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

**_______________________**

**FORM 10‐Q**

| S  | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**   |
|--------|----------------------------------------------------------------------------------------------|
|   | **For the quarterly period ended September 30, 2003**                                        |
|  ̈ | **TRANSITION REPORTPURSUANT 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. Employer*    |
| *incorporation or organization)*  |       | *Identification No.)* |

**0015 Benchmark Road, Suite 300, P.O. Box 6580, Avon, Colorado81620**(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 befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period thatthe registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90days.    Yes  S** **No  ̈ .

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule12b-2 of the Exchange Act).          Yes    ̈**   **No  S .

Indicate the number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date:   **As of October 31, 2003, there were 5,283,264 shares ofcommon stock ($1.00 par value per share) outstanding.**

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**Vail Banks, Inc.**

**FORM 10-QFOR THE QUARTER ENDED SEPTEMBER 30, 2003**

###### **TABLE OF CONTENTS**

 

| **PART I** | **FINANCIAL INFORMATION** |  
ITEM 1.

FINANCIAL STATEMENTS

 
* Consolidated Balance Sheets*

*3*
 *Consolidated Statements of Income and Comprehensive Income*

*4*
* Consolidated Statements of Cash Flows*

*5*
* Notes to Unaudited Consolidated Financial Statements*

*7*
ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OFOPERATIONS
 
* Forward Looking Statements*

*14*
* Basis of Presentation*

*14*
* Overview*

*14*
* Results of Operations*

*15*
* Financial Condition*

*16*
* Asset Quality*

*17*
* Liquidity*

*18*
* Capital Resources*

*20*
* Recent Accounting Pronouncements*

*20*   
ITEM 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

*21*
   
ITEM 4.

CONTROLS AND PROCEDURES

*22*   
**PART II**

**OTHER INFORMATION**
    
ITEM 6.

EXHIBITS AND REPORTS ON FORM 8-K

*23*   
SIGNATURES

* 24*   
** **

2
TABLE OFCONTENTS
**PART I         FINANCIAL INFORMATION****Item 1.     FINANCIALSTATEMENTS**
**VAIL BANKS, INC.**

**ConsolidatedBalanceSheets**         
**September 30,**
 
December 31,

(in thousands, except share data)
 
**2003**
 
2002

**ASSETS**
    
**(unaudited)**
  
Cash and due from banks

**$**

**16,954 **

 
24,940 

Federal funds sold
 
**94,115 **
 
50,040 

Investment securities, available for sale
 
**81,278 **
 
57,634 

Investment securities, held to maturity (fair value of
     
**$455**(unaudited) and $731 as of September30, 2003 and December 31, 2002,respectively)
 
**425 **
 
684 

Investments in bank stocks, at cost
 
**4,351 **
 
3,703 

Loans held for sale
 
**6,494 **
 
9,879 

Gross loans (includes related party loans of **$11,135** (unaudited) and$4,733
    
     as of September 30, 2003 and December 31,2002, respectively)
 
**312,270 **
 
331,162 

Allowance for loan losses
 
**(3,299)**
 
(3,747)

Net deferred loan fees
 
**(604)**
 
(159)

Premises and equipment, net
 
**38,853 **
 
39,005 

Interest receivable
 
**2,269 **
 
1,914 

Goodwill, net
 
**35,970 **
 
35,970 

Other intangible assets, net
 
**760 **
 
816 

Other assets
   
**6,239 **
 
2,422 
 
$

**596,075 **
 
554,263 

**LIABILITIES AND SHAREHOLDERS’ EQUITY**
    
Liabilities
        
Deposits (includes related party deposits of **$2,131** (unaudited) and$3,425at September 30, 2003 and December 31, 2002, respectively)
      
Non-interest bearing

**$**

**96,828 **
 
97,383 
  
Interest bearing
 
**366,243 **
 
331,315 

 
 
 
 
 
Total deposits

 
**463,071 **

 
428,698 
 
Federal funds purchased and securities sold under agreements torepurchase
 
**225 **
 
**— **
 
Federal Home Loan Bank advances
 
**44,961 **
 
30,000 

    Guaranteed preferred beneficial interest inCompany’s subordinated debt
 
**24,000 **
 
24,000 
 
Interest payable and other liabilities
 
**3,277 **
 
4,080 

 
 
 
 
 
Total liabilities

 
**535,534 **

 
486,778 

Minority interest
 
**710 **
 
713 

Shareholders' equity
     
Preferred stock – $1 par value; 2,250,000 shares authorized, noshares
    
issued and outstanding at September 30, 2003 (unaudited) and December 31,2002, respectively
 
**  — **
  
**— **
 
Common stock – $1 par value; 20,000,000 shares authorized,
       
  5,311,512 (unaudited) and 5,734,303 issued and outstandingat
       
  September 30, 2003 and December 31, 2002, respectively
 
**5,312 **
 
5,734 
 
 Additional paid-in capital
 
**33,942 **
 
41,123 
 
 Retained earnings
 
**20,912 **
 
19,492 
 
 Accumulated other comprehensive income, net of tax expenseof**     $(197)**(unaudited) and $243 at September30, 2003 and December 31,     2002,respectively
 
**(335)**

 

423 

 
 
 
 
 
Total shareholders' equity

 
**59,831 **

 
66,772 
        
$

**596,075 **
 
554,263 
     
The accompanying notes are an integral part of these unaudited consolidatedfinancial statements

3
TABLE OFCONTENTS

**VAIL BANKS, INC.ConsolidatedStatements of Income and ComprehensiveIncome**(in thousands, except share data)
  
Three months ended   September 30,
 
Nine months ended September 30,
  
**2003**
 
2002
 
**2003**
 
2002
  
**(unaudited)**
 
(unaudited)
 
**(unaudited)**
 
(unaudited)

Interest and dividend income
        
      Loans, including fees

$

**6,318 **
 
7,515 
 
**19,860 **
 
22,964 

      Investment securities
 
**850 **
 
878 
 
**2,847 **
 
2,541 

      Federal funds sold and other short-term             investments
 
**191 **
 
 190 
 
**480 **
 
 433 

                Total interest and dividendincome
 
**7,359 **
 
8,583 
 
**23,187 **
 
25,938 

Interest expense
        
      Deposits
 
**1,172 **
 
1,260 
 
**3,576 **
 
3,919 

      Short-term borrowings
 
**97 **
 
57 
 
**265 **
 
184 

      Long-term borrowings
  
**342 **
 
222 
 
**907 **
 
542 

      Guaranteed preferred beneficial interest in            Company’s subordinated debt
 
**612 **
 
612 
 
**1,835 **
 
1,835 

                Total interest expense
 
**2,223 **
 
2,151 
 
**6,583 **
 
6,480 

                Net interest income
 
**5,136 **
 
6,432 
 
**16,604 **
 
19,458 

Provision for loan losses
 
**164 **
 
**— **
 
**414 **
 
382 

                Net interest income afterprovision                        for loan losses
 
**4,972 **
 
6,432 
 
**16,190 **
 
19,076 

Non-interest income
        
      Deposit related
 
**747 **
 
880 
 
**2,323 **
 
2,660 

      Mortgage broker fees
 
**1,299 **
 
1,207 
 
**4,083 **
 
3,416 

      Other
 
**702 **
 
1,188 
 
**2,070 **
 
2,919 
  
**2,748 **
 
3,275 
 
**8,476 **
 
8,995 

Non-interest expense
        
      Salaries and employee benefits
 
**4,403 **
 
4,166 
 
**13,015 **
 
12,356 

      Occupancy
 
**850 **
 
807 
 
**2,478 **
 
2,413 

      Furniture and equipment
 
**696 **
 
711 
 
**2,095 **
 
2,162 

      Amortization of intangible assets
 
**19 **
 
19 
 
**56 **
 
56 

      Other
 
**1,326 **
 
1,370 
 
**3,569 **
 
4,156 
   
**7,294 **
 
7,073 
 
**21,213 **
 
21,143 

                Income before income taxexpense

 
**426 **

 
2,634 

 
**3,453 **

 
6,928 

Income tax expense

 
**63 **

 
946 

 
**978 **

 
2,411 

                Net income
 
**363 **
 
1,688 
 
**2,475 **
 
4,517 

Unrealized gain (loss) on available for sale      securities, net of taxes
   
 
    
Unrealized holding gains arising      during period
 
**(564)**
 
206 
 
**(579)**
 
325 

Reclassification adjustment for gains included      in income
 
**(140)**
 
(144)
 
**(179)**
 
39 

                Comprehensive (loss)income

$

**(341)**
 
1,750 
 
**1,717 **
 
4,881 

Earnings per share
        
      Basic

$

**0.07 **
 
0.30 
 
**0.47 **
 
0.80 

      Diluted

$

**0.07 **
 
0.29 
 
**0.44 **
 
0.76 

Weighted average common shares
        
      Basic
 
**5,064,981 **
 
5,641,412 
 
**5,295,502 **
 
5,666,207 

      Diluted
 
**5,498,653 **
 
5,909,963 
 
**5,689,159 **
 
5,937,041 

 

The accompanying notes are an integral part of these unaudited consolidatedfinancial statements

 

4
TABLE OFCONTENTS

**VAIL BANKS, INC.Consolidated Statements of Cash Flows**(in thousands)
  
Nine months ended September 30,
  
**2003**
 
2002
  
**(unaudited)**
 
  (unaudited)
     
Cash flows from operating activities
    
 Net income

$

**2,475 **
 
4,517 

 Adjustments to reconcile net income to netcash provided by      operating activities
    
Net amortization of premiums on investment securities
 
**371 **
 
249 

Provision for loan losses
 
**414 **
 
382 

Gain on sale of investment securities
 
**(15)**
 
(416)

Gain on sale of loans 
**(95)**
 
**— **

Depreciation and amortization
 
**1,724 **
 
1,805 

 Recognition of stock compensation on restrictedcommon stock and            stock options
 
**306 **
 
187 

Deferred income tax expense
 
**(176)**
 
**— **

Other
 
**(67)**
 
(106)

Changes in operating assets and liabilities
    
Loans held for sale
 
**3,385 **
 
2,821 

Interest receivable
 
**(355)**
 
560 

Other assets
 
**(728)**
 
(439)

Interest payable and other liabilities
 
**(803)**
 
(401)

Other, net
 
**(3)**
 
11 

Net cash provided by operating activities
 
**6,433 **
 
9,170 
     
Cash flows from investing activities
    
Purchases of investment securities, available for sale
 
**(75,312)**
 
(43,498)

Purchases of bank stocks
 
**(648)**
 
(676)

Proceeds from maturities of investment securities, held to maturity
 
**259 **
 
157 

Proceeds from maturities/calls of investmentsecurities, available for sale
 
**35,623 **
 
10,353 

Proceeds from sales of investment securities, available for sale
 
**14,490 **
 
15,414 

Net decrease in loans
 
**14,059 **
 
46,249 

Purchases of premises and equipment
 
**(1,828)**
 
(2,075)

Proceeds from sales of premises and equipment
 
**78 **
 
1,740 

Proceeds from sales of foreclosedproperties
 
**2,340 **
 
607 

Net cash (used) provided by investing activities
 
**(10,939)**
 
28,271 
     
Cash flows from financing activities
    
Net increase (decrease) in deposits
 
**34,373 **
 
(14,797)

Net change in federal funds purchased andsecurities sold under agreements     to repurchase
 
**225 **
 
**— **

Net increase in Federal Home Loan Bank advances
 
**14,961 **
 
8,900 

Proceeds from issuance of common stock
 
**111 **
 
160 

Repurchase of common stock
 
**(8,020)**
 
(1,273)

Payment of cash dividends on common stock
 
**(1,055)**
 
(929)

Net cash provided (used) by financing activities
 
**40,595 **
 
(7,939)

                               Net increase in cash and cash equivalents
 
**36,089 **
 
29,502 

Cash and cash equivalents at beginning of period
 
**74,980 **
 
35,526 

Cash and cash equivalents at end of period

$

**111,069 **
 
65,028 

5
TABLE OFCONTENTS

**VAIL BANKS,  INC.Consolidated Statements of Cash Flows(Continued)**(in thousands)
  
Nine months endedSeptember 30,
  
**2003**
 
2002
  
**(unaudited)**
 
(unaudited)

Supplemental disclosures of cash flow information
    
   Cash paid during the period for:
    
          Interest expense

$

**6,773 **
 
6,786 

          Income taxes

$

**1,414 **
 
2,280 
     
Non-cash investing and financing transactions   Foreclosure of collateralized loans, net of reserve

$

**4,511 **
 
468 

   Net change in unrealized gain/loss on investment securitiesavailable        for sale, net of taxes

$

**(758)**
 
364 

   Reclassification of idle premises and equipment to otherassets

$

**(274)**
 
**  — **

   Reclassification of other assets to premises andequipment

$

**57 **
 
**  — **

   Issuance of restricted common stock

$

**178 **
 
117 

The accompanying notes are an integral part of these unaudited consolidatedfinancial statements

6
TABLE OFCONTENTS

**VAIL BANKS, INC.**
**Notes to UnauditedConsolidated Financial Statements**
**1.  ORGANIZATIONAND BASIS OF PRESENTATION**

                The accompanying unauditedconsolidated financial statements include the accounts of Vail Banks, Inc. (Vail Banks) and its wholly owned subsidiaries, WestStarBank (WestStar), Vail Banks Statutory Trust I, and Vail Banks Statutory Trust II.  WestStar and Vail Banks own a combined54.04% interest in Avon 56 Limited and WestStar owns a 100% interest in First Western Mortgage Serviceswhich are also included in the accompanying consolidated financial statements.  All entities are collectively referredto as “the Company.”  All significant intercompany accounts and transactions have been eliminated inconsolidation.

                The accompanying unauditedconsolidated financial statements, which are for interim periods, do not include all disclosures provided in the consolidatedfinancial statements as of December 31, 2002.  These interim unaudited consolidated financial statements and the notes theretoshould be read in conjunction with the Company’s Annual Report on Form 10-K as of and for the year ended December 31,2002.

                In the opinion of the Company,all adjustments necessary, consisting of only normal recurring items, have been included for a fair presentation of theaccompanying consolidated financial statements.  Operating results for the three and nine months ended September 30, 2003, arenot necessarily indicative of the results that may be expected for the full year.

                Certain reclassifications havebeen made to the 2002 financial statements to conform to the 2003 presentation. 

**2.  INVESTMENT SECURITIES**

               Investment securities consist of the following:
  
**September 30, 2003**
 
December 31, 2002
  
**Amortized**
 
**Fair**
 
Amortized
 
Fair

(in thousands)
 
**Cost**
 
**Value**
 
Cost
 
Value
  
**(unaudited)**
 
**(unaudited)**
             
Securities available for sale
        
      Government agencies

**$**

**21,569**
 
**21,499**
 
13,299
 
13,323

      State and municipal
 
**20,855**
 
**20,512**
 
3,851
 
3,880

      Mortgage-backed securities
 
**34,869**
 
**34,850**
 
35,318
 
35,931

      Agency preferred stock
 
**4,517**
 
**4,417**
 
4,500
 
  4,500

           Total securities availablefor sale

**$**

**81,810**
 
**81,278**
 
56,968
 
  57,634
         
Securities held to maturity
        
      Mortgage-backed securities

**$**

**425**
 
**455**
 
  684
 
731

           Total securities held tomaturity

**$**

**425** 
**455** 
684 
731         
Investments in bank stocks
        
      Federal Home Loan Bank stock

**$**

**2,298**
 
**2,298**
 
1,650
 
1,650

      Federal Reserve Bank stock
 
**1,869**
 
**1,869**
 
1,869
 
1,869

      Bankers’ Bank of the West stock
 
**184**
 
**184**
 
184
 
  184
 
**$**

**4,351** 
**4,351** 
3,703 
3,703
  

7
TABLE OFCONTENTS

                The following table presents the components of investment income for the three and ninemonths ended September 30, 2003 and 2002.  
Three months endedSeptember 30,
 
Nine months endedSeptember 30,

(in thousands)
 
**2003**
 
2002
 
**2003**
 
2002
  
**(unaudited)**
 
(unaudited)
 
**(unaudited)**
 
(unaudited)

Taxable interest income

**$**

**502   **

 
749    

 
**1,907    **

 
2,150    

Nontaxable interest income
 
**293   **
 
77    
 
**789    **
 
244    

Dividends
 
**55   **
 
52    
 
**151    **
 
147    

 
**$**

**850   **

 
878    

 
**2,847    **

 
2,541

**3.  LOANS**

               Gross loans consist of the following:

(in thousands)

  

**September****30, 2003**

  

December 31,2002
  
**(unaudited)**       
Commercial, industrial and land

**$**
**190,852** 
203,932
Real estate - construction
 
**54,297** 
55,275
Real estate - mortgage
 
**59,668** 
62,188
Consumer and other
 
**7,453** 
9,767
      
**$**
**312,270** 
331,162

               As of September 30, 2003 and December 31, 2002, $336,000 and $172,000, respectively, of deposit account overdrafts have beenreclassified to loans. 

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

(in thousands)

 

**2003**

 

 

** **

Balance at January 1, 2003

$

**  4,733 **

     New loans, including renewals **

 

**7,102 **

     Payments, including renewals

 

**  (700)**

Balance at September 30, 2003 (unaudited)

$

**11,135 **
** Comprised of $6,152,000 of new loans and $950,000 relating to therepurchase of a loan participation.
 
8
TABLE OFCONTENTS

**4.  PROVISION AND ALLOWANCE FOR LOAN LOSSES**

Transactions in the allowance are summarized as follows:

(in thousands)
 
**2003**
   
Allowance at January 1, 2003

**$**

**3,747 **

Loans charged off

** **

**  (1,023)**

Recoveries on loans previously charged off

** **

**  161 **

Provision for loan losses

** **

**414 **

Allowance at September 30, 2003 (unaudited)

**$**

**3,299 **
**5.  PREMISES AND EQUIPMENT**

            During May 2003, theCompany entered into an agreement to sell one of its bank buildings and lease back a minor portion of the space.  The sale issubject to numerous contingencies that have not yet been met.  Assuming the contingencies are met, the transaction is expectedto close before the end of 2003 and would result in a gain to the Company.

**6.  SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE**

**           **Securities sold under agreements to repurchase, which are classified as securedborrowings, generally mature within one to four days from the transaction date. At September 30, 2003, the carrying amount of securities sold to securerepurchase agreements was $225,000.  Securities sold under agreements torepurchase are reflected at the amount of cash received in connection with thetransaction.  The Company may be required to provide additional collateralbased on the fair value of the underlying securities.

**7.  BORROWINGS**

            WestStar is a member ofthe Federal Home Loan Bank of Topeka (FHLB) and, as a regular part of its business, obtains both short and long-term advances fromthis FHLB. Advances are collateralized primarily by FHLB stock owned by WestStar and loans secured by certain mortgages or deeds oftrust. As of September 30, 2003, the Company’s total borrowing capacity was $105.8 million of which $45.0 million ofborrowings were outstanding ($11.4 million was short-term and $33.6 million was long-term) and $24.0 million in the form ofstand-by irrevocable letters of credit issued by the FHLB were pledged as collateral for uninsured public fund deposits.

            WestStar hasestablished an unsecured, overnight federal funds line with Bankers’ Bank of the West that expires on August 31, 2004. As of September 30, 2003, this authorized borrowing line totaled $42.1 million with $0 outstanding. 

            WestStar has alsoestablished overnight federal funds lines with First Tennessee Bank, N.A. (First Tennessee) totaling $20.0 million.  If drawnupon, $10.0 million will be a secured line and $10.0 million will be an unsecured line.  These lines are subject tocancellation by First Tennessee at any time upon the occurrence of certain conditions.  As of September 30, 2003, no amountswere outstanding under the lines. 

**8.  SHARHOLDERS’ EQUITY**

***Stock Repurchase Plan***

            On October 15, 2002,the Company’s Board of Directors reauthorized the Company’s stock repurchase program, allowing additional repurchasesof up to $10 million through October 2003.  Since inception of the program in March 2001, the Company has repurchased1,506,880 shares at an average cost of $12.06 per share.  During the first nine months of 2003, the Company repurchased622,590 common shares at an average cost of $12.88.  Please also see Footnote 12.

***Restricted Stock***

           The Company accounts for its restricted stock grants in accordance withAccounting Principles Board (APB) Opinion No. 25.  Accordingly,compensation expense is recorded over the vesting period of the restricted stockequal to the value of the restricted shares using the market price of the stockon the grant date.   On February 18, 2003, the Board granted 112,005shares of restricted stock to several officers of the Company.  The Companyis recognizing compensation expense of $1.3 million ratably over the vestingperiod of

9
TABLE OFCONTENTS

10 years.  On April 25, 2003, theBoard granted 18,272 shares of restricted stock to an officer of the Company. The Company is recognizing compensation expense of $226,000 related to thisgrant ratably over the vesting period of 10 years.  On May 12, 2003, theBoard granted 7,500 shares of restricted stock to an officer of the Company. The Company is recognizing compensation expense of $92,000 ratably over thevesting period of 10 years.

               During April and May of 2003, the Board granted 40,000 shares of restricted stock to several individuals as an inducement to becomeofficers of the Company.  These shares are unregistered and granted outside of the Vail Banks, Inc. Stock IncentivePlan.  The Company is recognizing compensation expense of $493,000 ratably over the vesting period of 10years. 

***Earnings Per Share***

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

               The following table presents the net income and weighted average common shares outstanding used to calculate earnings per share forthe nine months ended September 30, 2003 and 2002:

 

 

September 30,

(in thousands, except share data)

 

**2003**

** **

2002

 

 

 

 

 

 

 

(unaudited)

Basic earnings per share computation

 

 

 

 

 

** **

** **

 

 

Net income available to common shareholders

**$**

**2,475**

 

4,517

 

** **
 
 
  

Weighted average shares outstanding – basic

** **

**5,295,502**

 

5,666,207

 

** **
** **
 

 
Basic earnings per share

**$**

**0.47**
 
0.80

 

** **

September 30,

(in thousands, except share data)

** **

**2003**

 

2002

 

** **

(unaudited)

 

** **

** **

 

 

Diluted earnings per share computation

** **

** **

 

 

 

** **

** **

 

 

Net income available to common shareholders

**$**

**2,475**

 

4,517

 

 

 

 
 
Weighted average shares outstanding – basic

 

**5,295,502**

 

5,666,207

            Sharesassumed issued:

 

** **

 

 

                  Stockoptions

 

**147,801**

 

128,162

                  Restrictedstock

 

**245,856**

 

142,672

 

 

** **

 

 

Weighted average shares outstanding – diluted

 

**5,689,159**

 

5,937,041

 

 

** **

 

 

  Diluted earnings per share

**$**

**0.44**

 

0.76

                During the nine months ended September 30, 2002, options to purchase an average of 48,000 shares of common stock at an averageexercise price of $12.03 per share were outstanding, but were not included in the computation of diluted earnings per share becausethe exercise prices of these options were greater than the average market prices of the common stock during such periods. During the nine months ended September 30, 2003, there were no anti-dilutive stock options. 

10
TABLE OFCONTENTS

***Stock Options***

                On February 10, 2003, the Boardapproved the grant of 26,000 stock options under the Vail Banks, Inc. Stock Incentive Plan (the Plan) to employees and directors ofthe Company. On May 12, 2003, the Board approved the grant of 7,500 stock options under the Plan to anemployee of the Company.

               Also on May 12, 2003, the Board approved the grant of 6,250 stock options to several individuals as an inducement to becomeofficers of the Company.  The options were granted outside of the Plan and when exercised, these stock options will result inthe employees receiving unregistered shares of stock.

               The Company accounts for its stock options in accordance with SFAS No. 123, *Accounting for Stock-Based Compensation,* whichpermits entities to expense over the vesting period the fair value of stock‐based awards as measured on the date ofgrant.  Alternatively, SFAS 123 allows entities to apply the provisions of APB Opinion No. 25 while disclosing pro forma netincome and pro forma earnings per share for employee stock option grants made in 1995 and future years as if thefair‐value-based method defined in SFAS 123 had been applied.  The Company has elected to apply the accountingprovisions of APB Opinion No. 25 to employee stock option grants and provide the pro forma disclosure provisions of SFAS 123. Accordingly, stock-based compensation expense for employee option grants is not recognized in the consolidated financialstatements, as options granted under the Plan generally have an exercise price equal to the market value of the underlying commonstock on the date of grant.  However, during May 2002, approximately 20,000 stock options were granted at a strike price belowmarket value.  The Company recognized $4,000 and $7,000, respectively, of compensation expense during the nine months endedSeptember 30, 2003 and 2002 related to these options.  Any non-employee stock option grants are accounted for under SFAS123. 

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

 

 

**2003**

 

2002
  
**(unaudited)** 
(unaudited)
Dividend yield

 
**2.0%**
 
2.0%
Expected life
 
**7 years** 
6 years
Expected volatility
 
**27.5%** 
27.0%
Risk-free interest rate
 
**3.6%** 
4.8%
               Had the Company determined compensation cost based on the fair value accounting provisions prescribed by SFAS 123 and using theassumptions listed above, the Company’s net income and earnings per share would have been adjusted to the pro forma amountsindicated below:
  
Three months ended September 30,
 
Nine months endedSeptember 30,
(in thousands, except share data)
 

**2003**

 

2002

 

**2003**

 

2002
  
**(unaudited)** 
(unaudited) 
**(unaudited)** 
(unaudited)
Net income
        
As reported

**$**
**363 ** 
1,688  
**2,475 ** 
4,517 
Deduct:  Total stock-based employee     compensation determined under the                 fair value method, net of tax
 
**(20)**

  

(59)  

 

**(161)**

 

(211)

Pro forma

**$**
**343 **

 

1,629 

 

**2,314 **

 

4,306 
         
Earnings per share - basic
 
       
As reported
** $**
**0.07 ** 
0.30  
**0.47 ** 
0.80 
Pro forma
** $**
**0.07 ** 
0.29  
**0.44 ** 
0.76  ** **       
Earnings per share - diluted
** **       
 As reported
** $**
**0.07 ** 
0.29  
**0.44 ** 
0.76 
 Pro forma
** $**
**0.06 ** 
0.27  
**0.39 ** 
0.71 
11
TABLE OFCONTENTS

**9.  REGULATORY MATTERS**

            As ofSeptember 30, 2003, the Company met all capital adequacy requirements to which it was subject.  As of that date, the Companyhad Tier 1 and Total Risk-Based Capital ratios of 12.17% and 14.09%, respectively, and a Leverage ratio of 7.86%.  Regulatoryguidelines permit the Company’s trust preferred securities to be included in the calculation of Tier 1, Total Risk-Basedcapital, and the Leverage Ratio, subject to certain limitations. 

            As ofSeptember 30, 2003, WestStar met all capital adequacy requirements to which it was subject and exceeded the minimum ratios to bedesignated as “well-capitalized.”  As of September 30, 2003, WestStar had Tier 1 and Total Risk-Based Capitalratios of 12.41% and 13.32%, respectively, and a Leverage ratio of 8.00%.  

**10.  SEGMENT INFORMATION**

           Information about reportable segments and reconciliation of such information to the consolidated financial statements for the ninemonths ended September 30 is as follows:
  
**Nine****Months Ended September 30, 2003 (unaudited)**    
**Mortgage**
    
(in thousands)

 

**Banking**

 

**Brokerage**

 

**Other**

 

**Total**
         
Condensed income statement
                 
  Total income

**$**
**27,582** 
**4,078** 
**3 ** 
**31,663**
  Total expense
 
**21,739** 
**3,244** 
**3,227 ** 
**28,210**
         Income before incometaxes
 
**5,843** 
**834** 
**(3,224)** 
**3,453**
  Income taxes
 
**1,853** 
**306** 
**(1,181)**
 
**978**
         Net income

**$**
**3,990** 
**528** 
**(2,043)**
 
**2,475**         
 
  
Nine Months Ended September 30, 2002 (unaudited)
    
Mortgage    
(in thousands)

 

Banking

 

Brokerage

 

Other

 

Total
 
Condensed income statement
                 
  Total income

$
31,518 
3,411 
4  
34,933
  Total expense
 
22,192 
2,750 
3,063  
28,005
         Income before incometaxes
 
9,326 
611 
(3,059) 
6,928
  Income taxes
 
3,309 
233 
(1,131)
 
2,411
         Net income

$
6,017 
428 
(1,928)
 
4,517         
**11.  RECENT ACCOUNTING PRONOUNCEMENTS**

               During June 2002, the FASB issued SFAS No. 146, *Accounting for Costs Associated with Exit or Disposal Activities*.  Thisstatement is effective for exit or disposal activities initiated after December 31, 2002.  These activities may include saleor termination of a line of business, the closure of business activities in a particular location, the relocation of businessactivities from one location to another, changes in management structure, and a fundamental reorganization that affects the natureand focus of operations.  The Statement addresses financial accounting and reporting for costs associated with exit ordisposal activities and requires companies to recognize liabilities associated with exit or disposal activities at the time thatthey are incurred rather than at the date of a commitment to the exit or disposal plan.  The Company adopted this standard onJanuary 1, 2003.  Adoption of this standard did not have an effect on the Company’s consolidated financial condition orresults of operations. 

12
TABLE OFCONTENTS

               During April 2003, the FASB issued SFAS No. 149, *Amendment of Statement 133 on Derivative Instruments and HedgingActivities*.  This statement amends and clarifies financial accounting and reporting for derivative instruments, includingcertain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activitiesunder SFAS No. 133, *Accounting for Derivative Instruments and Hedging Activities*.  This statement is effective forcontracts entered into or modified after June 30, 2003, except for certain circumstances, and for hedging relationships designatedafter June 30, 2003.  The Company does not utilize derivative instruments or engage in hedging activities.  Accordingly,adoption of this standard did not have an effect on the Company’s consolidated financial condition or results ofoperations.

               During May 2003, the FASB issued SFAS No. 150, *Accounting for Certain Financial Instruments with Characteristics of bothLiabilities and Equity*.  This statement establishes standards for how an issuer classifies and measures certain financialinstruments with characteristics of both liabilities and equity.  It requires that an issuer classify a financial instrumentthat is within its scope as a liability when previously it was classified as equity.  This statement is effective forfinancial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interimperiod beginning after June 15, 2003.  It is to be implemented by reporting the cumulative effect of a change in an accountingprinciple for financial instruments created before the issuance of the statement and still existing at the beginning of the interimperiod of adoption.  Restatement is not permitted.  The Company adopted this statement on July 1, 2003.  Adoption ofthis statement did not have an effect on the Company’s consolidated financial condition or results of operations.

**12.  SUBSEQUENT EVENTS**

                On October 20, 2003, the Board ofDirectors declared a regular quarterly dividend of $0.07 per share payable on November 14, 2003 to shareholders of record onOctober 31, 2003. 

                On October 20, 2003, the Board ofDirectors reauthorized the Company’s stock repurchase program.  The total amount of repurchases under the program, bothpreviously completed and allowable up to January 20, 2004, aggregate approximately $19 million.

                Between October 1, 2003 andOctober 31, 2003, the Company repurchased 28,500 shares of common stock at a total cost of approximately $410,000, or $14.40 pershare. 

** **

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TABLE OFCONTENTS
**Item2.      MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OFOPERATIONS****Forward Looking Statements**
               This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities LitigationReform 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 thisreport, the words “expects,” “anticipates,” “intends,” “plans,”“believes,” “seeks,” “estimates” and similar expressions are generally intended to identifyforward-looking statements.  These forward-looking statements are inherently subject to significant business, economic andcompetitive uncertainties and contingencies, many of which are beyond our control.  In addition, these forward-lookingstatements 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 ofeconomic conditions and interest rates, loan losses, risks related to the execution of the Company’s growth strategy, thepossible loss of key personnel, factors that could affect the Company’s ability to compete in its trade areas, changes inregulations and government policies and other factors discussed in the Company’s filings with the Securities and ExchangeCommission.  Vail Banks does not intend to update any forward-looking statements whether written or oral, relating to mattersdiscussed in this Quarterly Report on Form 10-Q.
**Basis of Presentation**
                The following discussion and analysis provides information regarding the Company’s financial condition as of September 30, 2003,and its results of operations for the nine and three months ended September 30, 2003, in comparison to the nine and three monthsended September 30, 2002. The following discussion should be read in conjunction with the unaudited consolidated financialstatements and related notes included elsewhere in this Quarterly Report on Form 10-Q, and in conjunction with the Company’sAnnual Report on Form 10-K for the year ended December 31, 2002.
**Overview**
            Netincome was $2.5 million for the nine months ended September 30, 2003, down from $4.5 million for the nine months ended September30, 2002, a decrease of 45%.  Net income was $363,000 for the three months ended September 30, 2003, down from $1.7 millionfor the three months ended September 30, 2002, a decrease of 78%.

            Dilutedearnings per share for the nine months ended September 30, 2003, was $0.44 compared to $0.76 for the nine months ended September30, 2002, a decrease of 42%.  Diluted earnings per share for the three months ended September 30, 2003, was $0.07 compared to$0.29 for the three months ended September 30, 2002, a decrease of 76%.

            Theannualized return on average assets was 0.56% for the nine months ended September 30, 2003 compared to 1.07% for the nine monthsended September 30, 2002, and 0.24% for the quarter ended September 30, 2003, compared to 1.19% for the quarter ended September 30,2002. 

            Theannualized return on average equity was 5.21% for the nine months ended September 30, 2003 compared to 9.33% for the nine monthsended September 30, 2002, and 2.39% for the quarter ended September 30, 2003, compared to 10.20% for the quarter ended September30, 2002. 

            DuringMay 2003, the Company announced plans to expand its presence in the Denver Front Range market, a key Colorado market.  TheCompany intends to open additional banking offices over a period of years as market opportunities and availability of executivetalent dictates.  The first new Denver office was opened during July 2003 and net expenses for this new branch were $255,000,after tax, through September 30, 2003. 

            Duringthird quarter 2003, the Company broke ground on a new facility in Glenwood Springs to replace an existing branchbuilding.

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TABLE OFCONTENTS
**Results of Operations**
*                Net InterestIncome. * Net interest income, on a fully tax-equivalent basis (FTE), decreased by $2.6 million, or 13% to $17.0million for the nine months ended September 30, 2003 from $19.6 million for the nine months ended September 30, 2002.  * * Net interest income FTE decreased by $1.2 million, or18% to $5.3 million for the three months ended September 30, 2003 from $6.5 million for the three months ended September 30,2002.   The net interest margin on an FTE basis was 4.60% and 4.15% for the nine and three months ended September 30,2003 as compared to 5.58% and 5.49% for the comparable periods in 2002.  Net interest margin is influenced by the level andrelative mix of earning assets, interest bearing liabilities, non-interest bearing liabilities and shareholders’ equity aswell as the cost of interest bearing liabilities as compared to the yield on earning assets.   The decrease in netinterest margin during the first nine months of 2003 was primarily due to (1) an $18.9 million decrease in loan volumes sinceDecember 31, 2002 as a result of the soft economy and more conservative underwriting policies. This has resulted in additional liquidity that the Company has used to purchase lower yielding investments and federal fundssold.  At the same time, the Company (2) capitalized on the low interest rate environment and itswholesale funding source to extend fixed rate financing to several customers, thereby locking in a spread.  These borrowingscame at a higher interest cost than deposits.  Also contributing to the decrease in net interest margin was (3)the 25 basis point interest rate cut implemented by the Federal Reserve duringsecond quarter 2003 and the 50 basis point cut during November 2002. Finally, (4) the Company deferred more loan fees in the first nine months of2003 compared with the first nine months of 2002.  During the first ninemonths of 2003, the Company deferred $644,000 in loan fees, reflecting a moreconservative approach that more closely recognizes loan fee income over thelives of the related loans.  A portion of the deferral also included feeson long-term loans now being funded with long-term borrowings.  Asubstantial portion of such deferred fees will be recognized as income insubsequent quarters.

               Interest income FTE decreased to $23.6 million and $7.5 million for the nine and three months ended September 30, 2003, as comparedto $26.1 million and $8.6 million for the nine and three months ended September 30, 2002, despite the fact that average earningassets increased during this period.  Average earning assets increased 5%, from $469.2 million for the nine months endedSeptember 30, 2002 to $494.6 million for the nine months ended September 30, 2003.  Subsequent to September 30, 2002, the mixof earning assets shifted away from higher yielding loans toward lower yielding investment securities and federal funds sold. During the first nine months of 2003, average loans declined to 66% of earning assets as compared to 77% during the first ninemonths of 2002 while federal funds sold and investment securities increased to 32% of earning assets ascompared to 22% during the first nine months of 2002.  See discussion of these fluctuations,above.  During this time, loans had a yield of 8.08% as compared to the 4.43% yield on investment securities and 1.07% yieldon federal funds sold.   As a result of this shift, the total yield on average earnings assets decreased 105 basis pointsto 6.38% for the first nine months of 2003, as compared to 7.43% for the first nine months of 2002. 

               Interest expense increased to $6.6 million and $2.223 million for the nine and three months ended September 30, 2003, as comparedto $6.5 million and $2.151 million for the corresponding periods in 2002.  This increase was primarily due to a $13.6 millionincrease in average borrowings and a $16.3 million, or 5%, increase in average interest bearing deposits during the first ninemonths of 2003 as compared to the first nine months of 2002.  These increases were partially offset by the impact of the 25basis point decline in interest rates during second quarter and the 50 basis point decline in interest rates during November 2002as well as the effect of maturing certificates of deposit renewing at significantly lower interest rates.  As a result, thetotal cost of interest-bearing liabilities decreased 12 basis points to 2.05% for the first nine months of 2003, as compared to2.17% for the first nine months of 2002.   This decrease in cost of interest bearing liabilities, however, was not inproportion to the decrease in yield on average interest earning assets, resulting in an overall decrease in net interest income forthe first nine months of 2003. 

*           Non-Interest Income*. During the nine months ended September 30, 2003, non-interest income decreasedby $519,000, or 6%, to $8.5 million for the nine months ended September 30, 2003, from $9.0 million for the nine months endedSeptember 30, 2002.  During the three months ended September 30, 2003, non-interest income decreased by $527,000, or 16%, to$2.7 million for the three months ended September 30, 2003, from $3.3 million for the three months ended September 30, 2002. These decreases were primarily attributable to a decrease in deposit related service charges and other non-interest incomepartially offset by an increase in mortgage broker fees.  Deposit related income decreased $337,000 and $133,000, or 13% and15%, respectively, from the nine and three months ended September 30, 2002 primarily due to $280,000 and $106,000 decreases,respectively, in insufficient funds charges.   Mortgage broker fees increased $667,000 and $92,000 from the nine andthree months ended September 30, 2002, respectively, due to continued refinancing activity as a result of low interest rates.Refinancing activity, however, did begin to slow during third quarter 2003, decreasing $35,000, or 3%, from second quarter 2003levels.  Other non-interest income decreased $849,000 and $486,000, or 29% and 41%, respectively, from the nine and threemonths ended September 30, 2002 primarily due to the outsourcing of the Company’s merchant card program.  Thisoutsourcing accounted for a $367,000 and $126,000 reduction in other non-interest income and a $362,000 and $97,000 decrease inother non-interest expense for the nine and three months ended September 30, 2003 over the comparable periods in 2002. Additionally, during the third quarter of 2002, other non-interest income included a $416,000 gain on sale of investmentsecurities. 

15
TABLE OFCONTENTS

*                Non-InterestExpense*.   Non-interest expense increased by $70,000, or less than 1%, to $21.2 millionfor the nine months ended September 30, 2003, from $21.1 million for the nine months ended September 30, 2002.  Non-interestexpense increased by $221,000, or 3%, to $7.3 million for the three months ended September 30, 2003, from $7.1 million for thethree months ended September 30, 2002.  These increases are largely attributable to increasing costs of employee relatedexpenses.  Although staffing levels have been reduced, mortgage broker commissions increased $382,000, or 23%, from the firstnine months of 2002 due to increased refinancing activity.  Additionally, the Company opened a de novo branch in Denver duringthe third quarter.  Total non-interest expenses through September 30, 2003 for this new branch were $382,000.  Finally,the Company settled a lawsuit during third quarter at a cost of $150,000.  The lawsuit resulted from actions taken by a formerofficer at an acquired bank prior to the Company’s acquisition of such bank.  These increases were partially offset bythe outsourcing of the merchant card program during first quarter 2003 which resulted in decreased expenses of $362,000 and $97,000during the nine and three months ended September 30, 2003, respectively.  In addition, fees paid to outside professionalsdecreased. 

                The efficiency ratio increased to93% for the quarter ended September 30, 2003 and 85% for the nine months ended September 30, 2003, from 73% for the quarter endedSeptember 30, 2002 and 74% for the nine months ended September 30, 2002.  This increase in the efficiency ratio was due to thedecline in revenue (net interest income plus non-interest income) of $1.8 million during third quarter 2003 and $3.4 million duringthe first nine months of 2003, while non-interest expenses increased by $221,000 and $70,000, respectively, during the sameperiods.  

            * Income Taxes. * The Company’s effective income tax rate (income tax expense as a percentage of pre-tax income) was28.3% and 14.8% for the nine and three months ended September 30, 2003 as compared to 34.8% and 35.9% for the nine and three monthsended September 30, 2002.  This decrease in the effective income tax rate was primarily due to an increase in tax-exemptinterest income generated from municipal securities purchased during 2003.  This tax-exempt interest income also represented agreater percentage of pre-tax income during 2003 than it did during 2002.  In addition, deferred tax expense decreased $45,000for the nine months ended September 30, 2003. 
 **Financial Condition**
            TheCompany's assets increased by $41.8 million or 8%, to $596.1 million as of September 30, 2003, from $554.3 million as of December31, 2002.

            Federalfunds sold balances increased by $44.1 million, or 88%, to $94.1 million as of September 30, 2003 from $50.0 million at December31, 2002.  Investment securities increased to $86.1 million as of September 30, 2003, compared to $62.0 million as of December31, 2002, a 39% increase.  During this period, quality loan demand decreased while deposits continued to grow, resulting inadditional funds to invest.   In response, the Company capitalized on the low interest rate environment and its wholesalefunding source to extend fixed rate financing to several customers, thereby locking in a spread.  Between December 31, 2002and September 30, 2003, FHLB borrowings increased $15.0 million, or 50%.  Additionally, during the third quarter 2003, theCompany invested excess liquidity in overnight federal funds due to volatility in the securities markets. 

            As ofSeptember 30, 2003, loans held for sale decreased $3.4 million, or 34%, from December 31, 2002.  The ending balance of loansheld for sale at any particular date is dependent on the timing of the closing and ultimate funding of these loans by the outsideinvestor.  Thus, an increase or decrease in the ending balance is primarily a function of this timing and not indicative oftrends in mortgage loan demand. 

            Grossloans decreased $18.9 million, or 6%, from December 31, 2002.   This decrease was primarily due to the soft economy andmore conservative underwriting policies.

            Premisesand equipment decreased by $152,000, or less than 1%, from $39.0 million as of December 31, 2002, to $38.9 million as of September30, 2003.  This decrease was mainly attributable to $1.7 million of depreciation and amortization expense and the transfer of$274,000 of idle assets to other assets, offset by the purchase of $1.8 million of premises and equipment primarily related toequipment upgrades, remodeling of branches, and the construction of a new branch facility in Glenwood Springs to replace an olderbuilding.   During May 2003, the Company entered into an agreement to sell one of its bank buildings and leaseback a minor portion of the space.  The sale is subject to numerous contingencies that have not yet been met.  Assumingthe contingencies are met, the transaction is expected to close before the end of 2003 and would result in a gain to theCompany.

16
TABLE OFCONTENTS

            Depositsincreased by $34.4 million, or 8%, from $428.7 million as of December 31, 2002, to $463.1 million as of September 30, 2003. The increase in deposits was largely attributable to a $22.1 million increase in public funds between December 31, 2002 andSeptember 30, 2003 as well as a focused effort to attract new certificates of deposit at lower rates.  Public funds depositsincreased during this time frame due, to some degree, to the collection of property taxes by counties. 

            Duringthird quarter 2003, the Company began offering a repurchase agreement product to its customers, primarily in the Denver market, inorder to be competitive with other banks in the area.  As of September 30, 2003, securities sold under agreements torepurchase totaled $225,000. 
**Asset Quality**
*           Provision and Allowance for Loan Losses.*  Provision expense for the nine and three months endedSeptember 30, 2003, was $414,000 and $164,000, respectively, compared to $382,000 and $0, respectively, for the nine and threemonths ended September 30, 2002.  The allowance for loan losses of $3.3 million as of September 30, 2003, decreased 12% fromthe $3.7 million level as of December 31, 2002 and represents 1.06% of total loans and 157% of non-performing loans as of September30, 2003 as compared to 1.13% and 100%, respectively at December 31, 2002.   During this same time period, average loansdecreased $24.6 million, or 7%, and non-performing loans decreased $1.6 million, or 44%.  The majority of thisreduction was achieved by completing foreclosures and subsequent sales of real estate on several large loans that were onnon-accrual, resulting in no further loss to the Company.  The $2.3 million increase from December 2002 in foreclosedproperties is primarily due to a single credit for which the Company is well secured and in the process of selling theproperty.  The Company anticipates no loss on this sale.  Accordingly, the $448,000 decrease in theallowance for loan losses from December 31, 2002 reflects the Company’s revised estimate of probable losses in the loanportfolio. 

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

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

**Allowance for Loan Losses Analysis** (in thousands)

 

Nine months ended September 30,
 
** **

**2003**

 

2002

 

** **

**(unaudited)**

 

(unaudited)

Average total loans

**$**

**328,497 **

 

362,273 

 

** **

** **

 

 

Total loans at end of period

**$**

**311,666 **

 

344,353 

 

** **

** **

 

 

Allowance at beginning of period

**$**

**3,747 **

 

4,375 

      Loans charged off

** **

**(1,023)**

 

(1,253)

      Recoveries on loans previously chargedoff

** **

**161 **

 

598 

      Provision for loan losses

** **

**414 **

 

382 

Allowance at end of period

**$**

**3,299 **

 

4,102 

     

** **

** **

 

 

Annualized net charge-offs to average loans 

** **

**0.35%**

 

0.24%

Allowance to total loans at end of period

** **

**1.06%**

 

1.19%

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TABLE OFCONTENTS

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

**Non-Performing Assets **(inthousands)

 

September 30,
 
** **

**2003**

 

2002

 

** **

**(unaudited)**

 

(unaudited)

Nonaccrual loans

**$**

**2,105**

 

6,483

Restructured loans

** **

**—**

 

—

                Total non-performingloans

** **

**2,105**

 

6,483

Foreclosed properties

** **

**2,496**

 

214

                Total non-performingassets

** **

**4,601**

 

6,697

Loans 90 days or more past due and accruing

** **

**163**

 

243

        Total risk assets

**$**

**4,764**

 

6,940

 

** **

** **

 

 

Non-performing loans to total loans

** **

**0.68%**

 

1.88%

     

** **

** **

 

 

Non-performing assets to loan related assets

** **

**1.46%**

 

1.94%

 

** **

** **

 

 

Non-performing assets to total assets

** **

**0.77%**

 

1.21%

 

** **

** **

 

 

Risk assets to loan related assets

** **

**1.52%**

 

2.01%

               The Company believes that it has adequate collateral to recover the majority ofthe balance of the nonaccrual loans.   Foreclosed properties arerecorded at the lower of cost or fair value less estimated costs to sell. All anticipated losses are recorded at the time of transfer from loans. Management is not aware of any significant adverse trends relating to its loanportfolio. 
**Liquidity**
                Liquidity is a measure of theCompany’s ability to meet its commitments and obligations with available funds. These commitments may include payingdividends to shareholders, funding new loans for borrowers, funding withdrawals by depositors, paying general and administrativeexpenses, and funding capital expenditures. Historically, the Company's primary source of funds has beencustomer deposits.  Scheduled loan repayments are a relatively stable source of funds.  Deposit inflows and unscheduledloan repayments, which are influenced by fluctuations in the general level of interest rates, returns available on otherinvestments, competition, economic conditions and other factors, are relatively volatile.  Other sources of liquidity includesale or maturity of investment securities and the ability to borrow funds.  Company borrowing may be used on a short-termbasis to compensate for reductions in other sources of funds (such as deposit inflows at less than projected levels).  Companyborrowing may also be used on a longer-term basis to support expanded lending and investing activities and to match the maturity orrepricing intervals of assets. 

                As of September 30, 2003, theCompany had cash and cash equivalents (including federal funds sold) of $111.1 million and investment securities of $86.1million.  Approximately $81.3 million, or 94%, of the Company’s investment portfolio is classified as available-for-saleand can be readily sold, however $65.2 million of this amount has been pledged to secure public fund deposits and $225,000 ofthis amount has been  sold under agreements to repurchase.  Accordingly, these pledged amountsmay not be available to meet general liquidity needs.  Based on current plans and business conditions, the Companyexpects 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 next12 months. However, there can be no assurance that the Company will not be required to seek other financing sooner or that suchfinancing, if required, will be available on terms satisfactory to the Company.

***Cash Flows***

*Net Cash from Operating Activities*

                During the nine-month periodended September 30, 2003, cash of $6.4 million was provided by operating activities consisting primarily of net income of $2.5million plus non-cash expenses of $2.5 million and net decreases in operating assets and liabilities of $1.5 million. Non-cashexpenses consisted primarily of $1.7 million of depreciation and amortization expense on premises and equipment, a $414,000 loanloss provision, $371,000 of net amortization of premiums on investment securities, $306,000 of stock compensation, and a reversalof $176,000 of deferred income tax expense.  The net decrease in operating assets and liabilities was primarily due to a $3.4million decrease in loans held for sale offset by a $728,000 increase in other assets, a $355,000 increase in interest receivable,and an $803,000 decrease in interest payable and other liabilities.

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                During the nine-month periodended September 30, 2002, cash of $9.2 million was provided by operating activities consisting primarily of net income of $4.5million plus non-cash expenses of $2.1 million and net decreases in operating assets and liabilities of $2.6 million. Non-cashexpenses consisted primarily of $1.8 million of depreciation and amortization expense on premises and equipment, $249,000 ofpremium amortization on investment securities, and a $382,000 loan loss provision, offset by $416,000 of gains on sales ofinvestment securities.  The net decrease in operating assets and liabilities was primarily due to a $2.8 million decrease inloans held for sale and a $560,000 decrease in interest receivable, offset by a $439,000 increase in other assets and a $401,000decrease in interest payable and other liabilities. 

*Net Cash from Investing Activities*

           During the nine-month period ended September 30, 2003, cash of $11.0 million wasused for investing activities.  These outflows consisted primarily of thepurchase of $76.0 million of investment securities and $1.8 million in purchasesof premises and equipment, offset by the maturity and/or calls of $35.9 millionof investment securities, $14.5 million of proceeds from the sale of investmentsecurities, a decrease in loans of $14.1 million, and $2.3 million of proceedsfrom sales of foreclosed properties.

            Duringthe nine-month period ended September 30, 2002, investing activities provided cash of $28.3 million.  These inflows consistedprimarily of a $46.2 million decrease in loans, the maturity and/or calls of $10.5 million of investment securities, the sale of$15.4 million of investment securities, $1.7 million of proceeds from sales of premises and equipment and $607,000 of proceeds fromsales of foreclosed properties.  The proceeds from sales of premises and equipment were primarily related to the sale of theprevious office building in Dillon.   These inflows were offset by the purchase of $44.2 million of investment securitiesand the purchase of $2.1 million of premises and equipment. 

*Net Cash from Financing Activities*

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

            Duringthe nine-month period ended September 30, 2002, cash of $7.9 million was used by financing activities consisting primarily of adecrease in deposits of $14.8 million, the repurchase of $1.3 million of common stock and payment of dividends on common stock of$929,000, offset by the receipt of $8.9 million of proceeds from FHLB advances. 

***Borrowings***

            WestStar is a member ofthe Federal Home Loan Bank of Topeka (FHLB) and, as a regular part of its business, obtains both short and long-term advances fromthis FHLB. Advances are collateralized primarily by FHLB stock owned by WestStar and loans secured by certain mortgages or deeds oftrust. As of September 30, 2003, the Company’s total borrowing capacity was $105.8 million of which $45.0 million ofborrowings were outstanding ($11.4 million was short-term and $33.6 million was long-term) and $24.0 million in the form ofstand-by irrevocable letters of credit issued by the FHLB were pledged as collateral for uninsured public fund deposits.

            WestStar hasestablished an unsecured, overnight federal funds line with Bankers’ Bank of the West that expires on August 31, 2004. As of September 30, 2003, this authorized borrowing line totaled $42.1 million with $0 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 millionwill be a secured line and $10.0 million will be an unsecured line.  Theselines are subject to cancellation by First Tennessee at any time upon theoccurrence of certain conditions.  As of September 30, 2003, no amountswere outstanding under the lines.

***Dividends***

           Payment of dividends is at the discretion of the Board and is determined by taking into account the earnings, capital levels, cashrequirements, and the financial condition of Vail Banks and WestStar, as well as applicable government regulations and otherrelevant factors.  On October 20, 2003, the Board declared a regular quarterly dividend of $0.07 per sharepayable on November 14, 2003 to shareholders of record on October 31, 2003. 

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***Stock Repurchase Plan***

               On October 20, 2003, the Board of Directors reauthorized the Company’s stock repurchase program. The total amount of repurchases under the program, both previously completed and allowable up to January 20, 2004, aggregateapproximately $19 million.  Since inception of the program in March 2001, the Company hasrepurchased 1,506,880 shares at an average cost of $12.06 per share.  During the first nine months of 2003, the Companyrepurchased 622,590 common shares at an average cost of $12.88. 
**Capital Resources**
                As of September 30, 2003,shareholders’ equity had decreased $6.9 million, or 10%, to $59.8 million from $66.8 million as of December 31, 2002. This decrease is primarily related to the repurchase of 622,590 shares of common stock at a cost of $8.0 million, and the paymentof common stock dividends of $1.1 million, offset by the retention of $2.5 million of earnings. 

            As ofSeptember 30, 2003 and 2002, the Company met all capital adequacy requirements to which it was subject.  As of September 30,2003, the Company had Tier 1 and Total Risk-Based Capital ratios of 12.17% and 14.09%, respectively, and a Leverage ratio of7.86%.  Regulatory guidelines permit the Company’s trust preferred securities to be included in the calculation of Tier1, Total Risk-Based capital and the Leverage Ratio, subject to certain limitations.  As of September 30, 2002, the Company hadTier 1 and Total Risk-Based Capital ratios of 13.62% and 15.15%, respectively, and a Leverage ratio of 9.90%. 

            As ofSeptember 30, 2003 and 2002, WestStar met all capital adequacy requirements to which it was subject and exceeded the minimum ratiosto be designated as “well-capitalized**.**”  As of September 30, 2003, WestStar had Tier 1 and Total Risk-BasedCapital ratios of 12.41% and 13.32%, respectively, and a Leverage ratio of 8.00%.  As of September 30, 2002, WestStar had Tier1 and Total Risk-Based Capital ratios of 12.75% and 13.83%, respectively, and a Leverage ratio of 9.26%. 
**Recent AccountingPronouncements**
               During June 2002, the FASB issued SFAS No. 146, *Accounting for Costs Associated with Exit or Disposal Activities*.  Thisstatement is effective for exit or disposal activities initiated after December 31, 2002.  These activities may include saleor termination of a line of business, the closure of business activities in a particular location, the relocation of businessactivities from one location to another, changes in management structure, and a fundamental reorganization that affects the natureand focus of operations.  The Statement addresses financial accounting and reporting for costs associated with exit ordisposal activities and requires companies to recognize liabilities associated with exit or disposal activities at the time thatthey are incurred rather than at the date of a commitment to the exit or disposal plan.  The Company adopted this standard onJanuary 1, 2003.  Adoption of this standard did not have an effect on the Company’s consolidated financial condition orresults of operations.

               During April 2003, the FASB issued SFAS No. 149, *Amendment of Statement 133 on Derivative Instruments and HedgingActivities*.  This statement amends and clarifies financial accounting and reporting for derivative instruments, includingcertain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activitiesunder SFAS No. 133, *Accounting for Derivative Instruments and Hedging Activities*.  This statement is effective forcontracts entered into or modified after June 30, 2003, except for certain circumstances, and for hedging relationships designatedafter June 30, 2003.  The Company does not utilize derivative instruments or engage in hedging activities.  Accordingly,adoption of this standard did not have an effect on the Company’s consolidated financial condition or results ofoperations.

               During May 2003, the FASB issued SFAS No. 150, *Accounting for Certain Financial Instruments with Characteristics of bothLiabilities and Equity*.  This statement establishes standards for how an issuer classifies and measures certain financialinstruments with characteristics of both liabilities and equity.  It requires that an issuer classify a financial instrumentthat is within its scope as a liability when previously it was classified as equity.  This statement is effective forfinancial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interimperiod beginning after June 15, 2003.  It is to be implemented by reporting the cumulative effect of a change in an accountingprinciple for financial instruments created before the issuance of the statement and still existing at the beginning of the interimperiod of adoption.  Restatement is not permitted.  The Company adopted this statement on July 1, 2003.  Adoption ofthis statement did not have an effect on the Company’s consolidated financial condition or results of operations.

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**Item 3.     QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK**
**Quantitative Disclosures About Market Risk**

            The table below provides information about the Company’s financialinstruments as of December 31, 2002 that are sensitive to changes in interest rates. 
 
**Principal Amount Maturing (b)in:**   
(in thousands)
 
**2003**
**2004**
**2005**
**2006**
**2007**
**Thereafter or Non-Maturing**
**Total**
**Fair ValueDecember 31, 2002**
**INTEREST RATE SENSITIVE ASSETS**         
Federal funds sold and interest earning deposits

 
$50,072   
$              -
$         -
$             -
$             -
$             -
$50,072   
$50,072   
         Weighted average interest rate
 
1.09%
0.00%
0.00%
0.00%
0.00%
0.00%
1.09% 
Adjustable-rate securities
 
-
-
-
-
2,001
26,451
28,452
28,565
         Weighted average interest rate (a)
 
0.00%
0.00%
0.00%
0.00%
3.25%
5.08%
4.95% 
Fixed-rate securities
 
851
458
5
1,119
116
26,651
29,200
29,800
         Weighted average interest rate (a)
 
5.97%
5.26%
7.00%
5.36%
6.48%
5.79%
5.77% 
Investments in bank stocks
 
-
-
-
-
-
3,703
3,703
3,703
         Weighted average interest rate
 
0.00%
0.00%
0.00%
0.00%
0.00%
4.90%
4.90% 
Loans held for sale
 
9,879
-
-
-
-
-
9,879
9,879
         Weighted average interest rate
 
5.20%
0.00%
0.00%
0.00%
0.00%
0.00%
5.20% 
Adjustable-rate loans
 
113,373
49,486
21,546
17,880
24,941
25,804
253,030
253,177
         Weighted average interest rate
 
7.19%
6.39%
6.51%
6.13%
6.79%
7.35%
6.88% 
Fixed-rate loans
 
23,911
19,501
11,212
7,472
2,875
13,002
77,973
81,246
         Weighted average interest rate
 
8.50%
8.73%
8.36%
8.23%
7.38%
7.32%
8.27%   
**Total interest rate sensitive assets**
 
**$198,086**
**$69,445**
**$32,763**
**$26,471**
**$29,933**
**$95,611**
**$452,309**
**$456,442**
**       Weighted averageinterest rate**

 
**5.71%**
**7.04%**
**7.15%**
**6.69%**
**6.61%**
**6.19%**
**6.24%**
 
**INTEREST RATE SENSITIVE LIABILITIES**

Interest-bearing checking, savings and money marketaccounts
 
$             -
$         -
$            -
$         -
$         -
$209,964   
$209,964   
$209,964   
         Weighted average interest rate

 
0.00%
0.00%
0.00%
0.00%
0.00%
0.63%
0.63% 
Fixed-rate time deposits
 
106,668
12,026
1,639
381
637
-
121,351
122,215
         Weighted average interest rate

2.55%
3.19%
3.75%
4.04%
3.42%
0.00%
2.64% 
Fixed-rate borrowings

 
9,490
8,940
5,715
5,615
240
-
30,000
31,039
         Weighted average interest rate

2.91%
3.77%
3.99%
4.46%
4.80%
0.00%
3.68% 
Trust preferred
 
-
-
-
-
-
24,000
24,000
25,208
         Weighted average interest rate

 
0.00%
0.00%
0.00%
0.00%
0.00%
10.19%
10.19%   
**Total interest rate sensitive liabilities**
 
**$116,158**
**$20,966**
**$7,354**
**$5,996**
**$877**
**$233,964**
**$385,315**
**$388,426**
**       Weighted averageinterest rate**

 
**2.58%**
**3.44%**
**3.94%**
**4.43%**
**3.80%**
**1.61%**
**2.10%**
 
(a)     These interest rates are not adjusted toreflect tax equivalent yields. (b)     The above amounts represent scheduledmaturities and do not include prepayments that may occur.
**Qualitative Disclosures About Market Risk**

            Marketrisk is the exposure to loss resulting from changes in interest rates, foreign currency exchange rates, commodity prices and equityprices. The primary market risk to which the Company is exposed is interest rate risk arising from the instruments and transactionsentered 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 rateschange. Interest-sensitive assets and liabilities are those that are subject to repricing in the near term, including both variablerate instruments and those fixed rate instruments that are approaching maturity.  For example, if fixed-rate assets are fundedwith 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.

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TABLE OFCONTENTS

           The Company’s Asset/Liability Management Committee manages interest rate risk.  The principal objective ofasset/liability management is to manage the levels of interest-sensitive assets and liabilities to minimize net interest incomefluctuations in times of fluctuating market interest rates. To effectively measure and manage interest rate risk, the Company usescomputer simulations that determine the impact on net interest income of numerous interest rate scenarios, balance sheet trends andstrategies. 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 depositgrowth and pricing, changes in funding mix, and asset and liability repricing and maturity characteristics. Simulations are rununder various interest rate scenarios to determine the impact on net income and capital. From these computer simulations, interestrate risk is quantified and appropriate strategies are developed and implemented.  As of September 30, 2003, the Company hasnever used interest rate derivative financial instruments as an asset/liability management tool to hedge mismatches in interestrate exposures.

            Duringthe first nine months of 2003, Vail Banks experienced increased liquidity, which was used in part to purchase longer-terminvestment securities.  While the liquidity position increased, the overall balance sheet restructuring increased the assetsensitive nature of the balance sheet.  Therefore, Vail Banks was more sensitive to changes in interest rates at September 30,2003 than at December 31, 2002.

            Duringthe remainder of 2003, the Company will face risk primarily from the possibility of lower interest rates. Although theCompany’s gap position is positive at September 30, 2003, due to the low level of deposit rates, the bank is more sensitiveto downward changes in rates.  If rates fall, asset yields will decline faster than the cost of interest bearing liabilities,leading to a decline in the margin. The extent of this decline will depend on the degree to which retail deposit rates changerelative to market rates. The 550 basis point reduction in short-term rates by the Federal Reserve Bank since December 2000effectively repriced a significant portion of the Company’s loan portfolio.  While it also produced an opportunity toreduce funding costs, at the current level of interest rates, further reductions in funding costs may be limited.
**Item 4.     CONTROLS ANDPROCEDURES**
            Companymanagement, including the president and chief financial officer, supervised andparticipated in an evaluation of the Company’s disclosure controls andprocedures (as defined in rules of the Securities and Exchange Commission) as ofSeptember 30, 2003.  Based on, and as of the date of, that evaluation, theCompany’s president and chief financial officer have concluded that theCompany’s disclosure controls and procedures were effective in accumulating andcommunicating information to management, including the president and chieffinancial officer, as appropriate to allow timely decisions regarding requireddisclosures of that information under the Securities and Exchange Commission’srules and forms and that the disclosure controls and procedures are designed toensure that the information required to be disclosed in reports that are filedor submitted under the Securities and Exchange Act of 1934, as amended, arerecorded, processed, summarized and reported within the time periods specifiedin 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 affectthese controls subsequent to the date of their evaluation. 
 
 

 

 

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TABLE OFCONTENTS
**PARTII        OTHER INFORMATION****Item6.     EXHIBITS AND REPORTS ON FORM 8-K.**
                    

**(a)**

**Exhibits**

 

 

 

10.1

Change in Control Severance Payment Agreement by and between Vail Banks, Inc. and Dan E.Godec, dated August 18, 2003

 
 
10.2

Change in Control Severance Payment Agreement by and between Vail Banks,Inc. and Gary S. Judd, dated August 18, 2003

 
 
31.1

Certification by Lisa M. Dillon, President of the Company, as adoptedpursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 
 
31.2

Certification by Peter G. Williston, Senior Executive Vice President andChief Financial Officer of the Company, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 
 
32.1

Certification by Lisa M. Dillon, President of the Company, pursuant to 18U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 
 
32.2

Certification by Peter G. Williston, Senior Executive Vice President andChief Financial Officer of the Company, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of theSarbanes-Oxley Act of 2002

 
   
  

**(b)**

**Reports on Form 8-K**

 
 
The Company filed a Current Report on Form 8-K dated July 22, 2003, underItem 12.  The report included a press release reporting Vail Banks’ results of operations and financial condition forthe second quarter of 2003.

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TABLE OFCONTENTS

 

**SIGNATURES**

            Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this Quarterly Report on Form 10‐Q to be signed on its behalf by theundersigned thereunto duly authorized.
 
**VAIL BANKS, INC.**
 
** **

Date:  November 7, 2003

/s/ Lisa M.Dillon                                                          Lisa M. Dillon*President*

** **

** **

** **

** **

** **

** **

Date:  November 7, 2003

/s/Peter G.Williston                                                          Peter G. Williston*Senior Executive Vice President and Chief Financial Officer*

****

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