**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**


**_______________________**





**FORM
      10-Q**





**x 
QUARTERLY
      REPORT
      PURSUANT TO SECTION 13 OR 15(** **d** **)
      OF THE SECURITIES EXCHANGE ACT OF 1934**




For
      the
      quarterly period ended June 30, 2006




**or**




**o 
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: 000-25081








**VAIL
      BANKS,
      INC.**


(Exact
      name of registrant as specified in its charter)





**Colorado**
            
            **84-1250561**(State
                or other jurisdiction of
            
            (I.R.S.
                Employerincorporation
                or organization)
            
            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 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. (Check
      one):





Large
                accelerated filer o
            Accelerated
                filer o
            Non-accelerated
                filer x




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




Indicate
      the number of shares outstanding of each of the issuer’s classes of common
      shares, as of the latest practicable date:




**As
      of August 7, 2006, there were 5,606,235 common shares ($1.00 par value per
      share) outstanding.**








**VAIL
      BANKS, INC.**





**FORM
      10-Q**


**FOR
      THE QUARTER ENDED JUNE 30, 2006**





**TABLE
      OF CONTENTS**








**PART
                I FINANCIAL
                INFORMATION**ITEM
                1.  FINANCIAL STATEMENTS*Consolidated
                Balance Sheet (unaudited)*
            *3**Consolidated
                Statement of Income and Comprehensive Income
                (unaudited)*
            *4**Consolidated
                Statement of Cash Flows (unaudited)*
            *5**Notes
                to Unaudited Consolidated Financial Statements*
            *8*ITEM
                2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
                OF OPERATIONS*Forward
                Looking Statements*
            *17**Basis
                of Presentation*
            *17**Proposed
                Merger with U.S. Bancorp*
            *17**Overview*
            *18**Results
                of Operations - Quarter to Date*
            *18**Results
                of Operations - Year to Date*
            *19**Financial
                Condition*
            *20**Asset
                Quality*
            *20**Financial
                Instruments With Off-Balance-Sheet Risk*
            *20**Liquidity*
            *22**Capital
                Resources*
            *23*ITEM
                3. QUANTITATIVE
                AND QUALITATIVE
                DISCLOSURES ABOUT MARKET RISK
            24ITEM
                4.  CONTROLS AND PROCEDURES
            24**PART
                II      OTHER
                INFORMATION***ITEM
                1.      LEGAL PROCEEDINGS.*
            *25**ITEM
                1A.   RISK FACTORS.*
            *25**ITEM
                2.     UNREGISTERED SALES OF EQUITY SECURITIES AND USE
                OF PROCEEDS*
            *26**ITEM
                3.     DEFAULTS UPON SENIOR
                SECURITIES*
            *26**ITEM
                4.     SUBMISSION OF MATTERS TO A VOTE OF SECURITY
                HOLDERS*
            *26**ITEM
                5.     OTHER INFORMATION*
            *26**ITEM
                6.     EXHIBITS.*
            *27*SIGNATURES
            28




2




**PART
      1 FINANCIAL INFORMATION**






**Item
      1.**  **FINANCIAL STATEMENTS**




**VAIL
                BANKS, INC.****Consolidated
                Balance Sheet**
              (unaudited)**June
                30,**
            
            December
                31,(dollars
                in thousands, except share data)
            
            **2006**
            
            2005**ASSETS**Cash
                and due from banks
            
            $
            **21,793**
            
            $
            20,728Federal
                funds sold
            
            
            **4,990**
            
            
            10,630Total
                cash and cash equivalents
            
            
            **26,783**
            
            
            31,358Investment
                securities, available-for-sale
            
            
            **79,081**
            
            
            87,265Investment
                securities, held-to-maturity
            
            
            **158**
            
            
            175Investments
                in Trust I and Trust II
            
            
            **743**
            
            
            743Loans,
                net
            
            
            **530,684**
            
            
            481,511Investments
                in bank stocks, at cost
            
            
            **4,612**
            
            
            4,558Premises
                and equipment, net
            
            
            **38,775**
            
            
            38,686Interest
                receivable
            
            
            **3,110**
            
            
            2,796Goodwill
            
            
            **35,970**
            
            
            35,970Core
                deposit intangible
            
            
            **99**
            
            
            119Other
                assets
            
            
            **4,120**
            
            
            3,138**$**
            **724,135**
            
            $
            686,319**LIABILITIES
                AND SHAREHOLDERS’ EQUITY**LiabilitiesDepositsNon-interest
                bearing
            
            **$**
            **122,911**
            
            $
            133,250Interest
                bearing
            
            
            **438,516**
            
            
            419,258Total
                deposits
            
            
            **561,427**
            
            
            552,508Securities
                sold under agreements to repurchase
            
            
            **39,883**
            
            
            12,470Federal
                Home Loan Bank advances
            
            
            **23,673**
            
            
            25,759Subordinated
                notes to Trust I and Trust II
            
            
            **24,743**
            
            
            24,743Interest
                payable and other liabilities
            
            
            **6,163**
            
            
            4,606Total
                liabilities
            
            
            **655,889**
            
            
            620,086Minority
                interest
            
            
            **2,547**
            
            
            2,500Commitments
                and contingencies (Notes 7 and 11)Shareholders’
                equityPreferred
                shares - $1 par value; 2,250,000 shares authorized, no shares issued
                and
              outstanding
                at June 30, 2006 and December 31, 2005, respectively
            
            
            —
            
            
            —Common
                shares - $1 par value; 20,000,000 shares authorized, 5,606,235 shares
                issued
              and
                outstanding at June 30, 2006 and December 31, 2005
            
            
            **5,606**
            
            
            5,606Additional
                paid-in capital
            
            
            **36,355**
            
            
            35,976Retained
                earnings
            
            
            **25,158**
            
            
            23,188Accumulated
                other comprehensive loss, net of tax benefit of**$834**and $609 at
              June
                30, 2006 and December 31, 2005, respectively
            
            
            **(1,420**
            **)**
            
            (1,037
            )Total
                shareholders’ equity
            
            
            **65,699**
            
            
            63,733**$**
            **724,135**
            
            $
            686,319


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


3


**VAIL
      BANKS, INC.**


**Consolidated
      Statement of Income and Comprehensive Income**


(dollars
      in thousands, except share data)


(unaudited)




Three
                months ended
              June
                30,
            
            Six
                months ended
              June
                30,**2006**
            
            2005
            
            **2006**
            
            2005Interest
                incomeInterest
                and fees on loans
            
            **$**
            **11,917**
            
            $
            8,243
            
            **$**
            **22,780**
            
            $
            15,857Interest
                on investment securities
            
            
            **768**
            
            
            970
            
            
            **1,552**
            
            
            2,286Interest
                on federal funds sold
            
            
            **98**
            
            
            219
            
            
            **177**
            
            
            411Investments
                in Trust I and II
            
            
            **19**
            
            
            19
            
            
            **38**
            
            
            38Interest
                on bank stocks
            
            
            **57**
            
            
            58
            
            
            **118**
            
            
            113Total
                interest income
            
            
            **12,859**
            
            
            9,509
            
            
            **24,665**
            
            
            18,705Interest
                expenseDeposits
            
            
            **3,039**
            
            
            1,623
            
            
            **5,706**
            
            
            2,952Borrowings
            
            
            **247**
            
            
            241
            
            
            **502**
            
            
            605Securities
                sold under agreements to repurchase
            
            
            **370**
            
            
            98
            
            
            **591**
            
            
            123Federal
                funds purchased
            
            
            **13**
            
            
            —
            
            
            **20**
            
            
            —Subordinated
                notes to Trust I and II
            
            
            **630**
            
            
            630
            
            
            **1,261**
            
            
            1,261Total
                interest expense
            
            
            **4,299**
            
            
            2,592
            
            
            **8,080**
            
            
            4,941Net
                interest income
            
            
            **8,560**
            
            
            6,917
            
            
            **16,585**
            
            
            13,764Provision/(credit)
                for the allowance for loanlosses
            
            
            **240**
            
            
            (36
            )
            
            **455**
            
            
            29Net
                interest income after provision/(credit)
                for the
              allowance
                for loanlosses
            
            
            **8,320**
            
            
            6,953
            
            
            **16,130**
            
            
            13,735Non-interest
                incomeGain
                on sale of premises and equipment
            
            
            —
            
            
            11
            
            
            —
            
            
            3Deposit
                related
            
            
            **690**
            
            
            645
            
            
            **1,337**
            
            
            1,265Mortgage
                broker fees
            
            
            **461**
            
            
            459
            
            
            **864**
            
            
            853Other
            
            
            **481**
            
            
            426
            
            
            **945**
            
            
            855Total
                non-interest income
            
            
            **1,632**
            
            
            1,541
            
            
            **3,146**
            
            
            2,976Non-interest
                expenseSalaries
                and employee benefits
            
            
            **4,580**
            
            
            4,109
            
            
            **9,158**
            
            
            8,304Occupancy
            
            
            **939**
            
            
            1,044
            
            
            **1,915**
            
            
            2,043Furniture
                and equipment
            
            
            **603**
            
            
            650
            
            
            **1,219**
            
            
            1,333Other
            
            
            **1,803**
            
            
            1,272
            
            
            **3,094**
            
            
            2,361Total
                non-interest expense
            
            
            **7,925**
            
            
            7,075
            
            
            **15,386**
            
            
            14,041Income
                before income tax provision
            
            
            **2,027**
            
            
            1,419
            
            
            **3,890**
            
            
            2,670Provision
                for income taxes
            
            
            **585**
            
            
            448
            
            
            **1,135**
            
            
            814Net
                income
            
            
            **1,442**
            
            
            971
            
            
            **2,755**
            
            
            1,856Net
                change in unrealized (loss)/gain on investment
              securities
                available for sale, net of taxes
            
            
            **(268**
            **)**
            
            424
            
            
            **(383**
            **)**
            
            (47
            )Comprehensive
                income
            
            **$**
            **1,174**
            
            $
            1,395
            
            **$**
            **2,372**
            
            $
            1,809




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


4


**VAIL
      BANKS, INC.**


**Consolidated
      Statement of Income and Comprehensive Income (Continued)**


(dollars
      in thousands, except share data)


(unaudited)





Three
                  months ended
                June
                  30,
              
              
              Six
                  months ended
                June
                  30,**2006**
              
              
              2005
              
              
              **2006**
              
              
              2005Earnings
                  per shareBasic
              
              **$**
              **0.28**
              
              $
              0.19
              
              **$**
              **0.53**
              
              $
              0.36Diluted
              
              **$**
              **0.26**
              
              $
              0.18
              
              **$**
              **0.50**
              
              $
              0.34Weighted
                  average common sharesBasic
              
              
              **5,248,704**
              
              
              5,180,909
              
              
              **5,241,155**
              
              
              5,132,746Diluted
              
              
              **5,498,264**
              
              
              5,335,764
              
              
              **5,481,567**
              
              
              5,403,438Dividend
                  per share
              
              **$**
              **0.07**
              
              $
              0.07
              
              **$**
              **0.14**
              
              $
              0.14


The
        accompanying notes are an integral part of these unaudited consolidated
        financial statements.  5
  **VAIL
          BANKS, INC.**
 **Consolidated
          Statement of Cash Flows**
 (dollars
          in thousands)
 (unaudited)


Six
                months ended
              June
                30,**2006**
            
            2005Cash
                flows from operating activitiesNet
                income
            
            **$**
            **2,755**
            
            $
            1,856Adjustments
                to reconcile net income to net cash provided by operating
                activitiesNet
                amortization of premiums on investment securities
            
            
            **231**
            
            
            244Provision
                for loan losses
            
            
            **455**
            
            
            29Amortization
                of deferred loan fees
            
            
            **(618**
            **)**
            
            (611
            )Gain
                on sale of premises and equipment
            
            
            **—**
            
            
            (3
            )Depreciation
                and amortization
            
            
            **1,055**
            
            
            1,044Gain
                on sale of foreclosed properties
            
            
            **—**
            
            
            (27
            )Recognition
                of compensation expense on restricted common shares and stock
                options
            
            
            **379**
            
            
            254Minority
                interest expense
            
            
            **47**
            
            
            36Federal
                Home Loan Bank stock dividends
            
            
            **(54**
            **)**
            
            (51
            )Deferred
                income tax expense
            
            
            **5**
            
            
            —Changes
                in operating assets and liabilitiesLoans
                held for sale
            
            
            **—**
            
            
            5,910Interest
                receivable
            
            
            **(314**
            **)**
            
            (114
            )Other
                assets
            
            
            **(327**
            **)**
            
            49Interest
                payable and other liabilities
            
            
            **1,546**
            
            
            (683
            )Net
                cash provided by operating activities
            
            
            **5,160**
            
            
            7,933Cash
                flows from investing activitiesPurchases
                of investment securities, available for sale
            
            
            **(650**
            **)**
            
            (30,466
            )Proceeds
                from maturities of investment securities, held to maturity
            
            
            **17**
            
            
            59Proceeds
                from maturities/calls of investment securities, available for
                sale
            
            
            **7,995**
            
            
            37,882Net
                increase in loans
            
            
            **(49,434**
            **)**
            
            (13,697
            )Purchases
                of premises and equipment
            
            
            **(1,124**
            **)**
            
            (1,150
            )Proceeds
                from sales of premises and equipment
            
            
            **—**
            
            
            99Proceeds
                from sales of foreclosed properties
            
            
            **—**
            
            
            248Net
                cash used by investing activities
            
            
            **(43,196**
            **)**
            
            (7,025
            )Cash
                flows from financing activitiesNet
                increase in deposits
            
            
            **8,919**
            
            
            19,464Net
                increase in securities sold under agreements to repurchase
            
            
            **27,413**
            
            
            16,240Net
                decrease in Federal Home Loan Bank advances
            
            
            **(2,086**
            **)**
            
            (15,312
            )Proceeds
                from issuance of common shares
            
            
            **—**
            
            
            718Distribution
                to minority partners
            
            
            **—**
            
            
            (155
            )Payment
                of cash dividends on common shares
            
            
            **(785**
            **)**
            
            (766
            )Net
                cash provided by financing activities
            
            
            **33,461**
            
            
            20,189Net
                (decrease) increase in cash and cash equivalents
            
            
            **(4,575**
            **)**
            
            21,097Cash
                and cash equivalents at beginning of period
            
            
            **31,358**
            
            
            35,655Cash
                and cash equivalents at end of period
            
            **$**
            **26,783**
            
            $
            56,752





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


6


**VAIL
      BANKS, INC.**


**Consolidated
      Statement of Cash Flows (Continued)**


(dollars
      in thousands)


(unaudited)


Six
                months ended
              June
                30,**2006**
            
            2005Supplemental
                disclosures of cash flow informationCash
                paid during the period for:Interest
                on deposits and borrowed funds
            
            **$**
            **7,801**
            
            $
            4,912Income
                taxes
            
            **$**
            **1,675**
            
            $
            270Non-cash
                investing and financing transactions
              Foreclosure
                of collateralized loans, net of reserve
            
            **$**
            **424**
            
            $
            25Unrealized
                loss on investment securities available-for-sale, net of
                taxes
            
            **$**
            **(383**
            **)**
            $
            (47
            )







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


7
 **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 or the Company) and its wholly-owned subsidiary,
      WestStar Bank (WestStar). Vail Banks and WestStar own a combined 54.04% interest
      in Avon 56 Limited and 74.94% of Glenwood/Rose L.P. which are consolidated
      in
      the financial statements of Vail Banks in accordance with Statement of Financial
      Accounting Standards (SFAS) No. 94, *Consolidation
      of All Majority-Owned Subsidiaries* (SFAS
      94). Avon 56 Limited and Glenwood/Rose L.P. are partnerships that own bank
      buildings in Avon, Colorado and Glenwood Springs, Colorado, respectively. As
      a
      result of the fact that these partnerships are not fully-owned, the
      non-controlling interest in the partnerships is reflected as minority interest
      in the consolidated financial statements. All entities are collectively referred
      to as the Company. All significant intercompany balances and transactions have
      been eliminated in consolidation.





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, 2005. 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, 2005. In
      the
      opinion of management, all adjustments necessary, consisting of only normal
      recurring items, have been included for a fair presentation of the accompanying
      consolidated financial statements. Operating results for the three and six
      months ended June 30, 2006 are not necessarily indicative of the results that
      may be expected for the full year.





Certain
      reclassifications have been made to the 2005 financial statements to conform
      to
      the 2006 presentation.





**2. 
      PROPOSED MERGER WITH U.S. BANCORP**




On
      May
      31, 2006, the Company entered into an Agreement and Plan of Merger (the “Merger
      Agreement”) with U.S. Bancorp, a Delaware corporation (“USB”), and Powder
      Acquisition Corp., a Colorado corporation and a wholly-owned subsidiary of
      USB
      (“Merger Sub”). The Merger Agreement and the transaction contemplated thereby
      were approved by the Company’s board of directors and the board of directors
      agreed to recommend the transaction for approval by the Company’s
      shareholders on May 31, 2006. Pursuant to the terms of the Merger Agreement,
      at
      the effective time of the merger, Merger Sub will merge with and into the
      Company, with the Company continuing as the surviving corporation and a
      wholly-owned subsidiary of USB. All of the Company’s common shares issued and
      outstanding will be immediately and automatically converted into the right
      to
      receive $17.00 per share in cash, and all outstanding options will be
      immediately and automatically converted into the right to receive the excess,
      if
      any, of $17.00 per option in cash over the exercise price of such
      option, less any tax withholding. The total transaction value is approximately
      $98.6 million.




In
      addition, the Company has agreed, among other things and subject to certain
      exceptions as described in the Merger Agreement, (i) to conduct its
      business in the ordinary course consistent with past practice during the interim
      period between the execution of the Merger Agreement and consummation of this
      merger, (ii) not to engage in certain transactions during such period,
      (iii) to cause a shareholder meeting to be held to consider approval of
      this merger and the other transactions contemplated by the Merger Agreement,
      (iv) subject to certain limited exceptions to permit the board of directors
      to comply with their fiduciary duties, for the Company’s board of directors to
      recommend that the shareholders adopt the Merger Agreement and thereby approve
      this merger, and (v) subject to certain limited exceptions to permit the
      board of directors to comply with their fiduciary duties, not to solicit
      proposals relating to alternative business combination transactions, or to
      enter
      into discussions concerning, or to provide information in connection with,
      alternative business combination transactions.




Consummation
      of the merger, which is currently expected in the third quarter of 2006, is
      subject to a number of conditions, including shareholder approval, absence
      of
      any law or order prohibiting the consummation of this merger, expiration,
      regulatory approval, and certain other customary conditions. On June 28, 2006,
      the Company and USB made the required filings with the Board of Governors of
      the
      Federal Reserve System and the Colorado Division of Banking to gain approval
      of
      the merger. The Federal Reserve Board approved the merger application on August
      7, 2006 and the applicable waiting period will expire on August 22, 2006. The
      Company has submitted the Merger Agreement and the merger described above to
      shareholders for their consideration at a special meeting of shareholders to
      be
      held on August 31, 2006.




Pursuant
      to the terms of the Merger Agreement, the Company and USB each have certain
      termination rights. Upon termination of the Merger Agreement under specified
      circumstances, the Company may be required to pay USB a termination fee of
      approximately $3.95 million.




8
 **VAIL
          BANKS, INC.**
 Notes
          to Unaudited Consolidated Financial Statements


**3. 
      INVESTMENT SECURITIES**




Investment
      securities consist of the following:




**June
                30, 2006**
            
            December
                31, 2005**Amortized**
            
            **Estimated**
            
            Amortized
            
            Estimated(dollars
                in thousands)
            
            **Cost**
            
            **Fair
                Value**
            
            Cost
            
            Fair
                ValueSecurities
                available-for-saleGovernment
                agencies (1)
            
            **$**
            **18,935**
            
            **$**
            **18,643**
            
            $
            22,039
            
            $
            21,632State
                and municipal obligations
            
            
            **21,615**
            
            
            **21,517**
            
            
            21,225
            
            
            21,548Mortgage-backed
                securities
            
            
            **35,537**
            
            
            **34,211**
            
            
            40,647
            
            
            39,469Agency
                preferred stock
            
            
            **4,500**
            
            
            **3,978**
            
            
            4,500
            
            
            4,116Other
            
            
            **750**
            
            
            **732**
            
            
            500
            
            
            500Total
                securities available-for-sale
            
            **$**
            **81,337**
            
            **$**
            **79,081**
            
            $
            88,911
            
            $
            87,265Securities
                held-to-maturityMortgage-backed
                securities
            
            **$**
            **158**
            
            **$**
            **163**
            
            $
            175
            
            $
            184(1)
                Includes mortgage-backed government
                agencies.





After-tax
      net unrealized losses on investment securities increased $383,000 during the
      six
      months ended June 30, 2006 from an unrealized loss of $1.0 million at December
      31, 2005 to an unrealized loss of $1.4 million at June 30, 2006. The increase
      in
      the after-tax net unrealized losses on available-for-sale securities relates
      primarily to the 100 basis point increase in interest rates implemented by
      the
      Federal Reserve during the first and second quarters of 2006. Management does
      not believe any individual unrealized loss as of June 30, 2006 represents an
      other-than-temporary impairment.





The
      following table presents the components of investment income for the three
      and
      six months ended June 30, 2006 and 2005.





Three
                months ended
              June
                30,****
            
            Six
                months ended
              June
                30,(in
                thousands)
            
            **2006**
            
            2005
            
            **2006**
            
            2005Taxable
                interest income
            
            **$**
            **498**
            
            $
            746
            
            **$**
            **1,004**
            
            $
            1,719Nontaxable
                interest income
            
            
            **270**
            
            
            224
            
            
            **548**
            
            
            567**$**
            **768**
            
            $
            970
            
            **$**
            **1,552**
            
            $
            2,286








**4.
      LOANS**




Loans
      consist of the following:





(dollars
                in thousands)
            
            **June
                30,**
              **2006**
            
            December
                31,
              005Real
                estate - construction
            
            **$**
            **229,644**
            
            $
            222,857Commercial,
                industrial and agricultural
            
            
            **187,373**
            
            
            168,110Real
                estate - mortgage
            
            
            **113,762**
            
            
            88,679Consumer
                and other
            
            
            **5,915**
            
            
            7,455Gross
                loans
            
            
            **536,694**
            
            
            487,101Less:Allowance
                for loan losses
            
            
            **(4,929**
            **)**
            
            (4,473
            )Deferred
                loan fees, net
            
            
            **(1,081**
            **)**
            
            (1,117
            )Loans,
                net
            
            **$**
            **530,684**
            
            $
            481,511




9
 **VAIL
          BANKS, INC.**
 Notes
          to Unaudited Consolidated Financial Statements





Two
      loans, with total carrying values of $424,000, were transferred to foreclosed
      properties during the first quarter of 2006. No loans were transferred to
      foreclosed properties during the second quarter of 2006 and 2005. One
      other-real-estate-owned property was written down $200,000 during the second
      quarter of 2006.





The
      principal balance of loans on which the accrual of interest has been
      discontinued was $2.5 million at June 30, 2006. As of June 30, 2006, $27,000
      of
      loans were past due 90 days and still accruing interest. In comparison, as
      of
      June 30, 2005, there were no loans on which the accrual of interest had been
      discontinued and $181,000 of loans were past due 90 days and still accruing
      interest.





The
      majority of impaired loans requiring an allowance are measured using the fair
      value of the underlying collateral since these loans are considered collateral
      dependent. Any unsecured loans are measured using discounted cash flow analyses
      of the payments expected over the life of the loan considering any internal
      or
      external factors that currently exist that would impact the amount or timing
      of
      cash flows.





The
      following is a summary of information pertaining to impaired loans:





**June
                30,**
            
            December
                31,(dollars
                in thousands)
            
            **2006**
            
            2005Impaired
                loans without a valuation allowance
            
            **$**
            **4,077**
            
            $
            3,781Impaired
                loans with a valuation allowance
            
            
            **6,841**
            
            
            725Total
                impaired loans
            
            **$**
            **10,918**
            
            $
            4,506Valuation
                allowance related to impaired loans
            
            **$**
            **169**
            
            $
            173





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 common shares) of the Company and their affiliates as
      follows:





(dollars
                in thousands)
            
            **2006**Balance
                at January 1, 2006
            
            **$**
            **13,243**New
                loans
            
            
            **3,094**Payments
            
            
            **(3,628**
            **)**Balance
                at June 30, 2006
            
            **$**
            **12,709**







**5. 
      ALLOWANCE FOR LOAN LOSSES**




Activity
      in the allowance is summarized as follows:




(dollars
                in thousands)
            
            **2006**
            
            2005Allowance
                at January 1,
            
            **$**
            **4,473**
            
            $
            3,895Loans
                charged off
            
            
            **(4**
            **)**
            
            (25
            )Recoveries
                on loans previously charged off
            
            
            **5**
            
            
            104Provision
                for loan losses
            
            
            **455**
            
            
            29Allowance
                at June 30,
            
            **$**
            **4,929**
            
            $
            4,003




10
 **VAIL
          BANKS, INC.**
 Notes
          to Unaudited Consolidated Financial Statements


**6. 
      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 June
      30,
      2006 and December 31, 2005, the carrying amount of securities sold to secure
      repurchase agreements was $39.9 million and $12.5 million, respectively. This
      $27.4 million increase is due to the Company’s recent marketing efforts focused
      on increasing the use of this product. Securities sold under agreements to
      repurchase are reported as 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.





**7. 
      BORROWINGS**




As
      a
      member of the Federal Home Loan Bank (FHLB), and as a regular part of its
      business, WestStar obtains both short and long-term advances from the FHLB
      of
      Topeka. Advances are collateralized primarily by FHLB stock owned by WestStar
      and loans secured by certain mortgages or deeds of trust. As of June 30, 2006,
      the Company’s total borrowing capacity was $180.8 million of which $23.7 million
      of borrowings were outstanding. Additionally, the Company had $31.0 million
      in
      stand-by irrevocable letters of credit issued by the FHLB and pledged as
      collateral for uninsured public fund deposits at June 30, 2006. As of December
      31, 2005, the authorized borrowing line totaled $175.2 million of which $25.8
      million was outstanding. Additionally, as of December 31, 2005, the Company
      had
      a $5.0 million stand-by irrevocable letter of credit from the FHLB 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, 2006. As of June 30, 2006 and December
      31,
      2005, this authorized borrowing line totaled $40.1 million with no amounts
      outstanding.




WestStar
      has also established an unsecured, overnight federal funds line with First
      Tennessee Bank, N.A. that expires on September 30, 2006. As of June 30, 2006
      and
      December 31, 2005, this authorized borrowing line totaled $20.0 million with
      no
      amounts outstanding. This line is subject to cancellation by First Tennessee
      at
      any time upon the occurrence of certain conditions.




**8. 
      SHAREHOLDERS’ EQUITY**




***Shares
      Repurchase Plan***




At
      its
      meeting on January 16, 2006, the Company’s Board of Directors reauthorized the
      Company’s common shares repurchase program that was originally approved in
      February 2001. Since inception of the program through June 30, 2006, the Company
      has repurchased 1,535,380 common shares at an average price of $12.10 per share,
      for a total of approximately $19.0 million. The total amount of repurchases
      under the program, both previously completed and allowable up to January 2007,
      aggregate to approximately $29.0 million. During the first and second quarters
      of 2006, the Company did not repurchase any of its common shares.




***Restricted
      Shares***




On
      January 1, 2006, the Company adopted SFAS No. 123(R), *Share-Based
      Payment* (SFAS
      123(R)), under the modified prospective approach. Adoption of this standard
      had
      no impact on the Company’s accounting for its restricted share grants. The
      financial statements for prior interim periods and fiscal years have not been
      restated. Accordingly, compensation expense is recorded over the vesting period
      of the restricted shares equal to the value of the restricted shares using
      the
      market price of the shares on the grant date. Generally, the restricted share
      awards vest ratably over the service period; however, vesting may also be based
      upon attainment of certain performance measures. As of June 30, 2006, total
      unearned compensation on restricted share grants was $4.4 million.




11
 **VAIL
          BANKS, INC.**
 Notes
          to Unaudited Consolidated Financial Statements


The
      following table summarizes information related to restricted share grants for
      the six months ended June 30, 2006:





Non-vested
              Shares
            
            Weighted-
              Average
              Grant
                Date
              Fair
                ValueBalance
                at December 31, 2005
            
            
            **382,974**
            
            $
            12.50Granted
            
            
            **—**
            
            
            **—**Vested
            
            
            **29,881**
            
            
            12.50Balance
                at June 30, 2006
            
            
            **353,093**
            
            $
            12.50








**Stock
      Options**




In
      January 1998, the Company adopted a stock incentive plan pursuant to which
      the
      Compensation Committee (the Committee) of the Board may grant incentive stock
      options, nonqualified stock options, restricted share awards and performance
      share awards to certain employees, directors and others who perform services
      for
      the Company.





The
      number of shares available for grant of awards under such plan, if any, must
      be
      approved by the Company’s shareholders. 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 available under the Plan from 1,000,000
      to 1,250,000 shares and to provide that the new total number of shares will
      increase on January 1 st 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 to 625,000 shares. If granted,
      outstanding options will be counted against the authorized pool of shares,
      regardless of their vested status. At June 30, 2006 and December 31, 2005,
      there
      were 287,192 shares available for grant under the Plan.





The
      option exercise price for each stock option grant will not be less than the
      fair
      market value on the date the option is granted. The Committee may determine
      the
      restrictions and conditions under which options may be exercised. Options must
      be exercised within ten years of the date granted.





The
      Company accounts for its stock options in accordance with the provisions of
      SFAS
      123(R), which was adopted on January 1, 2006 under the modified prospective
      approach. In accordance with SFAS 123(R), the compensation cost that has been
      charged against income for stock options was $14,000 for the three months ended
      June 30, 2006 and $32,000 for the six months ended June 30, 2006. Tax benefits
      of $3,000 and $6,000 associated with this expense were recognized for the
      compensation expense related to the non-qualified stock options for the three
      and six months ended June 30, 2006, respectively. The financial statements
      for
      prior interim periods and fiscal years have not been restated.





In
      accordance with SFAS No. 148, *Accounting
      for Stock-Based Compensation - Transition and Disclosure, an Amendment to SFAS
      No. 123* ,
      the
      following table illustrates the effect on net income and earnings per share
      as
      if the Company had applied the fair value recognition provisions of SFAS 123
      to
      stock-based compensation in prior periods.


12
 **VAIL
          BANKS, INC.**
 Notes
          to Unaudited Consolidated Financial Statements





(in
                thousands, except share data)
            
            Three
                months ended June 30, 2005
            
            Six
                months ended June 30, 2005Net
                incomeAs
                reported
            
            $
            971
            
            $
            1,856Add
                back: Total stock-based compensation recorded, net of tax
            
            
            99
            
            
            160Deduct:
                Total stock-based compensation determined under the
              fair
                value method, net of tax
            
            
            (106
            )
            
            (176
            )Pro
                forma
            
            $
            964
            
            $
            1,840Earnings
                per share - basicAs
                reported
            
            $
            0.19
            
            $
            0.36Pro
                forma
            
            $
            0.19
            
            $
            0.36Earnings
                per share - dilutedAs
                reported
            
            $
            0.18
            
            $
            0.34Pro
                forma
            
            $
            0.18
            
            $
            0.34








The
      fair
      value of employee stock option grants is estimated on the date of grant using
      the Black-Scholes option-pricing model. The following weighted-average
      assumptions were used for the six months ended June 30, 2006 and 2005.





**2006**
            
            **2005**Dividend
                yield
            
            
            ******
            
            
            **2.17**%****Expected
                life
            
            
            **
            
            
            **7
                years**Expected
                volatility
            
            
            **
            
            
            **24.9**%****Risk-free
                interest rate
            
            
            **
            
            
            **4.2**%****




**No
      stock options were granted during 2006.





The
      dividend yield is calculated by taking the Company’s historical dividend payment
      amount per year divided by the average market price of the Company’s common
      shares. The expected term is determined using historical data which uses option
      exercises and employee terminations to calculate an expected term. Expected
      volatility is based on the historical volatility of the Company’s common shares
      over the expected term of the options. The risk-free interest rate is based
      on
      the U.S. Treasury yield curve for a similar expected term in effect at the
      time
      of the grant.





A
      summary
      of the Company’s stock incentive plan activity as of June 30, 2006 and changes
      during the six months then ended is presented below:





Options
            
            Shares
            
            Weighted
              Average
              Exercise
                Price
            
            Weighted-
              Average
              Remaining
              Contractual
              Term
            
            Aggregate
              Intrinsic
                Value
              ($000)Outstanding
                at January 1, 2006
            
            
            465,349
            
            $
            10.06
            
            
            4
                years
            
            $
            2,815Granted
            
            
            **—**
            
            
            **—**
            
            
            **—**
            
            
            **—**Exercised
            
            
            **—**
            
            
            **—**
            
            
            **—**
            
            
            **—**Forfeited
                or expired
            
            
            (63
            )
            $
            11.20
            
            
            **—**
            
            $
            1Outstanding
                at June 30, 2006
            
            
            465,286
            
            $
            10.06
            
            
            4
                years
            
            $
            3,070Exercisable
                at June 30, 2006
            
            
            431,411
            
            $
            9.79
            
            
            3
                years
            
            $
            2,964


13
 **VAIL
          BANKS, INC.**
 Notes
          to Unaudited Consolidated Financial Statements


As
      of
      June 30, 2006, there was $92,000 of total unrecognized compensation cost related
      to non-vested share-based compensation arrangements granted as stock options.
      Management does not anticipate any forfeitures for the remaining non-vested
      options. This cost is expected to be amortized on a straight-line basis over
      a
      weighted-average period of approximately 2.5 years and will be adjusted for
      subsequent changes in estimated forfeitures. The total fair value of shares
      vested during the three and six months ended June 30, 2006 was $12,000 and
      $28,000, respectively.





*Inducement
      Stock Options*





A
      summary
      of the Company’s inducement stock option activity as of June 30, 2006 and
changes during the six months then ended is presented below:





Options
            
            Shares
            
            Weighted
              Average
              Exercise
                Price
            
            Weighted
              Average
              Remaining
              Contractual
              Term
            
            Aggregate
              Intrinsic
                Value
              ($000)Outstanding
                at January 1, 2006
            
            
            8,750
            
            $
            12.86
            
            
            8
                years
            
            $
            28Granted
            
            
            **—**
            
            
            **—**
            
            
            **—**
            
            
            **—**Exercised
            
            
            **—**
            
            
            **—**
            
            
            **—**
            
            
            **—**Forfeited
                or expired
            
            
            **—**
            
            
            **—**
            
            
            **—**
            
            
            **—**Outstanding
                at June 30, 2006
            
            
            8,750
            
            $
            12.86
            
            
            8
                years
            
            $
            33Exercisable
                at June 30, 2006
            
            
            4,062
            
            $
            12.59
            
            
            7
                years
            
            $
            17





As
      of
      June 30, 2006, there was $15,000 of total unrecognized compensation cost related
      to non-vested share-based compensation arrangements granted as inducement stock
      options. Management does not anticipate any forfeitures for the remaining
      non-vested inducement options. This cost is expected to be amortized on a
      straight-line basis over a weighted-average period of approximately 2.5 years
      and will be adjusted for subsequent changes in estimated forfeitures. The total
      fair value of shares vested during the three and six months ended June 30,
      2006
      was $2,000 and $4,000, respectively.





***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.




14
 **VAIL
          BANKS, INC.**
 Notes
          to Unaudited Consolidated Financial Statements


The
      following table presents the net income and weighted-average common shares
      outstanding used to calculate earnings per share for the three and six months
      ended June 30, 2006 and 2005:





Three
                months ended
              June
                30,
            
            Six
                months ended
              June
                30,(dollars
                in thousands, except share and per share data)
            
            **2006**
            
            2005
            
            **2006**
            
            2005Basic
                earnings per share computationNet
                income available to common shareholders
            
            **$**
            **1,442**
            
            $
            971
            
            **$**
            **2,755**
            
            $
            1,856Weighted
                average shares - basic
            
            
            **5,248,704**
            
            
            5,180,909
            
            
            **5,241,155**
            
            
            5,132,746Basic
                earnings per share
            
            **$**
            **0.28**
            
            $
            0.19
            
            **$**
            **0.53**
            
            $
            0.36Diluted
                earnings per share computationNet
                income available to common shareholders
            
            **$**
            **1,442**
            
            $
            971
            
            **$**
            **2,755**
            
            $
            1,856Weighted
                average shares - basic
            
            
            **5,248,704**
            
            
            5,180,909
            
            
            **5,241,155**
            
            
            5,132,746Shares
                assumed issued:Stock
                options
            
            
            **166,089**
            
            
            125,321
            
            
            **163,337**
            
            
            124,719Restricted
                stock
            
            
            **83,471**
            
            
            29,533
            
            
            **77,075**
            
            
            145,973Weighted
                average shares - diluted
            
            
            **5,498,264**
            
            
            5,335,763
            
            
            **5,481,567**
            
            
            5,403,438Diluted
                earnings per share
            
            **$**
            **0.26**
            
            $
            0.18
            
            **$**
            **0.50**
            
            $
            0.34








There
      were no anti-dilutive options for the three or six months ended June 30, 2006
      and 2005.





**9. 
      REGULATORY MATTERS**




As
      of
      June 30, 2006, 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 9.65% and 10.88%, respectively, and a Leverage ratio of 8.18%.
      Regulatory guidelines permit the Company’s trust preferred securities to be
      included in the calculation of Tier 1, Total Risk-Based Capital, and Leverage
      ratios, subject to certain limitations.





As
      of
      June 30, 2006, WestStar met all capital adequacy requirements to which it was
      subject and exceeded the minimum ratios to be designated as “well-capitalized.”
As of June 30, 2006, WestStar had Tier 1 and Total Risk-Based Capital ratios
      of
      9.74% and 10.61%, respectively, and a Leverage ratio of 8.26%.





**10.** **RECENT
      ACCOUNTING PRONOUNCEMENTS**




In
      March
      2006, the Financial Accounting Standards Board (FASB) issued Statement No.
      156
      (SFAS 156), *Accounting
      for Servicing of Financial Assets - An Amendment of FASB Statement No.
      140* .
      SFAS
      156 (1) requires that a servicing asset or liability be recognized each time
      a
      contract to service a financial asset is entered into, (2) requires that all
      separately recognized servicing assets and servicing liabilities be initially
      measured at fair value, if practicable, and (3) permits the subsequent
      measurement of servicing assets and servicing liabilities based on the
      amortization method or the fair value measurement method. SFAS 156 also permits
      a one-time reclassification of available-for-sale securities to trading
      securities provided that the available-for-sale securities are identified in
      some manner as offsetting the entity’s exposure to changes in the fair value of
      servicing assets or servicing liabilities that are subsequently measured at
      fair
      value. SFAS 156 will become effective as of the beginning of the first fiscal
      year that begins after September 15, 2006. Earlier adoption is permitted at
      the
      beginning of an entity’s fiscal year provided the entity has not yet issued
      financial statements, including interim financial statements, for any period
      of
      that fiscal year.





The
      Company will apply the requirements for recognition and initial measurement
      of
      servicing assets and servicing liabilities prospectively to all transactions
      entered into on or after January 1, 2007. Management has not completed its
      evaluation of the impact of SFAS 156 but believes that the effect on the
      Company’s financial position and results of operations will not be material.




15
 **VAIL
          BANKS, INC.**
 Notes
          to Unaudited Consolidated Financial Statements


In
      July
      2006, the FASB issued FASB Interpretation No. 48 (FIN 48), *Accounting
      for Uncertainty in Income Taxes - an interpretation of FASB Statement No.
      109* .
       FIN 48 requires that realization of an uncertain income tax position be
“more likely than not” before it can be recognized in the financial statements.
      Further, FIN 48 prescribes the benefit to be recorded in the financial
      statements as the amount most likely to be realized assuming a review by tax
      authorities having all relevant information and applying current conventions.
      FIN 48 also clarifies the financial statement classification of tax-related
      penalties and interest and sets forth new disclosures regarding unrecognized
      tax
      benefits. FIN 48 is effective for fiscal years beginning after December 15,
      2006.  Management is currently evaluating the requirements of FIN 48 and
      the impact this interpretation may have on the Company’s financial
      statements.





**11.  
      LEGAL CONTINGENCIES**




From
      time
      to time, the Company is party to or otherwise involved in legal proceedings
      arising in the normal course of business, such as claims to enforce liens,
      claims involving the making and servicing of real property loans and other
      issues relating to the business of the Company. Management of the Company does
      not believe that there is any pending or threatened proceeding against the
      Company which would have a material effect on the Company’s consolidated
      financial statements.





**12.  
      SUBSEQUENT EVENTS**




On
      July
      17, 2006, the Board of Directors declared a regular quarterly dividend of $0.07
      per share payable on August 11, 2006 to shareholders of record on July 28,
      2006.




16


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





**Forward
      Looking Statements**





This
      Quarterly Report on Form 10-Q of Vail Banks, Inc. (Vail Banks or the Company)
      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 (SEC). 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 June 30, 2006 compared to December 31, 2005, and
      its
      results of operations for the three and six months ended June 30, 2006, in
      comparison to the three and six months ended June 30, 2005. 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, 2005.





**Proposed
      Merger with U.S. Bancorp**





On
        May
        31, 2006, the Company entered into an Agreement and Plan of Merger (the “Merger
        Agreement”) with U.S. Bancorp, a Delaware corporation (“USB”), and Powder
        Acquisition Corp., a Colorado corporation and a wholly-owned subsidiary of
        USB
        (“Merger Sub”). The Merger Agreement and the transaction contemplated thereby
        were approved by the Company’s board of directors and the board of directors
        agreed to recommend the transaction for approval by the Company’s
        shareholders on May 31, 2006. Pursuant to the terms of the Merger Agreement,
        at
        the effective time of the merger, Merger Sub will merge with and into the
        Company, with the Company continuing as the surviving corporation and a
        wholly-owned subsidiary of USB. All of the Company’s common shares issued and
        outstanding will be immediately and automatically converted into the right
        to
        receive $17.00 per share in cash, and all outstanding options will be
        immediately and automatically converted into the right to receive the excess,
        if
        any, of $17.00 per option in cash over the exercise price of such
        option, less any tax withholding. The total transaction value is approximately
        $98.6 million.


In
      addition, the Company has agreed, among other things and subject to certain
      exceptions as described in the Merger Agreement, (i) to conduct its
      business in the ordinary course consistent with past practice during the interim
      period between the execution of the Merger Agreement and consummation of this
      merger, (ii) not to engage in certain transactions during such period,
      (iii) to cause a shareholder meeting to be held to consider approval of
      this merger and the other transactions contemplated by the Merger Agreement,
      (iv) subject to certain limited exceptions to permit the board of directors
      to comply with their fiduciary duties, for the Company’s board of directors to
      recommend that the shareholders adopt the Merger Agreement and thereby approve
      this merger, and (v) subject to certain limited exceptions to permit the
      board of directors to comply with their fiduciary duties, not to solicit
      proposals relating to alternative business combination transactions, or to
      enter
      into discussions concerning, or to provide information in connection with,
      alternative business combination transactions.




Consummation
      of the merger, which is currently expected in the third quarter of 2006, is
      subject to a number of conditions, including shareholder approval, absence
      of
      any law or order prohibiting the consummation of this merger, expiration,
      regulatory approval, and certain other customary conditions. On June 28, 2006,
      the Company and USB made the required filings with the Board of Governors of
      the
      Federal Reserve System and the Colorado Division of Banking to gain approval
      of
      the merger. The Federal Reserve Board approved the merger application on August
      7, 2006 and the applicable waiting period will expire on August 22, 2006. The
      Company has submitted the Merger Agreement and the merger described above to
      shareholders for their consideration at a special meeting of shareholders to
      be
      held on August 31, 2006.


17


Pursuant
      to the terms of the Merger Agreement, the Company and USB each have certain
      termination rights. Upon termination of the Merger Agreement under specified
      circumstances, the Company may be required to pay USB a termination fee of
      approximately $3.95 million.





**Overview** ****





Net
      income was $1.4 million for the three months ended June 30, 2006, an increase
      of
      $471,000, or 49%, from $971,000 in the second quarter of 2005. Net income was
      $2.8 million for the six months ended June 30, 2006, an increase of $899,000,
      or
      48%, from $1.9 million for the six months ended June 30, 2005.





Diluted
      earnings per share for the three months ended June 30, 2006 were $0.26 compared
      to $0.18 for the second quarter of 2005, an increase of 44%. Diluted earnings
      per share for the six months ended June 30, 2006 were $0.50 compared to $0.34
      for the six months ended June 30, 2005, an increase of 47%.





The
      annualized return on average assets was 0.82% for the three months ended June
      30, 2006 compared to 0.60% for the three months ended June 30, 2005, a 37%
      increase. The annualized return on average assets was 0.79% for the six months
      ended June 30, 2006 compared to 0.57% for the six months ended June 30, 2005,
      a
      39% increase.




The
      annualized return on average equity was 8.85% for the three months ended June
      30, 2006 compared to 6.39% for the three months ended June 30, 2005, a 38%
      increase. The annualized return on average equity was 8.57% for the six months
      ended June 30, 2006 compared to 6.18% for the six months ended June 30, 2005,
      a
      39% increase.




**Results
      of Operations** **- Quarter to Date**





*Net
      Interest Income.* Net
      interest income, on a fully tax-equivalent basis (FTE), increased by $1.6
      million, or 23%, to $8.7 million for the three months ended June 30, 2006 from
      $7.0 million for the three months ended June 30, 2005. The net interest margin
      on an FTE basis was 5.68% for the three months ended June 30, 2006 as compared
      to 5.00% for the three months ended June 30, 2005. Net interest margin is
      influenced by the level and relative mix of earning assets and interest bearing
      liabilities as well as the cost of interest bearing liabilities as compared
      to
      the yield on earning assets. The increase in net interest margin during the
      second quarter of 2006 as compared to the second quarter of 2005 was due to
      the
      increase in the average yield on earning assets exceeding the increase in the
      average cost of interest bearing liabilities, as explained in more detail in
      the
      following two paragraphs.




Average
      loans increased $104.7 million, a 25% increase since June 30, 2005, due
      to an
      internal focus on building the loan portfolio. The growth in average deposits,
      up $29.0 million, or 6%, from June 30, 2005 enabled the Company to grow the
      loan
      portfolio without increasing higher-rate debt. The
      200
      basis point interest rate increase implemented by the Federal Reserve from
      June
      30, 2005 through June 30, 2006 also contributed to the increase in the net
      interest margin. Interest income FTE increased to $13.0 million for the three
      months ended June 30, 2006 from $9.6 million for the three months ended June
      30,
      2005. During this time, average earning assets increased $51.1 million, or
      9%,
      from $562.0 million for the three months ended June 30, 2005 to $613.1 million
      for the three months ended June 30, 2006. During the second quarter of 2006,
      loans had an average yield of 9.26%, an increase of 122 basis points from a
      yield of 8.04% for the second quarter of 2005. The average yield on federal
      funds sold also increased during the second quarter of 2006 as compared to
      the
      second quarter of 2005, rising 191 basis points to 4.82% for the second quarter
      of 2006. As a result of these increases in average yields, the total yield
      on
      average earning assets increased 164 basis points to 8.48% for the second
      quarter of 2006, as compared to 6.84% for the second quarter of 2005.




Interest
      expense increased to $4.3 million, a change of $1.7 million or 66%, for the
      three months ended June 30, 2006, as compared to $2.6 million for the
      corresponding period in 2005. This increase was comprised primarily of a $1.4
      million, or 87%, increase in interest expense on deposits, due to an increase
      in
      average balances and an increase in cost of funds due to rising interest rates.
      The Company also incurred increased expense related to its overnight sweep
      product (securities sold under agreements to repurchase). The average balance
      in
      this product increased 114%, or $18.4 million, since June 30, 2005. Accordingly,
      the interest expense associated with the overnight sweep product increased
      from
      $98,000 for the quarter ended June 30, 2005 to $370,000 for the quarter ended
      June 30, 2006. Average interest bearing deposits increased $26.7 million, or
      7%,
      in 2006 over the corresponding period in 2005. As a result, the total cost
      of
      interest-bearing liabilities increased 113 basis points to 3.35% for the second
      quarter of 2006, as compared to 2.22% for the second quarter of 2005. This
      increase in cost of interest bearing liabilities, however, was not in proportion
      to the increase in yield on average earning assets, resulting in an overall
      increase in net interest income and net interest margin for the second quarter
      of 2006.


18


*Non-Interest
      Income* .
      During
      the three months ended June 30, 2006, non-interest income increased by $91,000,
      or 6%, to $1.6 million from $1.5 million for the three months ended June 30,
      2005. This increase was primarily attributable to increases in service charges
      on deposits, increases in point of sale income and official check income.





*Non-Interest
      Expense* .
      Non-interest expense increased $850,000, or 12%, to $7.9 million for the three
      months ended June 30, 2006, from $7.1 million for the three months ended June
      30, 2005. This increase was attributable to an increase in salaries and benefits
      of $471,000, or 11%, compared to second quarter 2005 due to higher salaries
      and
      greater health insurance costs. In addition, other non-interest expenses
      increased $531,000, due to $319,000 of professional fees related to the pending
      merger with U.S. Bancorp, and a $200,000 write-down on one foreclosed property.
      These increases were partially offset by decreases in maintenance contracts
      and
      data line charges.




The
      efficiency ratio was 78% for the three months ended June 30, 2006, compared
      to
      84% for the three months ended June 30, 2005. The improvement in the efficiency
      ratio was due to the increase in revenue (net interest income plus non-interest
      income) of $1.7 million, or 21%, for the three months ended June 30, 2006,
      compared to the three months ended June 30, 2005, while at the same time
      non-interest expenses increased by a lesser degree, 12% or $850,000.




*Income
      Taxes.* The
      Company’s effective income tax rate (income tax expense as a percentage of
      pre-tax income) was 28.9% for the three months ended June 30, 2006, as compared
      to 31.6% for the three months ended June 30, 2005.





**Results
      of Operations - Year to Date**





*Net
      Interest Income.* Net
      interest income, on a FTE basis, increased by $2.8 million, or 20%, to $16.8
      million for the six months ended June 30, 2006 from $14.0 million for the six
      months ended June 30, 2005. The net interest margin on an FTE basis was 5.58%
      for the six months ended June 30, 2006 as compared to 5.05% for the six months
      ended June 30, 2005. The increase in net interest margin during the first six
      months of 2006 as compared to the same period in 2005 was due to the increase
      in
      the average yield on earning assets exceeding the increase in the average cost
      of interest bearing liabilities, as explained in more detail in the following
      two paragraphs.




Average
      loans for the six months ended June 30, 2006 increased $100.5 million, or 25%,
      over the six-month average for 2005. This
      increase was funded by an increase in deposits and securities sold under
      agreements to repurchase in addition to decreases in federal funds sold,
      investments, and loans held for sale. Average deposits increased $31.2 million,
      or 6%, when comparing the first six months of 2006 with the same period in
      2005.
      Average FHLB bank advances decreased $6.8 million, or 22%, since June 30, 2005
      to a six-month average balance of $24.3 million in 2006. The
      200
      basis point interest rate increase implemented by the Federal Reserve from
      June
      30, 2005 through June 30, 2006 has also contributed to the increase in the
      net
      interest margin. Interest income FTE increased to $24.9 million for the six
      months ended June 30, 2006 from $18.9 million for the six months ended June
      30,
      2005. During this time, average earning assets increased $48.9 million, or
      9%,
      from $558.1 million for the six months ended June 30, 2005 to $607.0 million
      for
      the six months ended June 30, 2006. For the six months ended June 30, 2006,
      loans had an average yield of 9.05%, an increase of 119 basis points from a
      yield of 7.86% for the first six months of 2005. The average yield on federal
      funds sold also increased during the first six months of 2006 as compared to
      the
      same period of 2005, rising 161 basis points to 4.54% during 2006. As a result
      of these increases in average yields, the total yield on average earning assets
      increased 143 basis points to 8.27% for the first six months of 2006, as
      compared to 6.84% for the first six months of 2005.




Interest
      expense increased to $8.1 million, a change of $3.1 million, or 64%, for the
      six
      months ended June 30, 2006, as compared to $4.9 million for the corresponding
      period in 2005. This increase was comprised primarily of a $2.8 million, or
      93%,
      increase in interest expense on deposits, due to an increase in average balances
      and an increase in cost of funds due to rising interest rates during the six
      months ended June 30, 2006, as compared to the corresponding period in 2005.
      The
      Company has also incurred increased expense related to its overnight sweep
      products (securities sold under agreements to repurchase). Due to an internal
      focus to market this product, the six-month average balance has increased 175%,
      or $18.0 million, since June 30, 2005. Accordingly, the interest expense
      associated with overnight sweep products has increased from $123,000 for the
      six
      months ended June 30, 2005 to $591,000 for the same period in 2006. Average
      interest bearing deposits increased $26.9 million, or 7%, in 2006 over the
      corresponding period in 2005. As a result, the total cost of interest-bearing
      liabilities increased 109 basis points to 3.22% for the first six months of
      2006, as compared to 2.13% for the same period in 2005. This increase in cost
      of
      interest bearing liabilities, however, was not in proportion to the increase
      in
      yield on average earning assets, resulting in an overall increase in net
      interest income and net interest margin for the first six months of
      2006.


19


*Non-Interest
      Expense* .
      Non-interest expense increased $1.3 million, or 10%, to $15.4 million for the
      six months ended June 30, 2006, from $14.0 million for the six months ended
      June
      30, 2005. This increase was attributable to the following: (1) an increase
      in
      salaries and benefits of $854,000, or 10%, due to higher salaries and greater
      health insurance costs; (2) $439,000 in professional fees related to the pending
      merger with U.S. Bancorp; and (3) a $200,000 charge taken in the second quarter
      of 2006 to write-down a foreclosed property to its fair market value. These
      increases were partially offset by decreases in occupancy and furniture and
      equipment expenses.




The
      efficiency ratio was 78% for the six months ended June 30, 2006, compared to
      84%
      for the six months ended June 30, 2005. The improvement in the efficiency ratio
      was due to the increase in revenue (net interest income plus non-interest
      income) of $3.0 million, or 18%, for the six months ended June 30, 2006,
      compared to the six months ended June 30, 2005, while at the same time
      non-interest expenses increased by a lesser degree, 10% or $1.3 million.




*Income
      Taxes.* The
      Company’s effective income tax rate (income tax expense as a percentage of
      pre-tax income) was 29.2% for the six months ended June 30, 2006, as compared
      to
      30.5% for the six months ended June 30, 2005.




**Financial
      Condition**





The
      Company's assets increased by $37.8 million, or 6%, to $724.1 million as of
      June
      30, 2006, from $686.3 million as of December 31, 2005.





Federal
      funds sold balances decreased by $5.6 million, or 53%, to $5.0 million as of
      June 30, 2006 from $10.6 million at December 31, 2005. Investment securities
      decreased to $79.2 million as of June 30, 2006, compared to $87.4 million as
      of
      December 31, 2005, a 9% decrease. The decrease in investment securities is
      due
      to maturities and principal payments received on mortgage-backed securities
      in
      the portfolio.





The
      Company originates consumer mortgage loans with the intent to sell those loans
      to third parties. As of June 30, 2006 and December 31, 2005, the Company did
      not
      have any loans held for sale. The ending balance of loans held for sale at
      any
      particular date is dependent on the timing of the closing and ultimate funding
      of the loans by third parties. Thus, an increase or decrease in the ending
      balance is primarily a function of timing and may not be indicative of trends
      in
      mortgage loan demand.




Deposits
      increased by $8.9 million, or 2%, from $552.5 million as of December 31, 2005,
      to $561.4 million as of June 30, 2006. The largest increase was in money market
      deposits, with a $34.4 million, or 17% increase. This was partially offset
      with
      decreases in both certificates of deposits, savings and non-interest bearing
      checking. Core deposits, which exclude certificates of deposits, increased
      $18.0
      million, or 4%, since December 31, 2005 to $480.5 million at June 30,
      2006.




**Asset
      Quality**





*Provision
      and Allowance for Loan Losses.* Provision expense for the three and six months ended June 30, 2006 was $240,000
      and $455,000, respectively compared to a credit of $36,000 for the three months
      ended June 30, 2005 and an expense of $29,000 for the six months ended June
      30,
      2005. The increase in the provision expense from 2005 to 2006 was primarily
      due
      to the Company’s loan growth. The allowance for loan losses of $4.9 million as
      of June 30, 2006 was up from $4.5 million as of December 31, 2005. The allowance
      for loan losses represented 0.92% of total loans as of both June 30, 2006,
      and
      December 31, 2005. Since December 31, 2005, average loans have increased $58.0
      million, or 13%.


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, internal asset review processes, the market value of collateral,
      the
      strength and availability of guarantees, concentrations of credit and other
      judgmental factors.


20


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**(dollars in thousands)
            
            Six
                months ended
              June
                30,**2006**
            
            2005Average
                total loans
            
            **$**
            **507,441**
            
            $
            406,943Total
                loans at end of period
            
            **$**
            **535,613**
            
            $
            420,715Allowance
                at beginning of period
            
            **$**
            **4,473**
            
            $
            3,895Loans
                charged off
            
            
            **(4**
            **)**
            
            (25
            )Recoveries
                on loans previously charged off
            
            
            **5**
            
            
            104Provision
                for loan losses
            
            
            **455**
            
            
            29Allowance
                at end of period
            
            **$**
            **4,929**
            
            $
            4,003Annualized
                net (charge-offs) recoveries to average loans
            
            
            **0.00**%****
            
            
            0.04%Allowance
                to total loans at end of period
            
            
            **0.92**%****
            
            
            0.95%








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





**Non-Performing
                Assets**(dollars
                in thousands)
            
            June
                30,**2006**
            
            2005Nonaccrual
                loans
            
            **$**
            **2,532**
            
            $
            —Restructured
                loans
            
            
            **—**
            
            
            —Total
                non-performing loans
            
            
            **2,532**
            
            
            —Foreclosed
                properties
            
            
            **795**
            
            
            589Total
                non-performing assets
            
            
            **3,327**
            
            
            589Loans
                90 days or more past due and accruing
            
            
            **27**
            
            
            181Total
                risk assets
            
            **$**
            **3,354**
            
            $
            770Non-performing
                loans to total loans
            
            
            **0.47**%****
            
            
            0.00%Non-performing
                assets to loan related assets
            
            
            **0.62**%****
            
            
            0.14%Non-performing
                assets to total assets
            
            
            **0.46**%****
            
            
            0.09%Risk
                assets to loan related assets
            
            
            **0.63**%****
            
            
            0.18%





The
      increase in non-accrual loans is primarily due to one relationship that is
      currently in the process of collection. Foreclosed properties are recorded
      at
      fair value less estimated costs to sell. Anticipated losses are recorded at
      the
      time of transfer from loans. Loans
      past due 90 days or more and still accruing interest decreased to $27,000 at
      June 30, 2006 compared to $83,000 at December 31, 2005 and $181,000 at June
      30,
      2005. Management is not aware of any significant adverse trends relating to its loan
      portfolio.


21




**Financial
      Instruments With Off-Balance-Sheet Risk**




The
      Company is a party to credit related financial instruments with
      off-balance-sheet risk in the normal course of business to meet the financing
      needs of its customers. These financial instruments include commitments to
      extend credit and letters of credit. Such commitments involve, to varying
      degrees, elements of credit and interest rate risk in excess of the amount
      recognized in the consolidated balance sheet. The Company’s exposure to credit
      loss is represented by the contractual amount of these commitments. The Company
      follows the same credit policies in making commitments as it does for
      on-balance-sheet instruments.





The
      following financial instruments represent off-balance-sheet risk:





(dollars
                in thousands)
            
            **June
                30,**
              **2006**
            
            December
                31,
              2005Financial
                instruments whose contractualamounts
                represent credit riskCommitments
                to extend credit
            
            **$**
            **110,884**
            
            $
            124,111Letters
                of credit
            
            
            **23,414**
            
            
            20,363Total
                commercial commitments
            
            **$**
            **134,298**
            
            $
            144,474





Commitments
      to extend credit are agreements to lend to a customer as long as there is no
      violation of any condition established in the contract. Commitments generally
      have fixed expiration dates or other termination clauses and may require payment
      of a fee. Since many of the commitments are expected to expire without being
      drawn upon, the commitments do not necessarily represent future cash
      requirements. The Company evaluates each customer’s creditworthiness on a
      case-by-case basis. The amount of collateral obtained is based on management’s
      credit evaluation. Collateral held varies, but may include accounts receivable,
      inventory, property, plant and equipment and income producing commercial
      properties.




Letters
      of credit are conditional commitments issued by the Company to guarantee the
      performance of a customer to a third party. Letters of credit are used to
      guarantee performance primarily on development and construction projects. The
      credit risk involved in issuing letters of credit is essentially the same as
      that involved in extending loan facilities to customers. Those commitments
      are
      primarily issued on behalf of local businesses.




**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 also 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
      June 30, 2006, the Company had cash and cash equivalents (including federal
      funds sold) of $26.8 million and investment securities of $79.2 million.
      Approximately $79.1 million of the Company’s investment portfolio is classified
      as available-for-sale. Of this amount, $27.1 million has been pledged to secure
      uninsured public fund deposits and $46.4 million has been pledged as securities
      sold under agreements to repurchase. Accordingly, these pledged amounts may
      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.


22


***Borrowings***




As
      a
      member of the FHLB and, as a regular part of its business, WestStar obtains
      both
      short and long-term advances from the FHLB. Advances are collateralized
      primarily by FHLB stock owned by WestStar and loans secured by certain mortgages
      or deeds of trust. As of June 30, 2006, the Company’s total borrowing capacity
      was $180.8 million of which $23.8 million of borrowings were outstanding.
      Additionally, the Company had $31.0 million in stand-by irrevocable letters
      of
      credit issued by the FHLB and pledged as collateral for uninsured public fund
      deposits at June 30, 2006.




WestStar
      has established an unsecured, overnight federal funds line with Bankers’ Bank of
      the West that expires on August 31, 2006. As of June 30, 2006, the authorized
      borrowing line totaled $40.1 million, with no amounts outstanding.




WestStar
      has also established an unsecured, overnight federal funds line with First
      Tennessee Bank, N.A. that expires on September 30, 2006. As of June 30, 2006,
      the authorized borrowing line totaled $20.0 million, with no amounts
      outstanding. This line is subject to cancellation by First Tennessee at any
      time
      upon the occurrence of certain conditions.




***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 payment of dividends by Vail Banks
      and WestStar may also be affected or limited by other factors, such as the
      requirement to maintain adequate capital to meet regulatory guidelines. In
      addition, if, in the opinion of the applicable regulatory authority, a bank
      under its jurisdiction is engaged in or is about to engage in an unsafe or
      unsound practice (which, depending upon the financial condition of the bank,
      could include the payment of dividends), such authority may require, after
      notice and hearing, that such bank cease and desist from such practice. Capital
      adequacy considerations could further limit the availability of dividends.
      Due
      to the volume of dividends paid relative to earnings in earlier years, any
      dividend payments from WestStar to Vail Banks required prior regulatory approval
      through December 31, 2005. Commencing January 1, 2006, WestStar is no longer
      required to obtain regulatory approval for dividend payments from WestStar
      to
      Vail Banks. A principal source of Vail Banks’ income is dividends from
      WestStar.





On
      July
      17, 2006, the Board declared a regular quarterly dividend of $0.07 per share
      payable on August 11, 2006 to Vail Banks’ shareholders of record on July 28,
      2006.





***Shares
      Repurchase Plan***




At
      its
      meeting on January 16, 2006, the Company’s Board of Directors reauthorized the
      Company’s common shares repurchase program that was originally approved in
      February 2001. Since inception of the program through June 30, 2006, the Company
      has repurchased 1,535,380 common shares at an average price of $12.10 per share,
      for a total of approximately $19.0 million. The total amount of repurchases
      under the program, both previously completed and allowable up to January 2007,
      equals in the aggregate approximately $29.0 million. The total amount of
      repurchases available under the program is approximately $10.0 million. During
      the first six months of 2006, the Company did not repurchase any of its common
      shares.




**Capital
      Resources** ****





As
      of
      June 30, 2006, shareholders’ equity had increased $2.0 million, or 3%, to $65.7
      million from $63.7 million as of December 31, 2005. This increase is primarily
      related to the retention of earnings of $2.8 million and an increase of $379,000
      in additional paid in capital for the vesting of restricted share awards; offset
      by an increase in accumulated other comprehensive loss of $383,000 due to the
      unrealized loss on available-for-sale securities, and the payment of dividends
      of $785,000.





As
      of
      June 30, 2006 and 2005, the Company met all capital adequacy requirements to
      which it was subject. As of June 30, 2006, the Company had Tier 1 and Total
      Risk-Based Capital ratios of 9.65% and 10.88%, respectively, and a Leverage
      ratio of 8.18%. As of June 30, 2005, the Company had Tier 1 and Total Risk-Based
      Capital ratios of 10.47% and 12.04%, respectively, and a Leverage ratio of
      7.98%.





As
      of
      June 30, 2006 and 2005, WestStar met all capital adequacy requirements to which
      it was subject and exceeded the minimum ratios to be designated as
“well-capitalized **.** ”
As
      of
      June 30, 2006, WestStar had Tier 1 and Total Risk-Based Capital ratios of 9.74%
      and 10.61%, respectively, and a Leverage ratio of 8.26%. As of June 30, 2005,
      WestStar had Tier 1 and Total Risk-Based Capital ratios of 10.68% and 11.54%,
      respectively, and a Leverage ratio of 8.09%.


23


**Item
      3.** **QUANTITATIVE
      AND 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.




The
      Company’s Asset/Liability 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. These simulations incorporate
      assumptions about balance sheet dynamics, such as loan and deposit growth and
      pricing, changes in funding mix, and asset and liability repricing and maturity
      characteristics. 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 June 30, 2006, the Company has never used interest rate
      derivative financial instruments as an asset/liability management tool to hedge
      mismatches in interest rate exposures.





Management
      continually monitors the Company’s exposure to fluctuations in market rates. One
      of the tools management utilizes to estimate the sensitivity of net interest
      revenue to changes in interest rates is an interest rate simulation model.
      Such
      estimates are based upon a number of assumptions for each scenario, including
      the level of loan growth and deposit and loan repricing characteristics. The
      simulation model measures the potential change in net interest income for future
      periods under various interest rate scenarios. Based on these simulation models,
      if interest rates increased 200 basis points over the twelve month period ended
      June 30, 2007 and then remained constant thereafter, net interest income would
      increase an estimated $1.7 million for the year ended June 30, 2007 and an
      estimated $4.6 million for the twelve months ended June 30, 2008. On the
      contrary, if interest rates decreased 200 basis points over the twelve month
      period ended June 30, 2007 and then remained constant thereafter, net interest
      income would decrease an estimated $1.7 million for the twelve months end June
      30, 2007 and $4.7 million for the year ended June 30, 2008.




The
      increase in short-term rates by the Federal Reserve during 2005, and thus far
      in
      2006, effectively repriced a significant portion of the Company’s loan
      portfolio. The Company was able to capitalize on the increased yield on loans,
      which was greater than the increased cost of interest-bearing liabilities,
      thereby increasing the net interest margin.





**Item
      4.** **CONTROLS
      AND PROCEDURES**





Company
      management, including the Chief Executive Officer and Chief Financial Officer,
      supervised and participated in an evaluation of the Company’s disclosure
      controls and procedures (as defined in rules of the SEC) as of June 30, 2006.
      Based on, and as of the date of, that evaluation, the Company’s Chief Executive
      Officer and Chief Financial 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 Chief
      Financial Officer, as appropriate to allow timely decisions regarding required
      disclosures of that information under the SEC’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 SEC’s rules and
      forms.





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


24


**PART
      II** **OTHER
      INFORMATION**





**Item
      1.**  **LEGAL
      PROCEEDINGS.**





Vail
      Banks and its banking subsidiary periodically are parties to or otherwise
      involved in legal proceedings arising in the normal course of business, such
      as
      claims to enforce liens, claims involving the making and servicing of real
      property loans and other issues incident to their business. Management does
      not
      believe that there is any pending or threatened proceeding against Vail Banks
      or
      its banking subsidiary which, if determined adversely, would have a material
      effect on the business, results of operations, or financial position of Vail
      Banks or its banking subsidiary.





**Item
      1A.**  **RISK FACTORS.**




The
      discussion of our results of operations and financial condition should be read
      together with the risk factors contained in our Annual Report on Form 10-K
      for
      the fiscal year ended December 31, 2005 (the 2005 10-K), which describe
      various risks and uncertainties to which we are or may become subject. These
      risks and uncertainties have the potential to affect our business, financial
      condition, results of operations, cash flows, strategies or prospects in a
      material and adverse manner. In addition to the risks identified in our 2005
      10-K, we are also subject to the following additional risks:




**Risks
      Related to the Proposed Merger with U.S. Bancorp**




On
      May 31, 2006, we entered into a definitive Merger Agreement pursuant to
      which we have agreed, subject to the approval of our shareholders and applicable
      regulatory agencies, to merge with a wholly-owned subsidiary of USB. Upon
      consummation of the merger, the Company will become a wholly-owned subsidiary
      of
      USB. A definitive proxy statement in connection with this special meeting of
      shareholders was filed with the SEC on August 7, 2006 and may be obtained by
      visiting the SEC’s website at www.sec.gov .
      The
      proxy statement contains important information about the Company and USB, the
      proposed merger and other related matters. The discussions below contain only
      limited information about the merger. As a result, you are encouraged to read
      the proxy statement in its entirety for additional information about the
      proposed merger.




In
      connection with the proposed merger, we are subject to certain risks including,
      but not limited to, those set forth below.




**If
      we are unable to consummate the proposed merger, our business, financial
      condition, operating results and share price could suffer.**




The
      completion of the proposed merger is subject to the satisfaction of numerous
      closing conditions, including the approval of the merger by the Company’s
      shareholders and applicable regulatory agencies. In addition, the occurrence
      of
      certain material events, changes or other circumstances could give rise to
      the
      termination of the Merger Agreement. As a result, no assurances can be given
      that the merger will be consummated. If our shareholders choose not to approve
      the proposed merger, we otherwise fail to satisfy, or obtain a waiver of the
      satisfaction of, the closing conditions to the transaction and the merger is
      not
      consummated, a material event, change or circumstance has occurred that results
      in the termination of the Merger Agreement, or any legal proceeding results
      in
      enjoining the merger, we could be subject to various adverse consequences,
      including, but not limited to, the following:




·
            we
                would remain liable for significant costs relating to the proposed
                merger,
                including, among others, legal, accounting, financial advisory and
                financial printing expenses;




·
            we
                may face various disruptions to the operation of our business as
                a result
                of the substantial time and effort invested by our management in
                connection with the merger;




·
            our
                decision to enter into the proposed merger may cause substantial
                harm to
                relationships with our employees and/or may divert employee attention
                away
                from day-to-day operations of our
                business;




·
            an
                announcement that we have abandoned the proposed merger could trigger
                a
                decline in our share price to the extent that our share price reflects
                a
                market assumption that we will complete the
                merger;




·
            the
                possibility that we could be required to pay a termination fee of
                approximately $3.95 million if the Merger Agreement is terminated
                under
                certain circumstances; and




·
            we
                may forego alternative business opportunities or fail to respond
                effectively to competitive
                pressures.


25




**Certain
      restrictive pre-closing covenants in the Merger Agreement may negatively affect
      our business, financial condition, operating results and cash flows.**




Pending
      completion of the proposed merger, we have agreed to conduct our business in
      the
      ordinary course and consistent with our past practices and with prudent banking
      practices, with specific limitations on the lending activities and other
      operations of Vail Banks. A list of certain items that we are prohibited from
      doing without USB written consent is set forth in our definitive proxy statement
      and the Merger Agreement. These restrictions could alter the manner in which
      we
      have customarily conducted our business and, therefore, significantly disrupt
      the operation of our business, and could have a material adverse effect on
      our
      business, financial condition, cash flows and operating results.




**Pending
      consummation of the proposed merger, existing or prospective customers, vendors
      and other parties may delay or defer decisions concerning their business
      transactions or relationships with us, which may harm our results of operations
      going forward if the merger is not consummated.**




Because
      the merger is subject to several closing conditions, including the approval
      of
      the merger by our shareholders, uncertainty exists regarding the completion
      of
      the merger. This uncertainty may cause existing or prospective customers,
      vendors and other parties to delay or defer decisions concerning their business
      transactions or relationships with us, which could negatively affect our
      business and results of operations.








**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.**




On
      May
      15, 2006, the Company held its annual meeting of shareholders. At that meeting,
      the security holders voted on the following items:






1.    
      Election of directors—Directors were elected with the following
      results: ****




**Name**
            **Term**
            **Votes
                Cast**
              **For
                Election**
            **Votes
                Cast**
              **Against
                Election**
            **Votes**
              **Withheld**
            **Abstentions**
            **Broker**
              **Non-Votes**Dennis
                R. Devor
            3
                years
            4,819,052
            0
            19,616
            0
            0Lisa
                M. Dillon
            3
                years
            4,819,052
            0
            19,616
            0
            0George
                N. Gillett, Jr.
            3
                years
            4,819,052
            0
            19,616
            0
            0Jack
                G. Haselbush
            3
                years
            4,810,435
            0
            28,233
            0
            0Kent
                Myers
            3
                years
            4,819,052
            0
            19,616
            0
            0





2.
            Security
                holders voted to ratify the selection of Perry-Smith LLP as Vail
                Banks’
                independent public accountants for the fiscal year 2006. The results
                of
                the vote were as follows: votes cast for the proposal were 4,825,170;
                votes cast against the proposal were 11,698; votes withheld were
                0;
                abstentions were 1,800; and broker non-votes were
                0.





**Item
      5.** **OTHER
      INFORMATION.**





None.




26


**Item
      6.   EXHIBITS.**





**Exhibit
      No.**  **Description**




2.1
            Agreement
                and Plan of Merger, dated as of May 31, 2006, by and among U.S. Bancorp,
                Powder Acquisition Corp., and Vail Banks, Inc. (incorporated by reference
                from Exhibit 2.1 on the Registrant’s Current Report on Form 8-K filed on
                June 1, 2006)





10.1
            Agreement,
                dated May 31, 2006, by and between Vail Banks, Inc. and E. B. Chester
                (incorporated by reference from Exhibit 10.1 on the Registrant’s Current
                Report on Form 8-K filed on June 1,
                2006)





31.1
            Certification
                byGary
                S. Judd, Chief Executive Officer and President of the Company,
                as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
                2002





31.2
            Certification
                by Brady T. Burt, Chief Financial Officer of the Company, as adopted
                pursuant to Section 302 of the Sarbanes-Oxley Act of
                2002


32.1
              Certification by Gary
                S. Judd, Chief Executive Officer and President of the Company,
                pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section
                906 of
                the Sarbanes-Oxley Act of
                2002





32.2
            Certification
                by Brady T. Burt, Chief Financial Officer of the Company, pursuant
                to 18
                U.S.C. Section 1350, as adopted pursuant to Section 906 of the
                Sarbanes-Oxley Act of 2002





27


**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: August
              11, 2006
            By:
            /s/
              Gary
              S.
              JuddGary
                S. Judd
              *Chief
                Executive Officer and President*
              *(Principal
                Executive Officer)*  Date: August
                11, 2006
              By:
              /s/
                Brady
                T.
                BurtBrady
                    T. Burt
                  *Chief
                    Financial Officer*
                  *(Principal
                    Financial Officer)*




28




**VAIL
        BANKS, INC.**
 **Exhibit
        Index**
   **Exhibit No.**  **Description**
  2.1
                Agreement
                    and Plan of Merger, dated as of May 31, 2006, by and among U.S.
                    Bancorp,
                    Powder Acquisition Corp., and Vail Banks, Inc. (incorporated
                    by reference
                    from Exhibit 2.1 on the Registrant’s Current Report on Form 8-K filed on
                    June 1, 2006)
 
 10.1
                Agreement,
                    dated May 31, 2006, by and between Vail Banks, Inc. and E. B.
                    Chester
                    (incorporated by reference from Exhibit 10.1 on the Registrant’s Current
                    Report on Form 8-K filed on June 1,
                    2006)
 
 31.1
                Certification
                    byGary
                    S. Judd, Chief Executive Officer and President of the Company,
                    as adopted pursuant to Section 302 of the Sarbanes-Oxley Act
                    of
                    2002
 
 31.2
                Certification
                    by Brady T. Burt, Chief Financial Officer of the Company, as
                    adopted
                    pursuant to Section 302 of the Sarbanes-Oxley Act of
                    2002
 32.1
                  Certification by Gary
                    S. Judd, Chief Executive Officer and President of the Company,
                    pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section
                    906 of
                    the Sarbanes-Oxley Act of
                    2002
 
 32.2
                Certification
                    by Brady T. Burt, Chief Financial Officer of the Company, pursuant
                    to 18
                    U.S.C. Section 1350, as adopted pursuant to Section 906 of the
                    Sarbanes-Oxley Act of 2002
 29