WestStar to Vail Banks will require prior regulatory approval. 
Management believes that approval will be granted as long as WestStar maintains its well-capitalized regulatory status and has no
reason to believe that this well-capitalized regulatory status will change.

21

---

On October 18, 2004, the Board declared a regular quarterly dividend of
$0.07 per share payable on November 12, 2004 to Vail Banks’ shareholders of record on October 29, 2004.

Stock Repurchase Plan

At its meeting
on January 19, 2004, the Companys Board of Directors reauthorized the Companys
stock repurchase program that was originally approved in February 2001. Since
inception of the program through September 30, 2004, the Company has repurchased
1,535,380 shares at an average price of $12.10 per share, or approximately $19
million.  The total amount of repurchases under the program, both
previously completed and allowable up to January 2005, aggregate approximately
$29 million.  During the first nine months of 2004, the Company did not
repurchase any common shares.

Stock Options

On May 17, 2004, shareholders approved an amendment to the Amended and Restated Stock
Incentive Plan, as amended (the Plan), to increase the number of shares of common stock reserved for issuance under the Plan from
1,000,000 shares to 1,250,000 shares and to provide that the new total number of shares will increase on January 1st of
each year using a formula based on increases in the total number of shares outstanding.  The amendment also increased the
number of shares reserved for the grant of incentive stock options from 500,000 shares to 625,000 shares.

### Capital Resources

As of September 30, 2004, shareholders’ equity had increased $1.5 million, or 3%, to
$59.4 million from $57.9 million as of December 31, 2003.  This increase is primarily related to the retention of earnings of
$2.3 million, the issuance of common stock of $569,000, and stock compensation expense of $267,000, offset by an increase in other
comprehensive loss of $491,000 and payment of common stock dividends of $1.1 million.

As of September 30, 2004 and 2003, the Company met all capital adequacy
requirements to which it was subject.  As of September 30, 2004, the Company had Tier 1 and Total Risk-Based Capital ratios of
10.88% and 12.47%, respectively, and a Leverage ratio of 8.28%.  Regulatory guidelines permit the Company’s trust
preferred securities to be included in the calculation of Tier 1, Total Risk-Based capital and the Leverage Ratio, subject to
certain limitations.  As of September 30, 2003, the Company had Tier 1 and Total Risk-Based Capital ratios of 12.95% and
14.60%, respectively, and a Leverage ratio of 8.47%.

As of September 30, 2004 and 2003, WestStar met all capital adequacy
requirements to which it was subject and exceeded the minimum ratios to be designated as
“well-capitalized.”  As of September 30, 2004, WestStar had Tier 1 and Total Risk-Based Capital ratios of
10.63% and 11.50%, respectively, and a Leverage ratio of 8.11%.  As of September 30, 2003, WestStar had Tier 1 and Total
Risk-Based Capital ratios of 13.39% and 14.25%, respectively, and a Leverage ratio of 8.74%.

Recent Accounting Pronouncements

The Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments

In November 2003, the Emerging Issues Task Force (EITF) published issue summary 03-1
(EITF 03-1), The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. EITF 03-01 addressed
an entity’s treatment of the impairment of securities when such impairment is considered other than temporary. The
preliminary summary required disclosures only related to other than temporary impairment. In March 2004, the EITF continued
its discussion and reached a consensus on the procedures for recognizing an impairment of securities considered other than
temporarily impaired. The guidance in EITF 03-1 was intended to be effective for reporting periods beginning after June 15,
2004. However, in September 2004, the FASB issued FSP EITF 03-1-1, which deferred the effective date for the measurement and
recognition provisions of EITF 03-1 until further implementation guidance could be established. Management does not believe the
provision of this standard, as currently written, will have a material impact on the results of future
operations. For the quarter ended September 30, 2004, the Company has
determined that it has the ability and intent to hold its investments classified as
available for sale for a reasonable period of time sufficient for the fair value of the securities to recover.

22

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Application of Accounting Principles to Loan Commitments

On March 9, 2004, the Securities and Exchange Commission (SEC) issued Staff
Accounting Bulletin (SAB) No. 105, Application of Accounting Principles to Loan Commitments. SAB No. 105 requires
that when a company is recognizing and valuing a loan commitment at fair value, only differences between the guaranteed interest
rate in the loan commitment and a market interest rate should be included. Any expected future cash flows related to the customer
relationships or loan servicing should be excluded from the fair value measurement. The expected future cash flows that are
excluded from the fair-value determination include anticipated fees for servicing the funded loan, late-payment charges, other
ancillary fees, or other cash flows from servicing rights. The guidance in SAB No. 105 is effective for mortgage-loan
commitments that are accounted for as derivatives and are entered into after March 31, 2004. The initial adoption of this
standard did not have an impact on the financial condition or the results of operations of the Company. Management does not believe
the provisions of this standard will have a material impact on the results of future operations.

Stock Based Compensation

At its meeting held on October 13, 2004, the FASB elected to defer, for public companies,
the effective date of its proposed standard, Share-Based Payment, from fiscal years beginning after December 15, 2004, to
periods beginning after June 15, 2005.  The new standard will apply to awards granted, modified or settled in cash on or after
that date.  The proposed statement will amend FASB Statement No. 123, Accounting for Stock-Based Compensation. 
Generally, this approach is similar to that of SFAS 123. However, the Exposure Draft would require all share-based payments to
employees, including grants of employee stock options, to be recognized in the statement of income for all awards that vest based
on their fair values. Companies will be able to choose from one of three methods when transitioning to the new standard.  The
FASB expects to issue a final standard by December 31, 2004.  The Company will wait until a final standard is issued to
determine which transition method it will choose.  Accordingly, the Company has not yet evaluated the potential impact on its
future financial condition or results of operations as a result of adopting this proposed standard.









23

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## Item 3.      QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
MARKET RISK

Quantitative Disclosures About Market Risk

The table below provides information about the Company’s financial
instruments as of December 31, 2003 that are sensitive to changes in interest rates.

Principal Amount Maturing (b) in:(in thousands)
  
  2004
  
  2005
  
  2006
  
  2007
  
  2008
  
  Thereafter
  or Non-Maturing
  
  Total
  
  Fair ValueDecember 31,
  2003INTEREST RATE SENSITIVE ASSETSFederal funds sold and interest earning deposits
  
  $
  81,280
  
  $
  
  
  $
  
  
  $
  
  
  $
  
  
  $
  
  
  $
  81,280
  
  
  $
  81,280Weighted average interest
  rate
  
  
  0.93
  %
  
  0.00
  %
  
  0.00
  %
  
  0.00
  %
  
  0.00
  %
  
  0.00
  %
  
  0.93
  %Adjustable-rate securities
  
  
  
  
  
  
  
  
  
  
  
  500
  
  
  231
  
  
  46,299
  
  
  47,030
  
  
  
  46,884Weighted average interest
  rate (a)
  
  
  0.00
  %
  
  0.00
  %
  
  0.00
  %
  
  2.25
  %
  
  3.76
  %
  
  3.65
  %
  
  3.64
  %Fixed-rate securities
  
  
  454
  
  
  2,577
  
  
  2,102
  
  
  5
  
  
  107
  
  
  24,840
  
  
  30,085
  
  
  
  30,067Weighted average interest
  rate (a)
  
  
  6.79
  %
  
  2.30
  %
  
  2.72
  %
  
  7.52
  %
  
  6.54
  %
  
  6.83
  %
  
  6.16
  %Investments in bank stocks
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  4,371
  
  
  4,371
  
  
  
  4,371Weighted average interest
  rate
  
  
  0.00
  %
  
  0.00
  %
  
  0.00
  %
  
  0.00
  %
  
  0.00
  %
  
  4.62
  %
  
  4.62
  %Loans held for sale
  
  
  2,515
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  2,515
  
  
  
  2,515Weighted average interest
  rate
  
  
  4.73
  %
  
  0.00
  %
  
  0.00
  %
  
  0.00
  %
  
  0.00
  %
  
  0.00
  %
  
  4.73
  %Adjustable-rate loans
  
  
  132,491
  
  
  27,237
  
  
  29,684
  
  
  20,000
  
  
  25,418
  
  
  21,654
  
  
  256,484
  
  
  
  255,438Weighted average interest
  rate
  
  
  6.39
  %
  
  6.38
  %
  
  5.98
  %
  
  6.46
  %
  
  6.30
  %
  
  6.32
  %
  
  6.33
  %Fixed-rate loans
  
  
  18,570
  
  
  7,443
  
  
  3,041
  
  
  1,681
  
  
  4,935
  
  
  20,390
  
  
  56,060
  
  
  
  57,569Weighted average interest
  rate
  
  
  6.51
  %
  
  7.84
  %
  
  8.93
  %
  
  7.34
  %
  
  6.10
  %
  
  6.90
  %
  
  6.95
  %Total interest rate sensitive assets
  
  $
  235,310
  
  $
  37,257
  
  $
  34,827
  
  $
  22,186
  
  $
  30,691
  
  $
  117,554
  
  $
  477,825
  
  
  $
  478,124Weighted average interest rate
  
  
  4.49
  %
  
  6.39
  %
  
  6.04
  %
  
  6.43
  %
  
  6.25
  %
  
  5.41
  %
  
  5.18
  %INTEREST RATE SENSITIVE LIABILITIESInterest-bearing checking, savings and money market accounts
  
  $
  
  
  $
  
  
  $
  
  
  $
  
  
  $
  
  
  $
  222,033
  
  $
  222,033
  
  
  $
  222,033Weighted average interest
  rate
  
  
  0.00
  %
  
  0.00
  %
  
  0.00
  %
  
  0.00
  %
  
  0.00
  %
  
  0.63
  %
  
  0.63
  %Fixed-rate time deposits
  
  
  92,686
  
  
  26,325
  
  
  2,852
  
  
  766
  
  
  2,548
  
  
  
  
  
  125,177
  
  
  
  126,139Weighted average interest
  rate
  
  
  1.92
  %
  
  2.68
  %
  
  3.14
  %
  
  3.31
  %
  
  3.22
  %
  
  0.00
  %
  
  2.14
  %Securities sold under agreements to repurchase
  
  
  907
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  907
  
  
  
  907Weighted
  average interest rate
  
  
  0.38
  %
  
  0.00
  %
  
  0.00
  %
  
  0.00
  %
  
  0.00
  %
  
  0.00
  %
  
  0.38
  %Fixed-rate borrowings
  
  
  9,690
  
  
  6,465
  
  
  6,365
  
  
  990
  
  
  662
  
  
  15,289
  
  
  39,461
  
  
  
  39,906Weighted average interest
  rate
  
  
  3.60
  %
  
  3.76
  %
  
  4.25
  %
  
  3.43
  %
  
  4.15
  %
  
  4.18
  %
  
  3.96
  %Trust preferred
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  24,000
  
  
  24,000
  
  
  
  26,127Weighted average interest
  rate
  
  
  0.00
  %
  
  0.00
  %
  
  0.00
  %
  
  0.00
  %
  
  0.00
  %
  
  10.19
  %
  
  10.19
  %Total interest rate sensitive liabilities
  
  $
  103,283
  
  $
  32,790
  
  $
  9,217
  
  $
  1,756
  
  $
  3,210
  
  $
  261,322
  
  $
  411,578
  
  
  $
  415,112Weighted average interest rate
  
  
  2.06
  %
  
  2.89
  %
  
  3.91
  %
  
  3.38
  %
  
  3.41
  %
  
  1.71
  %
  
  1.96
  %


(a)  These interest rates are not adjusted to reflect tax equivalent
yields.
(b)  The above amounts represent scheduled maturities and do not
include prepayments that may occur.

Qualitative Disclosures About Market Risk

Market risk is the exposure to loss resulting from changes in interest
rates, foreign currency exchange rates, commodity prices and equity prices. The primary market risk to which the Company is exposed
is interest rate risk arising from the instruments and transactions entered into by the Company.  They include loans,
securities available for sale, deposit liabilities, and borrowings.  Interest rate risk occurs when interest-sensitive assets
and liabilities reprice at different times as market interest rates change. Interest-sensitive assets and liabilities are those
that are subject to repricing in the near term, including both variable rate instruments and those fixed rate instruments that are
approaching maturity.  For example, if fixed-rate assets are funded with floating-rate debt, the spread between asset and
liability rates will decline or turn negative if rates increase. Additionally, interest rate risk results from changing spreads
between asset and liability rates.

24

---

The Companys
Asset/Liability Management Committee manages interest rate risk.  The
principal objective of asset/liability management is to manage the levels of
interest-sensitive assets and liabilities to minimize net interest income
fluctuations in times of fluctuating market interest rates. To effectively
measure and manage interest rate risk, the Company uses computer simulations
that determine the impact on net interest income of numerous interest rate
scenarios, balance sheet trends and strategies. These simulations cover the
following financial instruments: short-term financial instruments, investment
securities, loans, deposits, and borrowings. Simulations are run under various interest rate scenarios to determine the impact on net income and capital. From
these computer simulations, interest rate risk is quantified and appropriate strategies are developed and implemented.  As of
September 30, 2004, the Company has not used interest rate derivative financial instruments as an asset/liability management tool
to hedge mismatches in interest rate exposures.

During the
first three quarters of 2004, Vail Banks has experienced decreased liquidity due
to investment in securities and increased loan demand, partially offset by the
increase in deposits.  This decreased liquidity position decreased the
asset sensitivity of the balance sheet and has made Vail Banks less sensitive to
changes in interest rates at September 30, 2004 than at December 31, 2003. 
Given the Companys interest rate gap position at September 30, 2004, if rates
fall, asset yields will decline faster than the cost of interest bearing
liabilities, leading to a decline in the margin.  If rates rise, asset
yields will increase faster than the cost of interest bearing liabilities,
leading to an increase in the margin.  The extent of this decline or
increase will depend on the degree to which deposit rates change relative to
market rates.  Starting on June 30, 2004, the Federal Reserve raised the
target Fed Funds rate three times, increasing it from 1.00% to 1.75%.

## Item 4.      CONTROLS AND
PROCEDURES

Company management, including the chief executive officer and president
(principal executive officer) and the chief administrative officer (principal
financial and accounting officer), supervised and participated in an evaluation
of the Companys disclosure controls and procedures (as defined in rules of the
Securities and Exchange Commission) as of September 30, 2004.  Based on,
and as of the date of, that evaluation, the Companys chief executive officer
and president and the chief administrative officer have concluded that the
Companys disclosure controls and procedures were effective in accumulating and
communicating information to management, including the chief executive officer
and president, and the chief administrative officer, as appropriate to allow
timely decisions regarding required disclosures of that information under the
Securities and Exchange Commissions rules and forms and that the disclosure
controls and procedures are designed to ensure that the information required to
be disclosed in reports that are filed or submitted under the Securities and
Exchange Act of 1934, as amended, are recorded, processed, summarized and
reported within the time periods specified in the Securities and Exchange
Commissions rules and forms.

There were no significant changes in the Company’s internal controls or in other
factors that could significantly affect these controls subsequent to the date of their evaluation.

25

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# PART
II        OTHER INFORMATION

ITEM 1.LEGAL PROCEEDINGS

The Company is a defendant in various legal proceedings arising in the normal course of
business. The Company does not believe that the outcome of any such proceedings will have a material effect on its consolidated
financial position, operations, or liquidity.

## ITEM 6.
EXHIBITS

| | (a) | Exhibits
| | --- | --------
| |     |         
| |     | 10.9    
| |     |         
| |     | 31.1    
| |     |         
| |     | 31.2    
| |     |         
| |     | 32.1    
| |     |         
| |     | 32.2    



26

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SIGNATURES



Pursuant to the requirements of
the Securities Exchange Act of 1934, the registrant has duly caused this Quarterly Report on Form 10‐Q to be signed on its
behalf by the undersigned thereunto duly authorized.



|                         | VAIL BANKS, INC.                                                                                                                                               
|------------------------ | ---------------------------------------------------------------------------------------------------------------------------------------------------------------
|Date:  November 15, 2004 | /s/   Gary S.
JuddGary S. Judd  Chief Executive Officer and
President(Principal Executive Officer)                                                             
|                         |                                                                                                                                                                
|Date:  November 15, 2004 | /s/  Raymond E.
Verlinde Raymond E.
VerlindeSenior Executive Vice President and
Chief Administrative Officer
      (Principal Financial and Accounting
Officer)