**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 March 31, 2005**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 an accelerated filer (as defined in Rule
12b-2 of the Exchange Act).





Yes     oNo     
x.





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





**As
of April 30, 2005, there were 5,584,864 shares of common stock ($1.00 par value
per share) outstanding.**











Table of Contents





**VAIL
BANKS, INC.**





**FORM
10-Q**


**FOR
THE QUARTER ENDED MARCH 31, 2005**





**TABLE
OF CONTENTS**








**P****ART
      I******
    **FINANCIAL INFORMATION**Item
      1.
    FINANCIAL STATEMENTS*Consolidated Balance Sheets*
    *3**Consolidated Statements of Income and Comprehensive
      Income*
    *4**Consolidated Statements of Cash
      Flows*
    *5**Notes to Unaudited Consolidated Financial
      Statements*
    *7*Item
      2.
    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
      AND RESULTS OF OPERATIONS*Forward Looking Statements*
    *13**Basis of Presentation*
    *13**Overview*
    *13**Results of Operations*
    *13**Financial Condition*
    *14**Asset Quality*
    *15**Liquidity*
    *16**Capital Resources*
    *18**Recent Accounting Pronouncements*
    *18*Item
      3.
    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
      RISK
    *19*Item4.
    CONTROLS AND PROCEDURES
    *20***PART
      II**
    **OTHER INFORMATION**Item
      1.
    LEGAL PROCEEDINGS
    *21*Item
      2.
    CHANGES IN SECURITIES, USE OF PROCEEDS AND
      ISSUER
      PURCHASES OF EQUITY SECURITIES
    *21*Item
      3.
    DEFAULTS UPON SENIOR SECURITIES
    *21*Item
      4.
    SUBMISSION OF MATTERS TO A VOTE OF SECURITY
      HOLDERS
    *21*Item
      5.
    OTHER INFORMATION
    *21*Item
      6.
    EXHIBITS
    *21*SIGNATURES
    *22*








2
 Table of Contents





**PART
I** **FINANCIALINFORMATION**
   **Item
1.** **FINANCIALSTATEMENTS**





**VAIL
      BANKS, INC.****Consolidated
      BalanceSheets****March
      31,**
    
    December
      31,(in
      thousands, except share data)
    
    
    **2005**
    
    
    2004**ASSETS**
    
    
    **(unaudited)**
    ****Cash
      and due from banks
    
    **$******
    ******20,716**
    
    
    18,360Federal
      funds sold
    
    
    **51,120**
    
    
    17,295Total
      cash and cash equivalents
    
    
    **71,836**
    
    
    35,655Investment
      securities, available for sale
    
    
    **129,620**
    
    
    103,779Investment
      securities, held to maturity
    
    
    **238**
    
    
    246Investments
      in Trust I and Trust II
    
    
    **743**
    
    
    743Loans
      held for sale
    
    
    **450**
    
    
    7,110Loans,
      net (includes related party loans of**$9,952**(unaudited) and $10,682as
      of March 31, 2005 and December 31, 2004, respectively)
    
    
    **398,774**
    
    
    402,458Investments
      in bank stocks, at cost
    
    
    **4,481**
    
    
    4,457Premises
      and equipment, net
    
    
    **38,473**
    
    
    38,721Interest
      receivable
    
    
    **2,305**
    
    
    2,172Goodwill
    
    
    **35,970**
    
    
    35,970Other
      intangible assets, net
    
    
    **149**
    
    
    159Other
      assets
    
    
    **3,749**
    
    
    3,125**$******
    ******686,788**
    
    
    634,595**LIABILITIES
      AND SHAREHOLDERS’ EQUITY**LiabilitiesDeposits
      (includes related party deposits of**$17,969**(unaudited) and $4,596 at
      March
      31, 2005 and December 31, 2004, respectively)Non-interest
      bearing
    
    **$******
    ******119,915**
    
    
    120,127Interest
      bearing
    
    
    **434,737**
    
    
    380,317Total
      deposits
    
    
    **554,652**
    
    
    500,444Securities
      sold under agreements to repurchase
    
    
    **11,522**
    
    
    894Federal
      Home Loan Bank advances
    
    
    **29,738**
    
    
    42,444Subordinated
      notes to Trust I and Trust II
    
    
    **24,743**
    
    
    24,743Interest
      payable and other liabilities
    
    
    **3,090**
    
    
    3,605Total
      liabilities
    
    
    **623,745**
    
    
    572,130Minority
      interest
    
    
    **2,542**
    
    
    2,563Commitments
      and contingencies (Notes 6 and 11)Shareholders’
      equityPreferred
      stock - $1 par value; 2,250,000 shares authorized, no sharesissued
      and outstanding at March 31, 2005 (unaudited) and December 31, 2004,
      respectively
    
    
    **—**
    
    
    ****
      **—**Common
      stock - $1 par value; 20,000,000 shares authorized,5,578,824
      (unaudited) and 5,326,504 issued and outstanding at March 31, 2005
      and
      December
      31, 2004, respectively
    
    
    **5,579**
    
    
    5,327Additional
      paid-in capital
    
    
    **35,251**
    
    
    34,944Retained
      earnings
    
    
    **20,760**
    
    
    20,249Accumulated
      other comprehensive loss, net of tax benefit of
      **$641**(unaudited) and $364 at March 31, 2005 and December 31, 2004, respectively
    
    
    **(1,089**
    ****
      **)**
    
    (618
    )Total
      shareholders’ equity
    
    
    **60,501**
    
    
    59,902**$******
    ******686,788**
    
    
    634,595The
      accompanying notes are an integral part of these unaudited consolidated
      financial statements.




3
 Table of Contents


**VAIL
BANKS, INC.**
 **Consolidated
Statements of Income and Comprehensive Income**
 (in
thousands, except share data)





Three
      months ended
      March
      31,**2005**
    
    2004**(unaudited)**
    
    (unaudited)Interest
      incomeInterest
      and fees on loans
    
    **$**
    **7,614**
    
    
    6,064Interest
      on investment securities
    
    
    **1,371**
    
    
    773Interest
      on federal funds sold and other short-term investments
    
    
    **192**
    
    
    204Investments
      in Trust I and Trust II
    
    
    **19**
    
    
    19Total
      interest income
    
    
    **9,196**
    
    
    7,060Interest
      expenseDeposits
    
    
    **1,329**
    
    
    1,019Borrowings
    
    
    **364**
    
    
    372Securities
      sold under agreements to repurchase
    
    
    **25**
    
    
    1Subordinated
      notes to Trust I and Trust II
    
    
    **631**
    
    
    631Total
      interest expense
    
    
    **2,349**
    
    
    2,023Net
      interest income
    
    
    **6,847**
    
    
    5,037Provision
      for loan losses
    
    
    **65**
    
    
    158Net
      interest income after provision for loan losses
    
    
    **6,782**
    
    
    4,879Non-interest
      incomeGain
      on sale of building
    
    
    **—**
    
    
    1,678Deposit
      related
    
    
    **620**
    
    
    685Mortgage
      broker fees
    
    
    **394**
    
    
    803Other
    
    
    **556**
    
    
    678**1,570**
    
    
    3,844Non-interest
      expenseSalaries
      and employee benefits
    
    
    **4,195**
    
    
    4,019Occupancy
    
    
    **999**
    
    
    845Furniture
      and equipment
    
    
    **683**
    
    
    562Amortization
      of intangible assets
    
    
    **10**
    
    
    10Other
    
    
    **1,214**
    
    
    1,080**7,101**
    
    
    6,516Income
      before income tax expense
    
    
    **1,251**
    
    
    2,207Income
      tax expense
    
    
    **366**
    
    
    1,027Net
      income
    
    
    **885**
    
    
    1,180Net
      change in unrealized gain/loss on investment securities available for
      sale,
      net
      of taxes
    
    
    **(471**
    ****
      **)**
    
    404Comprehensive
      income
    
    **$**
    **414**
    
    
    1,584Earnings
      per shareBasic
    
    **$**
    **0.17**
    
    
    0.24Diluted
    
    **$**
    **0.16**
    
    
    0.22Weighted
      average common sharesBasic
    
    
    **5,084,048**
    
    
    5,019,263Diluted
    
    
    **5,471,864**
    
    
    5,401,988The
      accompanying notes are an integral part of these unaudited consolidated
      financial statements.








4
 Table of Contents





**VAIL
BANKS, INC.**


**Consolidated
Statements of CashFlows**


(in
thousands)










Three
      months ended
      March
      31,**2005**
    
    2004**(unaudited)**
    
    (unaudited)Cash
      flows from operating activitiesNet
      income
    
    **$**
    **885**
    
    $
    1,180Adjustments
      to reconcile net income to net cash provided by operating
      activitiesNet
      amortization of premiums on investment securities
    
    
    **204**
    
    
    151Provision
      for loan losses
    
    
    **65**
    
    
    158Amortization
      of deferred loan fees
    
    
    **(331**
    **)**
    
    (334
    )Loss
      (gain) on sale/disposal/write-off of premises and equipment
    
    
    **7**
    
    
    (1,678
    )Depreciation
      and amortization
    
    
    **520**
    
    
    471Gain
      on sale of foreclosed properties
    
    
    **(5**
    **)**
    
    (94
    )Recognition
      of stock compensation on restricted common stock and stock
      options
    
    
    **97**
    
    
    100Minority
      interest expense (income)
    
    
    **21**
    
    
    (7
    )Changes
      in operating assets and liabilitiesLoans
      held for sale
    
    
    **6,660**
    
    
    1,955Interest
      receivable
    
    
    **(133**
    **)**
    
    (119
    )Other
      assets
    
    
    **(330**
    **)**
    
    173Interest
      payable and other liabilities
    
    
    **(515**
    **)**
    
    10Net
      cash provided by operating activities
    
    
    **7,145**
    
    
    1,966Cash
      flows from investing activitiesPurchases
      of investment securities, available for sale
    
    
    **(30,316**
    **)**
    
    (43,078
    )Purchases
      of bank stocks
    
    
    **(24**
    **)**
    
    (20
    )Proceeds
      from maturities of investment securities, held to maturity
    
    
    **—**
    
    
    20Proceeds
      from maturities/calls of investment securities, available for
      sale
    
    
    **3,531**
    
    
    9,904Net
      decrease (increase) in loans
    
    
    **3,925**
    
    
    (8,747
    )Purchases
      of premises and equipment
    
    
    **(325**
    **)**
    
    (2,370
    )Proceeds
      from sales of premises and equipment
    
    
    **56**
    
    
    8,254Proceeds
      from sales of foreclosed properties
    
    
    **13**
    
    
    455Net
      cash used by investing activities
    
    
    **(23,140**
    **)**
    
    (35,582
    )Cash
      flows from financing activitiesNet
      increase in deposits
    
    
    **54,208**
    
    
    33,725Net
      increase (decrease) in securities sold under agreements to
      repurchase
    
    
    **10,628**
    
    
    (324
    )Net
      decrease in Federal Home Loan Bank advances
    
    
    **(12,706**
    **)**
    
    (4,691
    )Proceeds
      from issuance of common stock
    
    
    **462**
    
    
    143Distribution
      to minority partners
    
    
    **(42**
    **)**
    
    **—**Payment
      of cash dividends on common stock
    
    
    **(374**
    **)**
    
    (371
    )Net
      cash provided by financing activities
    
    
    **52,176**
    
    
    28,482Net
      increase (decrease) in cash and cash equivalents
    
    
    **36,181**
    
    
    (5,134
    )Cash
      and cash equivalents at beginning of period
    
    
    **35,655**
    
    
    100,908Cash
      and cash equivalents at end of period
    
    **$**
    **71,836**
    
    $
    95,774The
      accompanying notes are an integral part of these unaudited consolidated
      financial statements.











5
 Table of Contents





**VAIL
BANKS, INC.**
 **Consolidated
Statements of Cash Flows (Continued)**
 (in
thousands)





Three
      months ended
      March
      31,**2005**
    
    2004**(unaudited)**
    
    (unaudited)Supplemental
      disclosures of cash flow informationCash
      paid during the period for:Interest
      expense
    
    **$**
    **2,510**
    
    
    2,206Income
      taxes
    
    **$**
    **—**
    
    
    —Non-cash investing and financing transactionsForeclosure
      of collateralized loans, net of reserve
    
    **$**
    ****
      **25**
    
    
    673Net
      change in unrealized (loss) gain on investment securities
      available
      for sale, net of taxes
    
    **$**
    ****
      **(471**
    ****
      **)**
    
    404Issuance
      of restricted common stock
    
    **$**
    **2,727**
    
    
    —





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











6
 Table of Contents





**VAIL
BANKS, INC.**
 Notesto Unaudited Consolidated Financial Statements


**1.** **ORGANIZATION
AND BASIS OF PRESENTATION**





The
accompanying unaudited consolidated financial statements include the accounts of
Vail Banks, Inc. (Vail Banks) and its wholly owned subsidiary, WestStar Bank
(WestStar). Vail Banks and WestStar own a combined 54.04% interest in Avon 56
Limited and 74.42% of Glenwood/Rose L.P. Both Avon 56 Limited and Glenwood/Rose
L.P. are real estate partnerships. All entities are collectively referred to as
“the Company.” All significant intercompany accounts and transactions have been
eliminated in consolidation. The Company’s two trusts are reported separately in
accordance with Financial Interpretation No. 46 (Revised), *Consolidation
of Variable Interest Entities* .





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, 2004. 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, 2004. In the
opinion of the Company, all adjustments necessary, consisting of only normal
recurring items, have been included for a fair presentation of the accompanying
consolidated financial statements. Operating results for the three months ended
March 31, 2005, are not necessarily indicative of the results that may be
expected for the full year.





Certain
reclassifications have been made to the 2004 financial statements to conform to
the 2005 presentation.





**2. 
INVESTMENT SECURITIES**





Investment
securities consist of the following:





**March
      31, 2005**
    
    December
      31, 2004**Amortized**
    
    **Fair**
    
    Amortized
    
    Fair(in
      thousands)
    
    **Cost**
    
    **Value**
    
    Cost
    
    Value**(unaudited)**
    
    **(unaudited)**Securities
      available for saleU.S.
      Treasuries
    
    **$**
    **14,940**
    
    **$**
    **14,939**
    
    $
    —
    
    $
    —Government
      agencies (1)
    
    
    **38,670**
    
    
    **38,211**
    
    
    24,308
    
    
    23,962State
      and municipal
    
    
    **19,630**
    
    
    **19,785**
    
    
    19,663
    
    
    19,938Mortgage-backed
      securities
    
    
    **53,101**
    
    
    **51,940**
    
    
    56,294
    
    
    55,747Agency
      preferred stock
    
    
    **5,000**
    
    
    **4,745**
    
    
    4,496
    
    
    4,132Total
      securities available for sale
    
    **$**
    **131,341**
    
    **$**
    **129,620**
    
    $
    104,761
    
    $
    103,779Securities
      held to maturityMortgage-backed
      securities
    
    **$**
    **238**
    ****
    **$**
    **252**
    
    $
    246
    
    $
    262Total
      securities held to maturity
    
    **$**
    **238**
    ****
    **$**
    **252**
    
    $
    246
    
    $
    262(1)
      Includes mortgage-backed government
agencies.





The
unrealized loss on investment securities increased $471,000 during the first
quarter of 2005 from a loss of $618,000 at December 31, 2004 to a loss of $1.1
million at March 31, 2005. The increase in the unrealized loss on available for
sale securities relates primarily to the 50 basis point increase in interest
rates implemented by the Federal Reserve during the first quarter of
2005.





The
following table presents the components of investment income for the three
months ended March 31, 2005 and 2004.





(in
      thousands)
    
    **March
      31,**
      **2005**
    
    March
      31,
      2004**(unaudited)**
    
    (unaudited)Taxable
      interest income
    
    **$**
    **973**
    
    
    446Nontaxable
      interest income
    
    
    **343**
    
    
    271Dividends
    
    
    **55**
    
    
    56**$**
    **1,371**
    
    
    773





7
 Table of Contents





**VAIL
BANKS, INC.**


Notes to
Unaudited Consolidated Financial Statements










**3. 
LOANS**





Loans
consist of the following:




(in
      thousands)
    
    **March
      31,**
      **2005**
    
    December
      31,
      2004**(unaudited)**Commercial,
      industrial and land
    
    **$**
    **227,367**
    
    $
    239,946Real
      estate - construction
    
    
    **100,594**
    
    
    92,705Real
      estate - mortgage
    
    
    **70,920**
    
    
    69,164Consumer
      and other
    
    
    **5,002**
    
    
    5,814**403,883**
    
    
    407,629Less:   
      Allowance for loan losses
    
    
    **(3,989**
    **)**
    
    (3,895
    )Net deferred loan fees
    
    
    **(1,120**
    **)**
    
    (1,276
    )Loans,
      Net
    
    **$**
    **398,774**
    
    $
    402,458


As of
March 31, 2005 and December 31, 2004, $77,000 and $74,000, respectively, of
deposit account overdrafts have been reclassified to loans.





Loans
having carrying values of $16,000 and $673,000 were transferred to foreclosed
properties during the first quarter of 2005 and 2004, respectively.





The
principal balance of loans on which the accrual of interest has been
discontinued was $1.4 million and $1.6 million at March 31, 2005 and 2004,
respectively. As of March 31, 2005 and 2004, $1.0 million and $15,000,
respectively, of loans were past due 90 days and still accruing interest. This
$1.0 million increase was primarily due to a single credit for which the Company
is well secured and in the process of foreclosure.





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:





**March
      31,**
    
    December
      31,(in
      thousands)
    
    **2005**
    
    2004Impaired
      loans without a valuation allowance
    
    **$**
    **2,501**
    
    $
    5,539Impaired
      loans with a valuation allowance
    
    
    **3,018**
    
    
    2,006Total
      impaired loans
    
    **$**
    **5,519**
    
    $
    7,545Valuation
      allowance related to impaired loans
    
    **$**
    **589**
    
    $
    473





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





(in
      thousands)
    
    **2005**Balance
      at January 1, 2005
    
    **$**
    **10,682**New
      loans, including renewals
    
    
    **469**Payments
    
    
    **(1,199**
    **)**Balance
      at March 31, 2005 (unaudited)
    
    **$**
    **9,952**








8
 Table of Contents





**VAIL
BANKS, INC.**


Notes to
Unaudited Consolidated Financial Statements










**4.  
ALLOWANCE FOR LOAN LOSSES**





Transactions
in the allowance are summarized as follows:





(in
      thousands)
    
    **2005**
    
    2004Allowance
      at January 1,
    
    **$**
    **3,895**
    
    
    3,503Loans
      charged off
    
    
    **(24**
    **)**
    
    (338
    )Recoveries
      on loans previously charged off
    
    
    **53**
    
    
    38Provision
      for loan losses
    
    
    **65**
    
    
    158Allowance
      at March 31, (unaudited)
    
    **$**
    **3,989**
    
    
    3,361








**5.  
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 March 31,
2005 and December 31, 2004, the carrying amount of securities sold to secure
repurchase agreements was $11.5 million and $894,000 respectively. Securities
sold under agreements to repurchase are reflected at the amount of cash received
in connection with the transaction. The Company may be required to provide
additional collateral based on the fair value of the underlying securities.





**6.  
BORROWINGS**





WestStar
is a member of the Federal Home Loan Bank of Topeka (FHLB) and, as a regular
part of its business, obtains both short and long-term advances from the FHLB.
Advances are collateralized primarily by FHLB stock owned by WestStar and loans
secured by certain mortgages or deeds of trust. As of March 31, 2005, the
Company’s total borrowing capacity was $140.2 million of which $29.7 million of
borrowings were outstanding ($7.8 million was short-term and $21.9 million was
long-term).





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





WestStar
has also established overnight federal funds lines with First Tennessee Bank,
N.A. (First Tennessee) totaling $20.0 million. If drawn upon, $10.0 million will
be a secured line and $10.0 million will be an unsecured line. These lines are
subject to cancellation by First Tennessee at any time upon the occurrence of
certain conditions. As of March 31, 2005, no amounts were outstanding under the
lines.





**7.  
SHAREHOLDERS’ EQUITY**


******


***Stock
Repurchase Plan***





At its
meeting on January 17, 2005, the Company’s Board of Directors reauthorized the
Company’s stock repurchase program that was originally approved in February
2001. Since inception of the program through March 31, 2005, the Company has
repurchased 1,535,380 shares at an average price of $12.10 per share, or
approximately $19 million. The total amount of repurchases under the program,
both previously completed and allowable up to January 2006, aggregate
approximately $29 million. During the first three months of 2005, the Company
did not repurchase any common shares.





***Restricted
Stock***





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





9
 Table of Contents





**VAIL
BANKS, INC.**


Notes to
Unaudited Consolidated Financial Statements










In March
2005, the Company granted 75,000 shares of restricted stock to two officers of
the Company. These shares were granted under the Vail Banks, Inc. Stock
Incentive Plan, (the Plan), and vest upon achievement of certain performance
criteria. As such, they are accounted for as variable plan awards. The Company
computed unearned compensation expense of $998,000, based on the market price of
the stock on the date of grant, and has begun recognizing compensation expense
ratably over the vesting period of 10 years. This compensation expense will be
adjusted at each balance sheet date to reflect the then-current market price of
the stock and to reflect any changes in the number of shares vested.





In March
2005, the Board completed a grant of 130,000 shares of restricted stock to two
individuals as an inducement to become officers of the Company. These shares are
unregistered and granted outside of the Plan. These shares vest upon achievement
of certain performance criteria. As such, they are accounted for as variable
plan awards. The Company computed unearned compensation expense of $1,729,000,
based on the market price of the stock on the date of grant, and has begun
recognizing compensation expense ratably over the vesting period of 10 years.
This compensation expense will be adjusted at each balance sheet date to reflect
the then-current market price of the stock and to reflect any changes in the
number of shares vested.





***Earnings
Per Share***





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





The
following table presents the net income and weighted average common shares
outstanding used to calculate earnings per share for the three months ended
March 31, 2005 and 2004:








March
      31,(in
      thousands, except share data)
    
    **2005**
    
    2004**(unaudited)**
    
    (unaudited)Basic
      earnings per share computationNet
      income available to common shareholders
    
    **$**
    **885**
    
    
    1,180Weighted
      average shares outstanding - basic
    
    
    **5,084,048**
    
    
    5,019,263Basic
      earnings per share
    
    **$**
    **0.17**
    
    
    0.24







March
      31,(in
      thousands, except share data)
    
    **2005**
    
    2004**(unaudited)**
    
    (unaudited)Diluted
      earnings per share computationNet
      income available to common shareholders
    
    **$**
    **885**
    
    
    1,180Weighted
      average shares outstanding - basic
    
    
    **5,084,048**
    
    
    5,019,263Shares
      assumed issued:Stock
      options
    
    
    **124,110**
    
    
    127,975Restricted
      stock
    
    
    **263,706**
    
    
    254,750Weighted
      average shares outstanding - diluted
    
    
    **5,471,864**
    
    
    5,401,988Diluted
      earnings per share
    
    **$**
    **0.16**
    
    
    0.22





There
were 31,000 anti-dilutive options for the three months ended March 31, 2005 and
no anti-dilutive options for the three months ended March 31, 2004.





10
 Table of Contents





**VAIL
BANKS, INC.**


Notes to
Unaudited Consolidated Financial Statements










***Stock
Options***





The
Company accounts for its stock options in accordance with the provisions of APB
Opinion No. 25 while disclosing pro forma net income and pro forma earnings per
share for employee stock option grants made in 1995 and future years as if the
fair-value-based method defined in SFAS No. 123, *Accounting for Stock Based
Compensation*,  had been applied. The Company has elected to apply the
accounting provisions of APB Opinion No. 25 to employee stock option grants and
provide the pro forma disclosure provisions of SFAS 123.





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





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





There
were 31,000 stock options granted during the first quarter of 2005 and no stock
options granted during the first quarter of 2004.





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








Three
      months ended
      March
      31,(in
      thousands, except share data)
    
    **2005**
    
    2004**(unaudited)**
    
    (unaudited)Net
      incomeAs
      reported
    
    **$**
    **885**
    
    
    1,180Deduct:
      Total stock-based employee
      compensation
      determined under
      the
      fair value method, net of tax
    
    
    **(19**
    **)**
    
    (38
    )Pro
      forma
    
    
    **866**
    
    
    1,142Earnings
      per share - basicAs
      reported
    
    **$**
    **0.17**
    
    
    0.24Pro
      forma
    
    
    **0.17**
    
    
    0.23Earnings
      per share - dilutedAs
      reported
    
    
    **0.16**
    
    
    0.22Pro
      forma
    
    
    **0.15**
    
    
    0.20








11
 Table of Contents





**VAIL
BANKS, INC.**


Notes to
Unaudited Consolidated Financial Statements










**8.** **REGULATORY
MATTERS**





As of
March 31, 2005, the Company met all capital adequacy requirements to which it
was subject. As of that date, the Company had Tier 1 and Total Risk-Based
Capital ratios of 10.14% and 11.62%, respectively, and a Leverage ratio of
8.01%. Regulatory guidelines permit the Company’s trust preferred securities to
be included in the calculation of Tier 1, Total Risk-Based capital, and the
Leverage Ratio, subject to certain limitations.





As of
March 31, 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 March 31, 2005, WestStar had Tier 1 and Total Risk-Based Capital ratios of
10.36% and 11.21%, respectively, and a Leverage ratio of 7.91%.





**9.  
SEGMENT INFORMATION**





The
Company believes that the activities and assets of the mortgage brokerage
business segment are no longer of continuing significance and, therefore, do not
warrant separate disclosure in the current period. Information about reportable
segments and reconciliation of such information to the consolidated financial
statements for the three months ended March 31, 2004 is as follows:





Three
      Months Ended March 31, 2004 (unaudited)Mortgage(in
      thousands)
    
    
    Banking
    
    
    Brokerage
    
    
    Other
    
    
    TotalCondensed
      income statementTotal
      income
    
    $
    10,096
    
    
    803
    
    
    5
    
    
    10,904Total
      expense
    
    
    6,926
    
    
    672
    
    
    1,099
    
    
    8,697Income
      before income taxes
    
    
    3,170
    
    
    131
    
    
    (1,094
    )
    
    2,207Income
      taxes
    
    
    1,376
    
    
    49
    
    
    (398
    )
    
    1,027Net
      income
    
    $
    1,794
    
    
    82
    
    
    (696
    )
    
    1,180





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





On April
14, 2005, the Securities and Exchange Commission (SEC) adopted a new rule that
amends the compliance dates for SFAS No. 123(R), *Share-Based
Payment* . The
SEC’s new rule allows companies to implement SFAS No. 123(R) at the beginning of
the next fiscal year, instead of the next reporting period that begins after
June 15, 2005. The Company estimates that adoption of this standard will have an
insignificant effect on the Company’s consolidated financial condition or
results of operations.





**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 April
4, 2005, the Company repaid $6.1 million of FHLB advances prior to their
maturity dates resulting in a $63,000 prepayment penalty.





On April
18, 2005, the Board of Directors (Board) declared a regular quarterly dividend
of $0.07 per share payable on May 13, 2005 to shareholders of record on April
29, 2005.





12
 Table of Contents








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





**ForwardLooking Statements**





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





**Basisof Presentation** ****





The
following discussion and analysis provides information regarding the Company’s
financial condition as of March 31, 2005, and its results of operations for the
three months ended March 31, 2005, in comparison to the three months ended March
31, 2004. 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, 2004.





**Overview******





Net
income was $885,000 for the three months ended March 31, 2005, down from $1.2
million for the three months ended March 31, 2004, a decrease of 25%. First
quarter 2004 revenue included a $1.7 million pre-tax gain on the sale of the
Company’s Vail bank building. Without this gain, net income would have been
$419,000 for the first quarter 2004.





Diluted
earnings per share for the three months ended March 31, 2005, was $0.16 compared
to $0.22 for the three months ended March 31, 2004, a decrease of 27%. Excluding
the gain on the building sale, diluted earnings per share would have been $0.07
for the first quarter 2004.





The
annualized return on average assets was 0.55% for the three months ended March
31, 2005 compared to 0.80% for the three months ended March 31, 2004. Excluding
the gain on the building sale, the annualized return on average assets would
have been 0.28% for the first quarter 2004.





The
annualized return on average equity was 5.95% for the three months ended March
31, 2005 compared to 8.13% for the three months ended March 31, 2004. Excluding
the gain on the building sale, the annualized return on average equity would
have been 2.88% for the first quarter 2004.




****


**Resultsof Operations** ****





*Net
Interest Income.* Net
interest income, on a fully tax-equivalent basis (FTE), increased by $1.8
million, or 35%, to $7.0 million for the three months ended March 31, 2005 from
$5.2 million for the three months ended March 31, 2004. The net interest margin
on an FTE basis was 5.11% for the three months ended March 31, 2005 as compared
to 4.17% for the three months ended March 31, 2004. Net interest margin is
influenced by the level and relative mix of earning assets, interest bearing
liabilities, non-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 first three months of 2005 as compared to the
same period in 2004 was due primarily to the $87.7 million
increase, or 28%, in average loan volumes since March 31, 2004 as a result of the
strong economy and an internal focus on growing the loan portfolio. The
growth in loans also enabled the Company to reduce the amount of Federal Funds
sold and, instead, invest that money in higher-yielding assets, such as loans
and investment securities. The 175 basis point interest rate increases
implemented by the Federal Reserve from June 2004 through March
2005 have also contributed to the increase in the net interest margin.





13
 Table of Contents








Interest
income FTE increased to $9.3 million for the three months ended March 31, 2005
from $7.2 million for the three months ended March 31, 2004. Average earning
assets increased 11%, from $498.6 million for the three months ended March 31,
2004 to $554.2 million for the three months ended March 31, 2005. During the
first quarter of 2005, average loans increased to 73% of earning assets as
compared to 63% during the first three months of 2004 while
average federal funds sold and investment securities decreased to 27% of earning
assets as compared to 36% during the first three months of 2004.  During
the first quarter of 2005, loans had a yield of 7.67% as compared to the 5.13%
yield on investment securities and 2.77% yield on federal funds sold. As a
result of this shift, the total yield on average earning assets increased 103
basis points to 6.83% for the first quarter of 2005, as compared to 5.80% for
the first quarter of 2004.





Interest
expense increased to $2.3 million, or 16%, for the three months ended March 31,
2005, as compared to $2.0 million for the corresponding period in 2004. This
increase was comprised primarily of a $310,000, or 30%, increase in interest
expense on deposits, due to an increase in the average balance and, to a lesser
degree, the average cost of interest bearing deposits during the three months
ended March 31, 2005, as compared to the corresponding period in 2004. Average
interest bearing deposits increased $33.1 million, or 9%, in 2005 over the
corresponding period in 2004. As a result, the total cost of interest-bearing
liabilities increased 15 basis points to 2.05% for the first quarter of 2005, as
compared to 1.90% for the first quarter of 2004. This increase in cost of
interest bearing liabilities, however, was not in proportion to the increase in
yield on average interest earning assets, resulting in an overall increase in
net interest income and net interest margin for the first three months of
2005.





*Non-Interest
Income* . During
the three months ended March 31, 2005, non-interest income decreased by $2.3
million, or 59%, to $1.6 million from $3.8 million for the three months ended
March 31, 2004. This decrease was primarily attributable to the $1.7 million
pre-tax gain on the sale of the Vail bank building during March 2004. Also
contributing to the decrease was the $409,000 decline in mortgage broker fees,
due to the loss of personnel in the mortgage division during the first quarter
of 2005.





*Non-Interest
Expense* .
Non-interest expense increased $585,000, or 9%, to $7.1 million for the three
months ended March 31, 2005, from $6.5 million for the three months ended March
31, 2004. This increase was attributable to the following: (1) an increase in
salaries and benefits of $176,000, or 4%, compared to first quarter 2004 due to
a $60,000 increase in health insurance costs, a $68,000 increase in the accrual
for year-end bonuses and a $34,000 increase in recruiting fees; (2) an increase
in occupancy expenses of $154,000, or 18%, primarily due to the opening of a new
branch and the remodeling of existing branches; (3) an increase in furniture and
equipment expense of $121,000, or 22%, due to the completion of the Glenwood
Springs building and completion of significant remodeling of the Company’s Avon
and Norwood retail offices; (4) an increase of $66,000, or 44%, in marketing and
promotion costs for the new brand launch, ***WestStar Bank .*** ***Expect
Action*** ; and (5)
an increase of $53,000, or 29%, for professional fees.





The
efficiency ratio increased to 84% for the quarter ended March 31, 2005 compared
to 73% for the quarter ended March 31, 2004. This increase in the efficiency
ratio was due to the decrease in revenue (net interest income plus non-interest
income) of $464,000 from first quarter 2004 to first quarter 2005, while at the
same time non-interest expenses increased by $585,000. Excluding the gain on the
building sale, the efficiency ratio would have been 90% for the first quarter
2004.





*Income
Taxes.* The
Company’s effective income tax rate (income tax expense as a percentage of
pre-tax income) was 29.3% for the three months ended March 31, 2005 as compared
to 46.5% for the three months ended March 31, 2004. This decrease in the
effective income tax rate was partially due to a decrease in pre-tax income
during 2005. Additionally, the effective tax rate for the first quarter of 2004
was higher due to additional income tax expense as a result of the Vail building
sale.





**FinancialCondition**





The
Company's assets increased by $52.2 million or 8%, to $686.8 million as of March
31, 2005, from $634.6 million as of December 31, 2004.





14
 Table of Contents





Federal
funds sold balances increased by $33.8 million, or 196%, to $51.1 million as of
March 31, 2005 from $17.3 million at December 31, 2004. Investment securities
increased to $129.9 million as of March 31, 2005, compared to $104.0 million as
of December 31, 2004, a 25% increase. The increases during this period are the
result of deposits growing more quickly than loan demand, resulting in
additional funds to invest.





The
Company’s mortgage division originates consumer mortgage loans with the intent
to sell those loans to a third party. As of March 31, 2005, loans held for sale
decreased $6.7 million, or 94%, from December 31, 2004. The ending balance of
loans held for sale at any particular date is dependent on the timing of the
closing and ultimate funding of these loans by the outside investor. Thus, an
increase or decrease in the ending balance is primarily a function of this
timing and may not be indicative of trends in mortgage loan demand.





Deposits
increased by $54.2 million, or 11%, from $500.4 million as of December 31, 2004,
to $554.7 million as of March 31, 2005. The largest increase was in the money
market category, with a $49.8 million, or 38% increase, due in part to the
seasonal increase in deposits during the winter ski season. Additionally, the
Company continued to focus on enhancing existing deposit relationships and
attracting new deposit relationships. Core deposits, which exclude certificates
of deposits, increased $52.6 million, or 14%, since December 31, 2004 to $428.7
million at March 31, 2005.




****


**AssetQuality**





*Provision
and Allowance for Loan Losses.* Provision expense for the three months ended March 31, 2005, was $65,000
compared to $158,000 for the three months ended March 31, 2004. The allowance
for loan losses of $4.0 million as of March 31, 2005, was up slightly from $3.9
million as of December 31, 2004, and represents 0.99% of total loans as of March
31, 2005, as compared to 0.96% of total loans at December 31, 2004. Since
December 31, 2004, average loans have increased $7.6 million, or 2%. The $1.0
million increase from March 2004 in loans past due 90 days or more and still
accruing is primarily due to a single credit for which the Company is well
secured and in the process of foreclosure. The
$94,000 increase in the allowance for loan losses from December 31, 2004
reflects the Company’s revised estimate of probable losses in the loan
portfolio.





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





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





**Allowance
      for Loan Losses Analysis**(in thousands)
    
    Three
      months ended
      March
      31,**2005**
    
    2004**(unaudited)**
    
    (unaudited)Average
      total loans
    
    **$**
    **402,340**
    
    
    314,667Total
      loans at end of period
    
    **$**
    **402,763**
    
    
    319,882Allowance
      at beginning of period
    
    **$**
    **3,895**
    
    
    3,503Loans
      charged off
    
    
    **(24**
    **)**
    
    (338
    )Recoveries
      on loans previously charged off
    
    
    **53**
    
    
    38Provision
      for loan losses
    
    
    **65**
    
    
    158Allowance
      at end of period
    
    **$**
    **3,989**
    
    
    3,361Annualized
      net recoveries (charge-offs) to average loans
    
    
    **0.03**
    **%**
    
    (0.38
    )%Allowance
      to total loans at end of period
    
    
    **0.99**
    **%**
    
    1.05
    %








15
 Table of Contents





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





**Non-Performing
      Assets**(in
      thousands)****
    
    March
      31,**2005**
    
    2004**(unaudited)**
    
    (unaudited)Nonaccrual
      loans
    
    **$**
    **1,391**
    
    
    1,636Restructured
      loans
    
    
    —
    
    
    —Total
      non-performing loans
    
    
    **1,391**
    
    
    1,636Foreclosed
      properties
    
    
    **802**
    
    
    674Total
      non-performing assets
    
    
    **2,193**
    
    
    2,310Loans
      90 days or more past due and accruing
    
    
    **1,053**
    
    
    15Total
      risk assets
    
    **$**
    **3,246**
    
    
    2,325Non-performing
      loans to total loans
    
    
    **0.35**
    **%**
    
    0.51
    %Non-performing
      assets to loan related assets
    
    
    **0.54**
    **%**
    
    0.72
    %Non-performing
      assets to total assets
    
    
    **0.32**
    **%**
    
    0.38
    %Risk
      assets to loan related assets
    
    
    **0.80**
    **%**
    
    0.73
    %





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





**Liquidity******





Liquidity
is a measure of the Company’s ability to meet its commitments and obligations
with available funds. These
commitments may include paying dividends to shareholders, funding new loans for
borrowers, funding withdrawals by depositors, paying general and administrative
expenses, and funding capital expenditures. Historically,
the Company's primary source of funds has been customer deposits. Scheduled loan
repayments are 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
March 31, 2005, the Company had cash and cash equivalents (including federal
funds sold) of $71.8 million and investment securities of $129.9 million.
Approximately $129.6 million of the Company’s investment portfolio is classified
as available-for-sale and can be readily sold, however $71.6 million of this
amount has been pledged to secure public fund deposits and $11.5 million of this
amount has been 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.





16
 Table of Contents





***Cash
Flows***





*Net
Cash from Operating Activities*





During
the three-month period ended March 31, 2005, cash of $7.1 million was provided
by operating activities consisting primarily of net income of $885,000 plus
non-cash items of $561,000 plus net decreases in operating assets and
liabilities of $5.7 million. Non-cash items consisted primarily of amortization
and depreciation on premises and equipment of $510,000, net amortization of
premiums on investment securities of $204,000, and a $65,000 loan loss
provision, partially offset by the amortization of deferred loan fees of
$331,000. The net decrease in operating assets and liabilities was primarily due
to a $6.7 million decrease in loans held for sale, partially offset by a
$515,000 decrease in interest payable and other liabilities and a $330,000
increase in other assets.





During
the three-month period ended March 31, 2004, cash of $2.0 million was provided
by operating activities consisting primarily of net income of $1.2 million less
non-cash income of $1.2 million plus net decreases in operating assets and
liabilities of $2.0 million. Non-cash income consisted primarily of a $1.7
million pre-tax gain on the sale of the Vail bank building and $334,000 of
deferred loan fee amortization, offset by $471,000 of depreciation and
amortization expense on premises, equipment and intangible assets, a $158,000
loan loss provision and $151,000 of net amortization of premiums on investment
securities. The net decrease in operating assets and liabilities was primarily
due to a $2.0 million decrease in loans held for sale and a $173,000 decrease in
other assets, offset by a $10,000 decrease in interest payable and other
liabilities and a $119,000 decrease in interest receivable.





*Net
Cash from Investing Activities*





During
the three-month period ended March 31, 2005, cash of $23.1 million was used for
investing activities. These outflows consisted primarily of the purchase of
$30.3 million of investment securities and $325,000 for purchases of premises
and equipment, partially offset by a net decrease in loans of $3.9 million, and
proceeds from the maturity or call of investment securities of $3.5
million.





During
the three-month period ended March 31, 2004, cash of $35.6 million was used for
investing activities. These outflows consisted primarily of the purchase of
$43.1 million of investment securities, an $8.7 million increase in loans and
$2.4 million in purchases of premises and equipment, offset by the maturity
and/or calls of $9.9 million of investments and $8.3 million of proceeds from
the sale of the Vail bank building.





*Net
Cash from Financing Activities*





During
the three-month period ended March 31, 2005, cash of $52.2 million was provided
by financing activities consisting primarily of an increase of $54.2 million in
deposits and an increase of $10.6 million in securities sold under agreements to
repurchase, partially offset by the repayment of FHLB advances of $12.7 million.





During
the three-month period ended March 31, 2004, cash of $28.5 million was provided
by financing activities consisting primarily of an increase in deposits of $33.7
million, offset by the repayment of FHLB advances of $4.7 million.





***Borrowings***





WestStar
is a member of the Federal Home Loan Bank of Topeka (FHLB) and, as a regular
part of its business, obtains both short and long-term advances from the
FHLB. Advances are collateralized primarily by FHLB stock owned by WestStar and
loans secured by certain mortgages or deeds of trust. As of March 31, 2005, the
Company’s total borrowing capacity was $140.2 million of which $29.7 million of
borrowings were outstanding ($7.8 million was short-term and $21.9 million was
long-term).





On April
4, 2005, the Company repaid $6.1 million of higher rate FHLB advances prior to
their maturity dates. Although the Company incurred a $63,000 prepayment
penalty, the Company anticipates future cost savings, as current
borrowings are at lower interest rates.





17
 Table of Contents





***Dividends***





Payment
of dividends is at the discretion of the Board and is determined by taking into
account the earnings, capital levels, cash requirements, and the financial
condition of Vail Banks and WestStar, as well as applicable government
regulations and other relevant factors. The principal source of Vail Banks’
income is dividends from WestStar. There are statutory and regulatory
requirements applicable to the payment of dividends by WestStar to Vail Banks,
as well as by Vail Banks to its shareholders. Due to the volume of dividends
paid relative to earnings in earlier years, dividend payments from WestStar to
Vail Banks require prior regulatory approval. Management believes that approval
will be granted as long as WestStar maintains its well-capitalized regulatory
status.





On
January 17, 2005, the Board declared a regular quarterly dividend of $0.07 per
share to shareholders of record on January 28, 2005. The dividend of $374,000
was paid on February 11, 2005.





On April
18, 2005, the Board declared a regular quarterly dividend of $0.07 per share
payable on May 13, 2005 to Vail Banks’ shareholders of record on April 29, 2005.





***Stock
Repurchase Plan***





At its
meeting on January 17, 2005, the Company’s Board of Directors reauthorized the
Company’s stock repurchase program that was originally approved in February
2001. Since inception of the program through March 31, 2005, the Company has
repurchased 1,535,380 shares at an average price of $12.10 per share, or
approximately $19.0 million. The total amount of repurchases under the program,
both previously completed and allowable up to January 2006, aggregate
approximately $29.0 million. During the first three months of 2005, the Company
did not repurchase any common shares.





**CapitalResources** ****





As of
March 31, 2005, shareholders’ equity had increased $599,000, or 1%, to $60.5
million from $59.9 million as of December 31, 2004. This increase is primarily
related to the retention of earnings of $885,000 and an increase of $559,000 for
the issuance of common stock; offset by an increase in accumulated other
comprehensive loss of $471,000 due to the unrealized loss on available-for-sale
securities, and the payment of common stock dividends of $374,000.





As of
March 31, 2005 and 2004, the Company met all capital adequacy requirements to
which it was subject. As of March 31, 2005, the Company had Tier 1 and Total
Risk-Based Capital ratios of 10.14% and 11.62%, respectively, and a Leverage
ratio of 8.01%. Regulatory guidelines permit the Company’s trust preferred
securities to be included in the calculation of Tier 1, Total Risk-Based capital
and the Leverage Ratio, subject to certain limitations. As of March 31, 2004,
the Company had Tier 1 and Total Risk-Based Capital ratios of 11.91% and 13.96%,
respectively, and a Leverage ratio of 7.80%.





As of
March 31, 2005 and 2004, WestStar met all capital adequacy requirements to which
it was subject and exceeded the minimum ratios to be designated as
“well-capitalized **.** ” As of
March 31, 2005, WestStar had Tier 1 and Total Risk-Based Capital ratios of
10.36% and 11.21%, respectively, and a Leverage ratio of 7.91%. As of March 31,
2004, WestStar had Tier 1 and Total Risk-Based Capital ratios of 11.46% and
12.39%, respectively, and a Leverage ratio of 7.49%.





**RecentAccounting Pronouncements**





On April
14, 2005, the SEC adopted a new rule that amends the compliance dates for
SFAS 123(R) . The
SEC’s new rule allows companies to implement SFAS 123(R) at the beginning
of the next fiscal year, instead of the next reporting period that begins after
June 15, 2005. The Company estimates that adoption of this standard will have an
insignificant effect on the Company’s consolidated financial condition or
results of operations.














18
 Table of Contents





**Item
3.**  **QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK** ****





**Quantitative
Disclosures About Market Risk**





The table
below provides information about the Company’s financial instruments as of
December 31, 2004 that are sensitive to changes in interest rates.







**Principal
      Amount Maturing (b) in:**(in
      thousands)
    
    
    **2005**
    
    
    **2006**
    
    
    **2007**
    
    
    **2008**
    
    
    **2009**
    
    
    **Thereafter**
      **or
      Non-**
      **Maturing**
    
    
    **Total**
    
    
    **Fair
      Value**
      **December
      31,**
      **2004****INTEREST
      RATE SENSITIVE ASSETS**Federal
      funds sold and interest earning deposits
    
    $
    17,295
    
    $
    —
    
    $
    —
    
    $
    —
    
    $
    —
    
    $
    —
    
    $
    17,295
    
    $
    17,295Weighted
      average interest rate
    
    
    2.16
    %
    
    0.00
    %
    
    0.00
    %
    
    0.00
    %
    
    0.00
    %
    
    0.00
    %
    
    2.16
    %Adjustable-rate
      securities
    
    
    983
    
    
    1,021
    
    
    1,059
    
    
    1,101
    
    
    1,146
    
    
    45,489
    
    
    50,799
    
    
    50,332Weighted
      average interest rate (a)
    
    
    3.94
    %
    
    3.94
    %
    
    3.94
    %
    
    3.94
    %
    
    3.95
    %
    
    3.94
    %
    
    3.94
    %Fixed-rate
      securities
    
    
    1,453
    
    
    10,068
    
    
    9,045
    
    
    4,234
    
    
    233
    
    
    29,175
    
    
    54,208
    
    
    53,709Weighted
      average interest rate (a)
    
    
    1.71
    %
    
    2.63
    %
    
    2.98
    %
    
    4.24
    %
    
    3.28
    %
    
    5.65
    %
    
    4.42
    %Investments
      in Trust I and II
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    743
    
    
    743
    
    
    743Weighted
      average interest rate
    
    
    0.00
    %
    
    0.00
    %
    
    0.00
    %
    
    0.00
    %
    
    0.00
    %
    
    10.19
    %
    
    10.19
    %Investments
      in bank stocks
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    4,457
    
    
    4,457
    
    
    4,457Weighted
      average interest rate
    
    
    0.00
    %
    
    0.00
    %
    
    0.00
    %
    
    0.00
    %
    
    0.00
    %
    
    4.83
    %
    
    4.83
    %Loans
      held for sale
    
    
    7,110
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    7,110
    
    
    7,110Weighted
      average interest rate
    
    
    4.75
    %
    
    0.00
    %
    
    0.00
    %
    
    0.00
    %
    
    0.00
    %
    
    0.00
    %
    
    4.75
    %Adjustable-rate
      loans
    
    
    136,519
    
    
    77,914
    
    
    42,228
    
    
    17,461
    
    
    42,073
    
    
    27,241
    
    
    343,436
    
    
    346,567Weighted
      average interest rate
    
    
    6.74
    %
    
    6.67
    %
    
    6.35
    %
    
    6.38
    %
    
    6.31
    %
    
    6.31
    %
    
    6.57
    %Fixed-rate
      loans
    
    
    14,817
    
    
    2,274
    
    
    5,472
    
    
    2,137
    
    
    7,969
    
    
    31,524
    
    
    64,193
    
    
    64,778Weighted
      average interest rate
    
    
    4.76
    %
    
    8.25
    %
    
    6.85
    %
    
    6.26
    %
    
    5.89
    %
    
    6.53
    %
    
    6.12
    %**Total
      interest rate sensitive assets**
    
    **$**
    **178,177**
    
    **$**
    **91,277**
    
    **$**
    **57,804**
    
    **$**
    **24,933**
    
    **$**
    **51,421**
    
    **$**
    **138,629**
    
    **$**
    **542,241**
    
    **$**
    **546,001****Weighted
      average interest rate**
    
    
    **5.99**
    **%**
    
    **6.23**
    **%**
    
    **5.83**
    **%**
    
    **5.90**
    **%**
    
    **6.18**
    **%**
    
    **5.42**
    **%**
    
    **5.88**
    **%**





**INTEREST
RATE SENSITIVE LIABILITIES**





Interest-bearing
      checking, savings and money market accounts
    
    $
    —
    
    $
    —
    
    $
    —
    
    $
    —
    
    $
    —
    
    $
    255,928
    
    $
    255,928
    
    $
    255,928Weighted
      average interest rate
    
    
    0.00
    %
    
    0.00
    %
    
    0.00
    %
    
    0.00
    %
    
    0.00
    %
    
    0.79
    %
    
    0.79
    %Fixed-rate
      time deposits
    
    
    104,621
    
    
    12,738
    
    
    3,533
    
    
    2,523
    
    
    758
    
    
    216
    
    
    124,389
    
    
    124,606Weighted
      average interest rate
    
    
    2.03
    %
    
    2.55
    %
    
    3.05
    %
    
    3.19
    %
    
    3.39
    %
    
    2.41
    %
    
    2.15
    %Securities
      sold under agreements to repurchase
    
    
    894
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    894
    
    
    894Weighted
      average interest rate
    
    
    1.60
    %
    
    0.00
    %
    
    0.00
    %
    
    0.00
    %
    
    0.00
    %
    
    0.00
    %
    
    1.60
    %Fixed-rate
      borrowings
    
    
    15,719
    
    
    7,885
    
    
    2,596
    
    
    2,133
    
    
    1,682
    
    
    12,429
    
    
    42,444
    
    
    42,556Weighted
      average interest rate
    
    
    3.15
    %
    
    4.20
    %
    
    3.83
    %
    
    3.92
    %
    
    4.12
    %
    
    4.45
    %
    
    3.95
    %Subordinated
      notes to Trust I and Trust II
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    24,743
    
    
    24,743
    
    
    27,840Weighted
      average interest rate
    
    
    0.00
    %
    
    0.00
    %
    
    0.00
    %
    
    0.00
    %
    
    0.00
    %
    
    10.19
    %
    
    10.19
    %**Total
      interest rate sensitive liabilities**
    
    **$**
    **121,234**
    
    **$**
    **20,623**
    
    **$**
    **6,129**
    
    **$**
    **4,656**
    
    **$**
    **2,440**
    
    **$**
    **293,316**
    
    **$**
    **448,398**
    
    **$**
    **451,824****Weighted
      average interest rate**
    
    
    **2.17**
    **%**
    
    **3.18**
    **%**
    
    **3.38**
    **%**
    
    **3.52**
    **%**
    
    **3.89**
    **%**
    
    **1.74**
    **%**
    
    **1.99**
    **%**





(a) These
interest rates are not adjusted to reflect tax equivalent yields.


(b) The
above amounts represent scheduled maturities and do not include prepayments that
may occur.





**Qualitative
Disclosures About Market Risk**





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





19
 Table of Contents





The
Company’s Asset/Liability Management Committee manages interest rate risk. The
principal objective of asset/liability management is to manage the levels of
interest-sensitive assets and liabilities to minimize net interest income
fluctuations in times of fluctuating market interest rates. To effectively
measure and manage interest rate risk, the Company uses computer simulations
that determine the impact on net interest income of numerous interest rate
scenarios, balance sheet trends and strategies. These simulations cover the
following financial instruments: short-term financial instruments, investment
securities, loans, deposits, and borrowings. 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 March 31, 2005, 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 during the remainder of 2005, net
interest income would increase an estimated $1.4 million for the year ended
December 31, 2005 and an estimated $5.9 million for the year ended December 31,
2006. On the contrary, if interest rates decreased 100 basis points during 2005
net interest income would decrease an estimated $500,000 for the year-end
December 31, 2005 and $2.4 million for the year ended December 31,
2006.





The
increase in short-term rates by the Federal Reserve during 2004, and thus far in
2005, have effectively repriced a significant portion of the Company’s loan
portfolio. Due to the strong deposit growth during the first quarter of 2005,
the Company has been able to minimize increases to funding costs, while
capitalizing on the increased yield on loans, thereby increasing the net
interest margin.





**Item
4.** **CONTROLSAND PROCEDURES**





Company
management, including the Chief Executive Officer, Vice Chairman and Principal
Financial and Accounting Officer, supervised and participated in an evaluation
of the Company’s disclosure controls and procedures (as defined in rules of the
Securities and Exchange Commission) as of March 31, 2005. Based on, and as of
the date of, that evaluation, the Company’s Chief Executive Officer and
Principal Financial and Accounting 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 Principal Financial and Accounting Officer, as appropriate to allow timely
decisions regarding required disclosures of that information under the
Securities and Exchange Commission’s rules and forms and that the disclosure
controls and procedures are designed to ensure that the information required to
be disclosed in reports that are filed or submitted under the Securities and
Exchange Act of 1934, as amended, are recorded, processed, summarized and
reported within the time periods specified in the Securities and Exchange
Commission’s rules and forms.





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





20
 Table of Contents








**PART
II** **OTHERINFORMATION**





**Item
1.** **LEGALPROCEEDINGS.**





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
2.** **CHANGESIN SECURITIES, USE OF PROCEEDS AND ISSUER
PURCHASES OF EQUITY SECURITIES.**





During
the first quarter of 2005, the Company issued 75,000 shares of restricted stock
to individuals of the Company. These shares were registered and granted under
the Vail Banks, Inc. Stock Incentive Plan (the Plan). The Company also issued
130,000 shares of restricted stock to individuals of the Company. These shares
were unregistered and granted outside of the Plan. See Note 7 to the Unaudited
Consolidated Financial Statements for additional discussion.





**Item 3.   DEFAULTSUPON SENIOR SECURITIES**.





None.





**Item 4.   SUBMISSIONOF MATTERS TO A VOTE OF SECURITY
HOLDERS.**


****


None.




Item
5.   OTHERINFORMATION.




No events
have transpired that would make a response to this item
appropriate.


****


**Item
6.    EXHIBITS.**





**(a)** **Exhibits**




31.1
    Certification
      by Gary 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 Raymond E. Verlinde, Chief Administrative Officer and Principal
      Financial and Accounting 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 Raymond E. Verlinde, Chief Administrative Officer and Principal
      Financial and Accounting 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








21
 Table of Contents





**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:
      May 13, 2005
    /s/Gary
      S. JuddGary S. Judd*Chief
      Executive Officer and President**(Principal
      Executive Officer)**May
      13, 2005*Date:
      May 13, 2005
    /s/Raymond
      E. VerlindeRaymond E. Verlinde*Chief
      Administrative Officer**(Principal
      Financial and Accounting Officer)**May
      13, 2005*





22