SECURITIES AND EXCHANGE COMMISSION

                             Washington, D.C. 20549

                                    FORM 10-K

                ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
                       THE SECURITIES EXCHANGE ACT OF 1934
                   FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996
                         COMMISSION FILE NUMBER 0-11595


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


Incorporated in the State of Delaware    Employer Identification No. 03-0287342


     164 College St., Burlington, Vermont                     05401
---------------------------------------------------    ----------------------
    (Address of principal executive office)                 (Zip Code)


                   Registrants telephone number:  (802) 658-3400
             Securities registered pursuant to Section 12(b) of the Act:
                                (Not Applicable)
           Securities registered pursuant to Section 12(g) of the Act:

              Title of Class: Common Stock (Par Value $.01 a share)
                    Name of Exchange on which listed: NASDAQ

      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  [ ]

      Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's  knowledge,  in definitive proxy or information  statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.

          [X]  Contained herein      [ ]  Not contained herein

      The aggregate market value of the voting stock held by  non-affiliates  is
$60,692,385 as computed  using the average bid and asked prices of stock,  as of
February 21, 1997.

      The number of shares  outstanding for each of the registrant's  classes of
common stock, as of February 21, 1997 is:

                  Class: Common stock, par value $.01 per share
                          Outstanding: 4,427,873 shares

                       DOCUMENTS INCORPORATED BY REFERENCE

      Portions of the Annual Report to Shareholders  for the year ended December
31, 1996 are incorporated herein by reference to Parts I and II.

      Portions  of the  Proxy  Statement  to  Shareholders  for the  year  ended
December 31, 1996 are incorporated herein by reference to Part III.




TABLE OF CONTENTS                                                       Page

Independent Auditors' Report                                              2


Consolidated Balance Sheets                                               3


Consolidated Statements of Operations                                     4


Consolidated Statements of Changes in Stockholders' Equity                5


Consolidated Statements of Cash Flows                                     6


Notes to Consolidated Financial Statements                                7


Summary of Unaudited Quarterly Financial Information                      26


Five Year Selected Financial Data                                         30


Management's Discussion and Analysis of Financial Condition and
 Results of Operations                                                    31


Form 10-K                                                                 37


Signatures                                                                62




TO THE STOCKHOLDERS AND BOARD OF DIRECTORS OF
MERCHANTS BANCSHARES, INC.


We have  audited  the  accompanying  consolidated  balance  sheets of  Merchants
Bancshares,  Inc. (a Delaware  corporation)  and subsidiaries as of December 31,
1996 and 1995, and the related consolidated statements of operations, changes in
stockholders'  equity and cash  flows for each of the three  years in the period
ended  December  31,  1996.  These  consolidated  financial  statements  are the
responsibility of the Company's management.  Our responsibility is to express an
opinion on these consolidated financial statements based on our audits.

We  conducted  our  audits  in  accordance  with  generally   accepted  auditing
standards.  Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement.  An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements.  An audit also includes
assessing the  accounting  principles  used and  significant  estimates  made by
management,  as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated  financial statements referred to above present
fairly,  in  all  material   respects,   the  financial  position  of  Merchants
Bancshares,  Inc. and  subsidiaries  as of December  31, 1996 and 1995,  and the
results of their  operations and their cash flows for each of the three years in
the period ended  December 31,  1996,  in  conformity  with  generally  accepted
accounting principles.



/s/  ARTHUR ANDERSEN LLP
Boston, Massachusetts
January 16, 1997



                          Merchants Bancshares, Inc.
                          Consolidated Balance Sheets

<TABLE>
<CAPTION>

At December 31,                                                1996              1995
----------------------------------------------------------------------------------------------

<S>                                                            <C>               <C>
ASSETS:
Cash and Due from Banks (Note 1)                               $  29,726,308     $  38,366,772
Trading Securities (at market value) (Notes 1 and 2)                 500,000           500,000
Securities Available for Sale (Notes 1 and 2):
  Debt Securities                                                 57,655,914        97,943,234
  Marketable Equity Securities                                       230,017           309,508
Debt Securities Held to Maturity                                  86,903,743                 0
----------------------------------------------------------------------------------------------
      Total Investment Securities                                144,789,674        98,252,742
----------------------------------------------------------------------------------------------
Loans (Notes 1 and 3)                                            387,232,761       379,930,413
Segregated Assets (Note 3)                                                 0        69,793,604
  Reserve for Possible Loan Losses                               (15,699,791)      (16,234,481)
----------------------------------------------------------------------------------------------
      Net Loans                                                  371,532,970       433,489,536
----------------------------------------------------------------------------------------------
Federal Home Loan Bank Stock                                       2,840,500         3,174,400
Premises and Equipment, Net (Notes 1 and 4)                       13,791,388        12,454,708
Investments in Real Estate Limited Partnerships (Note 1)           2,499,095         3,141,245
Other Real Estate Owned, Net (Note 1)                              1,924,530         7,772,067
Other Assets (Notes 5 and 6)                                      14,031,569        17,896,993
----------------------------------------------------------------------------------------------
      Total Assets                                             $ 581,636,034     $ 615,048,463
==============================================================================================
LIABILITIES:
Deposits:
  Demand                                                       $  80,576,424     $  85,417,465
  Savings, NOW and Money Market Accounts                         263,881,654       278,241,601
  Time Deposits Over $100,000                                     20,369,480        20,473,321
  Other Time                                                     143,451,954       160,381,588
----------------------------------------------------------------------------------------------
      Total Deposits                                             508,279,512       544,513,975
Other Borrowed Funds (Note 7)                                      9,598,712         5,335,422
Other Liabilities (Note 5)                                        11,088,092         9,525,446
Debt (Note 8)                                                      6,419,950        15,424,757
----------------------------------------------------------------------------------------------
      Total Liabilities                                        $ 535,386,266     $ 574,799,600
----------------------------------------------------------------------------------------------

Commitments and Contingencies (Note 11)

STOCKHOLDERS' EQUITY (Note 9):
Preferred Stock
  Class  A:
    $.01 par value, non-voting Shares Authorized: 200,000
     Shares Outstanding: None                                  $           0     $           0
  Class  B:
    $.01 par value, voting Shares Authorized: 1,500,000
     Shares Outstanding: None                                              0                 0
Common Stock, $.01 par value Shares Authorized: 4,700,000
 in 1996 and 1995 Shares Issued: 4,434,620 in 1996 and 1995           44,346            44,346
Capital in Excess of Par Value                                    33,154,407        33,154,407
Retained Earnings                                                 14,844,614         8,620,881
Treasury Stock (at Cost) 144,278 Shares in 1996 and 1995          (2,037,927)       (2,037,927)
Net Unrealized Appreciation of Investment Securities
 Available for Sale, Net of Taxes                                    244,328           467,156
----------------------------------------------------------------------------------------------
      Total Stockholders' Equity                                  46,249,768        40,248,863
----------------------------------------------------------------------------------------------
      Total Liabilities and Stockholders' Equity               $ 581,636,034     $ 615,048,463
==============================================================================================
</TABLE>


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



                          Merchants Bancshares, Inc.
                    Consolidated Statements of Operations


<TABLE>
<CAPTION>

For the years ended December 31,                                  1996           1995           1994
--------------------------------------------------------------------------------------------------------------

<S>                                                                <C>            <C>            <C>
INTEREST AND DIVIDEND INCOME:
Interest and Fees on Loans                                         $ 39,953,105   $ 46,067,109   $ 48,938,668
Interest and Dividends on Investments:
  U.S. Treasury and Agency Obligations                                7,587,824      4,525,095      3,508,523
  Other                                                                 463,061        722,539        872,267
--------------------------------------------------------------------------------------------------------------
      Total Interest and Dividend Income                             48,003,990     51,314,743     53,319,458
--------------------------------------------------------------------------------------------------------------

INTEREST EXPENSE:
  Savings, NOW and Money Market Accounts                              8,216,152      9,077,337      8,419,716
  Time Deposits Over $100,000                                         1,396,197      1,432,520      1,335,775
  Other Time                                                          8,112,475      8,981,211      8,095,686
  Other Borrowed Funds                                                  344,702        256,439        495,997
  Debt                                                                  602,477      3,254,128      4,029,479
--------------------------------------------------------------------------------------------------------------
      Total Interest Expense                                         18,672,003     23,001,635     22,376,653
--------------------------------------------------------------------------------------------------------------

      Net Interest Income                                            29,331,987     28,313,108     30,942,805

Provision for Possible Loan Losses (Note 3)                           3,150,000     12,100,000     10,000,000
--------------------------------------------------------------------------------------------------------------
Net Interest Income after Provision for Possible Loan Losses         26,181,987     16,213,108     20,942,805
--------------------------------------------------------------------------------------------------------------


NON-INTEREST INCOME:
  Trust Department Income                                             1,493,275      1,796,138      1,729,376
  Service Charges on Deposits                                         3,347,128      3,183,525      3,451,507
  Merchant Discount Fees                                              1,696,387      1,861,313      2,123,526
  Gains on Sale of Investment Securities, Net (Note 2)                   33,483        351,771         72,884
  Gain on Curtailment of Pension Plan (Note 5)                                0      1,562,670              0
  FDIC Assistance Received-Loss Sharing (Note 3)                        406,595      2,950,840      6,248,802
  Other                                                               2,385,439      1,059,660      1,411,587
--------------------------------------------------------------------------------------------------------------
      Total Non-Interest Income                                       9,362,307     12,765,917     15,037,682
--------------------------------------------------------------------------------------------------------------


NON-INTEREST EXPENSES:
  Salaries and Wages                                                  8,222,050     10,728,741     10,664,411
  Employee Benefits (Note 5)                                          1,790,795      2,705,164      2,531,980
  Occupancy Expense                                                   2,054,256      2,177,612      2,324,171
  Equipment Expense                                                   2,024,248      2,068,991      2,004,352
  Losses on and Write-downs of Other Real Estate Owned                3,400,214      2,986,555      3,791,819
  Equity in Losses of Real Estate Limited Partnerships                  845,644        645,600      1,588,914
  Trust Customers' Reimbursement, Net (Note 11)                               0              0      3,246,100
  Losses and Write-downs of Segregated Assets (Note 3)                  406,595      2,950,840      6,248,802
  Reengineering Expenses and Related Consultants' Fees (Note 10)              0      4,055,510              0
  Other                                                               8,745,228      8,286,836      9,312,413
--------------------------------------------------------------------------------------------------------------
      Total Non-Interest Expenses                                    27,489,030     36,605,849     41,712,962
--------------------------------------------------------------------------------------------------------------

Income (Loss) Before Provision (Benefit) for Income Taxes             8,055,264     (7,626,824)    (5,732,475)
Provision (Benefit) for Income Taxes (Notes 1 and 6)                  1,831,531     (3,784,885)    (2,842,451)
--------------------------------------------------------------------------------------------------------------

      NET INCOME (LOSS)                                            $  6,223,733   $ (3,841,939)  $ (2,890,024)
==============================================================================================================


INCOME (LOSS) PER SHARE, based upon weighted average common 
 shares outstanding of 4,290,342 in 1996, 4,269,231 in 1995,
 and 4,230,194 in 1994 (Note 9):                                   $       1.45   $      (0.90)  $      (0.68)
==============================================================================================================
</TABLE>


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



                          Merchants Bancshares, Inc.

          Consolidated Statements of Changes in Stockholders' Equity

       For Each of the Three Years in the Period Ended December 31, 1996




<TABLE>
<CAPTION>
                                                                                Net Unrealized
                                                                                 Appreciation
                                                                               (Depreciation)
                                           Common    Capital in                 of Investment
                                           Stock      Excess of     Retained      Securities       Treasury
                                          (Note 9)    Par Value     Earnings       (Note 2)         Stock          Total
----------------------------------------------------------------------------------------------------------------------------

<S>                                       <C>       <C>           <C>            <C>             <C>            <C>
Balance, December 31, 1993                $ 42,429  $ 30,647,120  $ 15,352,844   $  (143,657)    $   (178,730)  $ 45,720,006
Net Loss                                        --            --    (2,890,024)           --               --     (2,890,024)
Change in Net Unrealized Depreciation
 of Securities Available for Sale, Net
 of Tax                                         --            --            --      (530,012)              --       (530,012)
----------------------------------------------------------------------------------------------------------------------------

Balance, December 31, 1994                $ 42,429  $ 30,647,120  $ 12,462,820   $  (673,669)    $   (178,730)  $ 42,299,970
Net Loss                                        --            --    (3,841,939)           --               --     (3,841,939)
Sale of Treasury Stock                          --       (44,598)           --            --          178,730        134,132
Purchase of Treasury Stock                      --            --            --            --       (2,037,927)    (2,037,927)
Issuance of Common Stock                     1,917     2,551,885            --            --               --      2,553,802
Change in Net Unrealized Appreciation
 (Depreciation) of Securities
 Available for Sale, Net of Tax                 --            --            --     1,140,825               --      1,140,825
----------------------------------------------------------------------------------------------------------------------------

Balance, December 31, 1995                $ 44,346  $ 33,154,407  $  8,620,881   $   467,156    $  (2,037,927)  $ 40,248,863
Net Income                                      --            --     6,223,733            --               --      6,223,733
Change in Net Unrealized Appreciation
 (Depreciation) of Securities
 Available for Sale, Net of Tax                 --            --            --      (359,309)              --       (359,309)
Change in Net Unrealized Appreciation
 of Securities Transferred to the Held
 to Maturity Portfolio, Net of Tax              --            --            --       136,481               --        136,481
----------------------------------------------------------------------------------------------------------------------------

Balance, December 31, 1996                $ 44,346  $ 33,154,407  $ 14,844,614   $   244,328    $  (2,037,927)  $ 46,249,768
============================================================================================================================
</TABLE>


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



                          Merchants Bancshares, Inc.
                    Consolidated Statements of Cash Flows


<TABLE>
<CAPTION>

For the Years Ended December 31,                                        1996             1995              1994
--------------------------------------------------------------------------------------------------------------------

<S>                                                                <C>              <C>               <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net Income (Loss)                                                  $    6,223,733   $   (3,841,939)   $   (2,890,024)
Adjustments to Reconcile Net Income (Loss) to Net Cash Provided
 by Operating Activities:
  Provision for Possible Loan Losses                                    3,150,000       12,100,000        10,000,000
  Provision for Possible Losses on Other Real Estate Owned              2,494,758        1,365,011         2,388,469
  Provision for Depreciation and Amortization                           2,667,329        4,357,768         6,685,094
  Prepaid Income Taxes                                                 (1,474,913)        (692,726)       (1,890,304)
  Net Gains on Sales of Investment Securities                             (33,483)        (351,771)          (72,884)
  Net Gains on Sales of Loans and Leases                                 (505,422)        (463,919)         (218,510)
  Net Gains on Sales of Premises and Equipment                           (565,350)        (222,895)                0
  Net Gains on Sales of Other Real Estate Owned                          (327,647)               0                 0
  Equity in Losses of Real Estate Limited Partnerships                    845,644          645,600         1,588,916
  Changes in Assets and Liabilities:
    Decrease in Interest Receivable                                       935,703        1,099,212            40,651
    Increase (Decrease) in Interest Payable                              (313,478)         170,331           347,000
    (Increase) Decrease in Other Assets                                 7,004,634        8,810,236        (3,336,601)
    Increase (Decrease) in Other Liabilities                             (723,876)       1,567,069        (1,418,975)
--------------------------------------------------------------------------------------------------------------------
       Net Cash Provided by Operating Activities                       19,377,632       24,541,977        11,222,832
--------------------------------------------------------------------------------------------------------------------

CASH FLOWS FROM INVESTING ACTIVITIES:
  Proceeds from Sales of Investment Securities Available for 
   Sale                                                                42,521,602       50,377,072           682,030
  Proceeds from Maturities of Investment Securities Available
   for Sale                                                            16,000,000       59,000,000                 0
  Proceeds from Sales of Loans and Leases                              19,575,786       35,573,702        48,911,562
  Proceeds from Sales of FHLB Stock                                       333,900        3,681,800                 0
  Proceeds from Sales of Premises and Equipment                         1,817,818          327,500            39,631
  Proceeds from Sales of Other Real Estate Owned                        6,143,639        8,377,527         5,684,332
  Purchases of FHLB Stock                                                       0                0        (1,282,500)
  Purchases of Available for Sale Investment Securities              (105,928,484)    (102,822,744)      (10,014,063)
  Purchases of Held to Maturity Investment Securities                           0                0       (10,098,437)
  Principal Repayments in Excess of (Less Than) Loans Originated       37,291,808        4,075,622        (2,272,774)
  Investments in Real Estate Limited Partnerships                        (110,727)               0          (273,742)
  Purchases of Premises and Equipment                                  (4,687,458)        (792,762)       (2,258,284)
  Decrease in Net Investment in Leveraged Leases                                0                0            41,731
--------------------------------------------------------------------------------------------------------------------
      Net Cash Provided by Investing Activities                        12,957,884        57,797,717       29,159,486
--------------------------------------------------------------------------------------------------------------------

CASH FLOWS FROM FINANCING ACTIVITIES:
  Net Decrease in Deposits                                            (36,234,463)      (37,710,409)     (37,085,500)
  Net Increase (Decrease) in Other Borrowed Funds                       4,263,290       (12,959,312)       3,370,653
  Principal Payments on Debt                                           (9,004,807)      (28,804,609)      (2,404,056)
  Acquisition of Treasury Stock                                                 0        (2,082,525)               0
  Issuance of Common Stock                                                      0         2,553,802                0
  Sale of Treasury Stock                                                        0           178,730                0
--------------------------------------------------------------------------------------------------------------------
    Net Cash Used in Financing Activities                             (40,975,980)      (78,824,323)     (36,118,903)
--------------------------------------------------------------------------------------------------------------------
Increase (Decrease) in Cash and Cash Equivalents                       (8,640,464)        3,515,371        4,263,415
Cash and Cash Equivalents at Beginning of Year                         38,366,772        34,851,401       30,587,986
--------------------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents at End of Year                           $   29,726,308   $    38,366,772   $   34,851,401
====================================================================================================================
Total Interest Payments                                            $   18,985,481   $    22,831,304   $   22,029,653
Total Income Tax Payments                                          $            0   $             0   $       50,000

Transfer of loans to Other Real Estate Owned                       $    2,814,578   $     2,777,117   $    7,899,401
Transfer of securities Available for Sale to Held to Maturity
 Portfolio                                                         $   87,508,657   $             0   $            0
</TABLE>


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



                           Merchants Bancshares, Inc.
                   Notes to Consolidated Financial Statements
                                December 31, 1996


(1)  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

The  accompanying  consolidated  financial  statements  include the  accounts of
Merchants  Bancshares,  Inc. (the "Company") and its wholly owned  subsidiaries,
Merchants Bank (the "Bank") (including its wholly owned  subsidiaries  Merchants
Trust  Company,  Queneska  Capital  Corp.  and  certain  trusts)  and  Merchants
Properties,  Inc., after elimination of all material  intercompany  accounts and
transactions.  The Bank and the  Merchants  Trust  Company offer a full range of
deposit, loan, cash management and trust services to meet the financial needs of
individual  consumers,  businesses and municipalities at 33 full-service banking
locations throughout the State of Vermont.

Use of Estimates in Preparation of Financial Statements

The preparation of financial  statements in conformity  with generally  accepted
accounting principles requires management to make estimates and assumptions that
affect  the  reported  amounts  of assets  and  liabilities  and  disclosure  of
contingent  assets and  liabilities at the date of the financial  statements and
the  reported  amounts of income and  expenses  during  the  reporting  periods.
Operating  results  in the  future  could  vary from the  amounts  derived  from
management's estimates and assumptions.

Investment Securities

The  Company  classifies  certain  of its  investments  in  debt  securities  as
held-to-maturity and measures the value of such investments at amortized cost if
the  Company has the  positive  intent and  ability to hold such  securities  to
maturity.   Investments   in  debt   securities   that  are  not  classified  as
held-to-maturity  and equity  securities  that have  readily  determinable  fair
values are classified as trading  securities or  available-for-sale  securities.
Trading  securities  are  investments  purchased  and held  principally  for the
purpose  of  selling  in  the  near  term;   available-for-sale  securities  are
investments not classified as trading or held-to-maturity.

Transfers from securities  available for sale to securities held to maturity are
recorded at the  securities'  fair values on the date of the  transfer.  Any net
unrealized  gains or losses  continue to be reported as a separate  component of
stockholders'  equity,  on a net of tax  basis  as  long as the  securities  are
carried in the held to maturity portfolio,  and are amortized over the estimated
remaining  life of the  transferred  securities  as an  adjustment to yield in a
manner consistent with the amortization of premiums and discounts.

Dividend and interest income,  including amortization of premiums and discounts,
is recorded in earnings for all categories of investment  securities.  Discounts
and  premiums  related to debt  securities  are  amortized  using a method which
approximates the level-yield  method. The gain or loss recognized on the sale of
an investment security is based upon the adjusted cost of the specific security.

Management  reviews all  reductions  in fair value below book value to determine
whether the impairment is other than temporary.  If the impairment is determined
to be other than  temporary  in nature,  the  carrying  value of the security is
written down to the appropriate level by a charge to earnings.

Loan Origination and Commitment Fees

Loan origination and commitment fees and certain direct loan  origination  costs
are deferred and  amortized  over the lives of the related  loans.  Net deferred
origination  fees were  $946,723  and  $956,333 at  December  31, 1996 and 1995,
respectively.

Premises and Equipment

Premises  and  equipment  are  stated at cost,  less  accumulated  depreciation.
Depreciation is provided using  straight-line  and accelerated  methods at rates
that  depreciate  the original  cost of the premises  and  equipment  over their
estimated useful lives.  Expenditures  for maintenance,  repairs and renewals of
minor items are generally charged to expense as incurred.

Gains and Losses on Sales of Loans

Gains and  losses on sales of loans are  recognized  based  upon the  difference
between  the selling  price and the  carrying  amount of loans  sold.  Gains and
losses are  adjusted  for excess  servicing  rights  resulting  from the sale of
certain  loans with  servicing  rights  retained.  Excess  servicing  rights are
recorded at the net present  value of estimated  future  servicing  revenue when
they are greater  than normal  servicing  fees.  Deferred  excess  servicing  is
amortized over the period of estimated net servicing  income.  Origination  fees
collected, net of commitment fees paid in connection with the sales of loans and
net of the direct cost of loan  originations,  are  recognized  at the time such
loans are sold.

Income Taxes

Deferred tax assets and  liabilities  are reflected at currently  enacted income
tax  rates  applicable  to the  period  in which  the  deferred  tax  assets  or
liabilities  are  expected to be realized or settled.  As changes in tax laws or
rates are enacted,  deferred tax assets and liabilities are adjusted through the
provision for income taxes. Low income housing tax credits are recognized in the
year in which they are earned.

Investments in Real Estate Limited Partnerships

The Bank has  investments  in various  real  estate  limited  partnerships  that
acquire,  develop,  own and operate low and moderate income housing.  The Bank's
ownership interest in these limited  partnerships  varies from 35% to 100% as of
December 31, 1996. The Bank consolidates the financial statements of the limited
partnership in which the Company is the general partner and is actively involved
in  management  and  has a  controlling  interest.  The  Bank  accounts  for its
investments in limited partnerships where the Bank does not actively participate
and have a controlling interest under the equity method of accounting.

Management  periodically  reviews the results of  operations of the various real
estate limited partnerships to determine if the partnerships generate sufficient
operating cash flow to fund their current obligations.  In addition,  management
reviews the current value of the underlying property compared to the outstanding
debt  obligations.  If it is  determined  that  the  investment  suffers  from a
permanent  impairment,  the  carrying  value is  written  down to the  estimated
realizable  value. The Bank recognized losses of $97,000 and $546,000 due to the
impairment  of an investment in a real estate  limited  partnership  in 1996 and
1994, respectively.

Cash and Cash Equivalents

Cash and cash  equivalents  consist of cash on hand,  amounts due from banks and
federal funds sold in the accompanying consolidated statements of cash flows. At
December 31, 1996 and 1995, cash and cash  equivalents  included  $4,704,000 and
$5,187,000,  respectively,  held to  satisfy  the  reserve  requirements  of the
Federal Reserve Bank.

Other Real Estate Owned

Collateral acquired through foreclosure is recorded at the lower of cost or fair
value,  less estimated  costs to sell, at the time of  acquisition.  A valuation
allowance  is  established  for the  estimated  costs to sell and is  charged to
expense.  Subsequent  changes in the fair value of other real  estate  owned are
reflected in the  valuation  allowance  and charged or credited to expense.  Net
operating  income or expense  related to  foreclosed  property  is  included  in
non-interest expense in the accompanying  consolidated statements of operations.
There  are  inherent  uncertainties  in  the  assumptions  with  respect  to the
estimated  fair  value of other real  estate  owned.  Because of these  inherent
uncertainties,  the amount  ultimately  realized on real estate owned may differ
from the amounts reflected in the consolidated  financial  statements.  The Bank
recognized  losses due to additions to the  valuation  allowance of  $2,441,547,
$1,361,000 and $2,392,000 during 1996, 1995 and 1994, respectively.

Mortgage Servicing Rights

In May 1995, the Financial  Accounting Standards Board ("FASB") issued Statement
of Financial  Accounting  Standards No. 122,  "Accounting for Mortgage Servicing
Rights",  as amended by SFAS No. 125  "Accounting for Transfers and Servicing of
Financial  Assets and  Extinguishments  of Liabilities"  ("SFAS No. 122").  This
statement  requires a banking  enterprise  that sells or  securitizes  loans and
retains the mortgage  servicing  rights, to allocate the total cost of the loans
to the  mortgage  servicing  rights and the loans based on their  relative  fair
value if it is practicable to estimate those fair values beginning on January 1,
1996. Mortgage servicing rights are recognized as a separate asset and amortized
in proportion  to, and over the period of,  estimated net servicing  income.  In
addition,  these  servicing  rights are evaluated by management  for  impairment
based on their fair value.  The adoption of this standard by the Bank on January
1,  1996  did not have a  significant  effect  on the  consolidated  results  of
operations for 1996.

Stock-based Compensation Plans

The Company applies Accounting Principles Bulletin (APB) No. 25, "Accounting for
Stock Issued to Employees"  and related  interpretations  in accounting  for its
stock-based compensation plans. Accordingly,  no accounting recognition is given
to stock  options  granted at fair market value until they are  exercised.  Upon
exercise, net proceeds, including tax benefits realized, are credited to equity.

Earnings Per Share

Earnings per share have been computed  based on the weighted  average  number of
shares  outstanding  during  the  period.  Because  the  effect of common  stock
equivalents would be immaterial, they have been excluded from the calculation of
weighted average shares.

Intangible Assets

Premiums paid for the purchase of core deposits are recorded as other assets and
amortized on a straight-line method over the estimated period of time over which
value is  realized.  Management  reviews  the value of the  intangible  asset by
comparing  purchased deposit levels to the current level of acquired deposits in
the branches  purchased.  If any significant  deposit runoff has occurred and is
determined to be permanent in nature, the asset is written down accordingly.

Accounting for Impairment of Long-Lived Assets

In March 1995 the FASB issued SFAS No. 121,  "Accounting  for the  Impairment of
Long-Lived  Assets and for Long-Lived  Assets To Be Disposed Of." This statement
requires a review for impairment of long-lived  assets and certain  identifiable
intangibles  to be  held  and  used by an  entity  when  events  or  changes  in
circumstances  indicate  that  the  carrying  amount  of the  assets  may not be
recoverable.  The Bank adopted the  statement,  which did not have a significant
effect on earnings,  on January 1, 1996. If the sum of the  undiscounted  future
cash flows expected to result from the use and eventual disposition of the asset
is less than the carrying amount of the asset, an impairment loss is recognized.
Measurement  of the  impairment  loss is  determined  by comparing  the carrying
amount of the  asset to its fair  value.  For  certain  long-lived  assets to be
disposed of, the cost to sell the asset is deducted  from the asset's fair value
in  determining  the  impairment  loss, if any. This statement does not apply to
financial  instruments,  core deposit intangibles,  mortgage and other servicing
rights, or deferred tax assets.

Reclassification

Certain  amounts in 1994 and 1995  consolidated  financial  statements have been
reclassified to be consistent with the 1996 presentation.


(2)  INVESTMENT SECURITIES

Investments in debt securities are classified as trading,  available for sale or
held to maturity as of December 31, 1996 and 1995.  The amortized  cost and fair
values  of the debt  securities  classified  as  available  for sale and held to
maturity as of December 31, 1996 and 1995 are as follows:


SECURITIES AVAILABLE FOR SALE:

<TABLE>
<CAPTION>
                                                    Gross         Gross
                                   Amortized      Unrealized    Unrealized       Fair
                                     Cost           Gains         Losses         Value
------------------------------------------------------------------------------------------

<S>                               <C>              <C>           <C>           <C>
1996
  U.S. Treasury Obligations       $18,146,244      $ 13,607      $ 35,993      $18,123,858
  U.S. Agency Obligations          23,098,045       177,893             0       23,275,938
  Mortgage-backed Securities       16,218,220        97,434        59,536       16,256,118
                                  --------------------------------------------------------
                                  $57,462,509      $288,934      $ 95,529      $57,655,914
                                  ========================================================


<CAPTION>

                                                    Gross         Gross
                                   Amortized      Unrealized    Unrealized       Fair
                                     Cost           Gains         Losses         Value
    --------------------------------------------------------------------------------------

<S>                               <C>              <C>           <C>           <C>
1995
  U.S. Treasury Obligations       $49,644,093      $219,355      $ 11,835      $49,851,613
  Mortgage-backed Securities       47,561,580       592,975        62,934       48,091,621
                                  --------------------------------------------------------
                                  $97,205,673      $812,330      $ 74,769      $97,943,234
                                  ========================================================
</TABLE>

SECURITIES HELD TO MATURITY:

<TABLE>
<CAPTION>
                                                    Gross         Gross
                                   Amortized      Unrealized    Unrealized       Fair
                                     Cost           Gains         Losses         Value
    --------------------------------------------------------------------------------------

<C>                               <C>              <C>           <C>           <C>
1996
  U.S. Agency Securities          $ 2,502,922      $      0      $ 51,360      $ 2,451,562
  Mortgage-backed Securities       84,400,821        22,852       870,928       83,552,745
                                  --------------------------------------------------------
                                  $86,903,743      $ 22,852      $922,288      $86,004,307
                                  ========================================================
</TABLE>

There were no securities classified as held to maturity as of December 31, 1995.

Marketable  equity  securities  are classified as available for sale at December
31, 1996 and 1995 and are stated at their fair value of $230,017  and  $309,508,
respectively.  Gross  unrealized  losses on equity  securities  were  $30,000 at
December 31, 1996 and 1995.

The fair value of securities  held for trading was $500,000 at December 31, 1996
and 1995.  There were no unrealized  gains or losses related to securities  held
for trading at December 31, 1996 or 1995.

The  contractual  maturities  of all debt  securities  held at December 31, 1996
(except for  mortgage-backed  securities  which are presented based on estimated
duration) are as follows:

<TABLE>
<CAPTION>
                                                Amortized           Fair
                                                   Cost             Value
    ------------------------------------------------------------------------

<S>                                            <C>              <C>
U.S. Treasuries and Agencies:
  Due in one year or less                      $  9,246,769     $  9,236,826
  Due after one year through five years          34,500,442       34,614,532
Mortgage-backed securities:
  Due within five years                          40,878,015       40,752,944
  Due after five years through ten years         28,395,010       28,099,961
  Due after ten years                            31,346,011       30,955,958
                                               -----------------------------
                                               $144,366,247     $143,660,221
                                               =============================
</TABLE>

Proceeds from sales of available for sale debt securities,  including  principal
repayments on  mortgage-backed  securities,  were  $42,521,602  and  $50,377,072
during  1996 and 1995,  respectively.  Gross  gains of  $119,486,  $659,994  and
$91,780 and gross losses of $86,003,  $308,223 and $18,896,  were  realized from
sales of debt and equity securities in 1996, 1995 and 1994, respectively.

On  November  29,  1996,  $87,508,657  of  securities  available  for sale  were
transferred to the held to maturity portfolio.  Net unrealized gains of $202,462
associated with these securities are being amortized over the remaining lives of
the individual securities.

At December 31, 1996,  securities with a face value of $20,819,868  were pledged
to secure federal funds lines, public deposits, securities sold under agreements
to repurchase and for other purposes required by law.


(3)  LOANS

The  composition of the loan portfolio at December 31, 1996 and 1995  (including
Segregated Assets in 1995) is as follows:

<TABLE>
<CAPTION>

                                                        1996                 1995
--------------------------------------------------------------------------------------

<S>                                                 <C>                   <C>
Commercial, Financial and Agricultural              $ 61,091,132          $ 76,925,602
Real Estate - Commercial                             182,199,150           207,235,189
Real Estate - Residential                            128,576,970           148,611,053
Installment Loans to Individuals                      14,831,421            16,559,626
All Other Loans (including overdrafts)                   534,088               392,547
--------------------------------------------------------------------------------------
                                                    $387,232,761          $449,724,017
======================================================================================
</TABLE>

In connection with an acquisition,  the Bank received financial assistance (loss
sharing) with respect to certain  acquired  loans charged off by the Bank during
the three-year  period ended June 30, 1996.  The FDIC  reimbursed the Bank, on a
quarterly  basis,  80% of net charge-offs and certain  expenses related to loans
subject  to  loss  sharing  aggregating  $41.1  million.   Charge-offs,  net  of
recoveries, and eligible expenses on Segregated Assets aggregated $2,210,845 and
$3,688,550  for 1996  and  1995.  The Bank  received  $406,595,  $2,950,840  and
$6,248,802  from  the FDIC  for  eligible  charge-offs,  net of  recoveries  and
eligible expenses,  related to 1996, 1995 and 1994, respectively,  in accordance
with the loss  sharing  arrangement.  Prior to June  30,  1996,  acquired  loans
subject to loss sharing were classified as Segregated Assets in the accompanying
consolidated  balance sheet.  After June 30, 1996,  acquired loans are no longer
subject to loss sharing and are no longer classified as Segregated  Assets.  The
composition  of the  Segregated  Assets  portfolio  at  December  31, 1995 is as
follows:

<TABLE>

      <S>                                                 <C>
      ---------------------------------------------------------------
      Commercial, Financial and Agricultural              $11,793,297
      Real Estate - Commercial                             28,625,693
      Real Estate - Residential                            29,352,150
      Installment Loans to Individuals                         22,464
      ---------------------------------------------------------------
                                                          $69,793,604
      ===============================================================
</TABLE>

There has been an insignificant  effect on the Bank's  noninterest  expenses for
1996,  1995 and 1994 as a result of  expenses  and  charge-offs  relating to the
Segregated  Assets.  The  Bank's  share of the  charge-offs  was  charged to the
allowance for losses on the Segregated  Assets (such allowance being a component
of the Bank's  overall  allowance for loan  losses),  which was  established  in
conjunction  with the  acquisition.  Any  future  losses on these  loans will be
charged  to the Bank's  allowance  for loan  losses.  The Bank  continues  to be
obligated to compensate  the FDIC for a portion of recoveries  received  through
June,  1998 on  loans  previously  charged  off and on which  the Bank  received
reimbursement from the FDIC.

The Company  originates  primarily  residential and commercial real estate loans
and a lesser amount of commercial and installment loans to customers  throughout
the state of Vermont.  In order to minimize its  interest  rate and credit risk,
the Company  sells  certain  residential  loans to the  secondary  market and to
financial  investors  such as insurance  companies  and pension funds located in
other states. There were no loans held for sale at December 31, 1996; loans held
for sale at December 31, 1995 aggregated  $7,985,000.  Substantially  all of the
Company's  loan  portfolio is based in the state of Vermont.  There are no known
significant  industry  concentrations in the loan portfolio.  Loans serviced for
others at December 31, 1996 and 1995 amounted to $313,063,620 and  $322,292,294,
respectively.

The reserve for possible  loan losses is based on  management's  estimate of the
amount  required  to  reflect  the  risks  in  the  loan  portfolio,   based  on
circumstances  and conditions known or anticipated at each reporting date. There
are inherent  uncertainties  with respect to the final outcome of certain of the
Bank's loans and nonperforming assets. Because of these inherent  uncertainties,
actual  losses may  differ  from the  amounts  reflected  in these  consolidated
financial  statements.  Factors  considered  in  evaluating  the adequacy of the
reserve include previous loss experience,  current economic conditions and their
effect on the  borrowers,  the  performance  of individual  loans in relation to
contract terms and estimated fair values of properties to be foreclosed.  Losses
are charged  against the reserve for loan losses when  management  believes that
the collectibility of principal is doubtful.

Key  elements  of the  above  estimates,  including  those  used in  independent
appraisals, are dependent upon the economic conditions prevailing at the time of
the  estimates.  Accordingly,  uncertainty  exists  as to the final  outcome  of
certain  of  the   valuation   judgments  as  a  result  of  the  difficult  and
unpredictable  conditions  in the  region.  The  inherent  uncertainties  in the
assumptions relative to the projected sales prices or rental rates may result in
the ultimate realization of amounts on certain loans that are different from the
amounts reflected in these consolidated financial statements.

An analysis of the reserve for possible loan losses for the years ended December
31, 1996 and 1995 is as follows:

<TABLE>
<CAPTION>

                                                  1996           1995
-------------------------------------------------------------------------

<S>                                            <C>            <C>
Balance, Beginning of Year                     $16,234,481    $19,928,817
Provision for Possible Loan Losses               3,150,000     12,100,000
Loans Charged Off                               (5,135,150)   (18,360,790)
Recoveries                                       1,450,460      2,566,454
-------------------------------------------------------------------------
Balance, End of Year                           $15,699,791    $16,234,481
=========================================================================
</TABLE>

Loans charged off include $157,620 and $749,103 and recoveries  include $247,472
and $145,380  related to the Bank's  portion of  charge-offs  and  recoveries on
Segregated Assets for 1996 and 1995, respectively.

Effective  January 1, 1995,  the Company  adopted SFAS No. 114,  "Accounting  by
Creditors  for  Impairment  of a Loan,"  as  amended.  Under the  standard,  the
allowance  for  possible  loan losses  related to loans that are  identified  as
impaired is based on discounted cash flows using the loan's  effective  interest
rate or the fair value of the collateral for certain collateral dependent loans.
The Company has determined  that  commercial  and  commercial  real estate loans
recognized by the Company as  nonaccrual,  loans past due over 90 days and still
accruing, restructured troubled debt and certain internally classified loans are
generally equivalent to "impaired loans."

Total impaired loans at December 31, 1996 and 1995 with a related allowance were
$8,442,892 and $29,629,572,  respectively, and the specific allowance associated
with such loans was $875,000 and $2,724,371,  respectively. Interest payments on
impaired loans are generally  recorded as principal  reductions if the remaining
loan  balance is not  expected  to be paid in full.  If full  collection  of the
remaining loan balance is expected,  payments are recognized as interest  income
on a cash basis.  During 1996 and 1995 the Company  recorded  interest income on
impaired loans of approximately $505,000 and $949,000, respectively. The average
balance of impaired loans was $16,439,760 in 1996 and $35,280,318 in 1995.

Nonperforming assets at December 31, 1996 and 1995 were as follows:

<TABLE>
<CAPTION>
                                                             1996                    1995
                                                          ----------   --------------------------------------
                                                                                        Segregated
                                                            Total        Loans        Assets     Total
-------------------------------------------------------------------------------------------------------------

<S>                                                       <C>          <C>           <C>          <C>
Nonaccrual loans                                          $4,091,058   $19,580,747   $6,035,520   $25,616,267
Restructured Loans                                         2,403,344     1,364,018       65,756     1,429,774
Loans Past Due 90 Days or More and Still Accruing            216,537       236,817            0       236,817
-------------------------------------------------------------------------------------------------------------
Total Nonperforming Loans                                 $6,710,939   $21,181,582   $6,101,276   $27,282,858
Other Real Estate Owned, Net                               1,924,530     7,224,395      547,672     7,772,067
-------------------------------------------------------------------------------------------------------------
Total Nonperforming Assets                                $8,635,469   $28,405,977   $6,648,948   $35,054,925
=============================================================================================================
</TABLE>

Included in  nonaccrual  loans are $14,520 and  $8,362,454  of loans whose terms
have been substantially modified in troubled restructurings at December 31, 1996
and 1995, respectively.  Additionally, the Bank had $2,403,344 and $1,429,774 of
restructured  loans  that  were  performing  in  accordance  with  the  modified
agreement at December 31, 1996 and 1995,  respectively.  Other Real Estate Owned
is shown net of valuation  reserves of $2,716,789 and $2,430,301 at December 31,
1996 and 1995.

The  Bank's  policy is to  discontinue  the  accrual  of  interest  and  reverse
uncollected   interest  receivable  on  loans  when  scheduled  payments  become
contractually  past due in excess of 90 days or, in the judgment of  management,
the ultimate collectibility of principal or interest becomes doubtful.

The amount of interest which was not earned but which would have been earned had
the  nonaccrual  and  restructured  loans  performed  in  accordance  with their
original  terms and  conditions  was  approximately  $1,493,000,  $3,466,000 and
$1,859,000 in 1996, 1995 and 1994, respectively.

During 1996, the Bank consummated three  transactions  involving sales of loans,
including certain loans classified as impaired.  The aggregate net book value of
loans sold was approximately $13,224,000,  resulting in a total loss on sales of
$556,000,  which was charged  against the  allowance  for possible  loan losses.
These loans were sold without recourse.

An analysis of loans in excess of $60,000 to directors  and  executive  officers
for the year ended December 31, 1996 is as follows:

<TABLE>

          <S>                                       <C>
          Balance, December 31, 1995                $12,574,659
          Additions                                     273,791
          Repayments                                 (1,007,507)
                                                    -----------
          Balance, December 31, 1996                $11,840,943
                                                    ===========
</TABLE>

It is the  policy  of the Bank to grant  such  loans on  substantially  the same
terms,  including  interest  rates  and  collateral,  as  those  prevailing  for
comparable lending transactions with other persons.


(4)  PREMISES AND EQUIPMENT

The  components  of  premises  and  equipment   included  in  the   accompanying
consolidated balance sheets are as follows:

<TABLE>
<CAPTION>

                                                            1996           1995
----------------------------------------------------------------------------------

<S>                                                     <C>            <C>
Land and Buildings                                      $12,139,121    $14,461,616
Leasehold Improvements                                      962,493        867,775
Furniture and Equipment                                  13,860,467     11,373,256
----------------------------------------------------------------------------------
                                                         26,962,081     26,702,647
Less:  Accumulated Depreciation and Amortization         13,237,283     14,247,939
----------------------------------------------------------------------------------
                                                        $13,724,798    $12,454,708
==================================================================================
</TABLE>

Depreciation  and amortization  expense  amounted to $1,679,057,  $1,932,074 and
$1,786,213 in 1996, 1995 and 1994, respectively.

The Bank leases certain  properties for branch  purposes.  Rent expense on these
properties totaled $240,075,  $213,096 and $214,891 for the years ended December
31,  1996,  1995 and  1994,  respectively.  Minimum  lease  payments  for  these
properties subsequent to December 31, 1996 are as follows: 1997 - $235,667; 1998
- $217,663;  1999 -  $220,176;  2000 - $222,764;  2001 - $225,430  and  $156,079
thereafter.

During 1996, the Bank began a capital  improvement project to upgrade its branch
facilities and to make further investments in technology.  At December 31, 1996,
approximately  $4,100,000 has been  capitalized and will be depreciated over the
estimated  useful lives of the individual  improvements  once they are placed in
service.  Additionally,  the Bank retired  assets with a total net book value of
$601,582 in conjunction  with these  projects,  which amount was charged against
current earnings.


(5)  EMPLOYEE BENEFIT PLANS

Pension Plan

Prior to January 1995, the Company maintained a noncontributory  defined benefit
plan covering all eligible employees. The plan was a final average pay plan with
benefits based on the average salary rates over the five  consecutive plan years
out of the last ten consecutive plan years that produce the highest average.  It
was the Company's policy to fund the cost of benefits  expected to accrue during
the  year  plus   amortization  of  any  unfunded  accrued  liability  that  had
accumulated  prior to the valuation date based on IRS  regulations  for funding.
During  1994,  the Company  made the  decision to freeze the plan  beginning  on
January 1, 1995. During 1995, the plan was curtailed.  Accordingly,  all accrued
benefits  were fully  vested and no  additional  years of service or age will be
accrued.  As a result  of the  curtailment,  the Bank  recognized  a gain in the
amount of $1.56 million in 1995.

The plan's funded status and amounts recognized in the accompanying consolidated
balance sheets and statements of operations as of December 31, 1996 and 1995 are
as follows:

<TABLE>
<CAPTION>
                                                                  1996          1995
---------------------------------------------------------------------------------------
<S>                                                            <C>           <C>

Actuarial Present Value of Benefit Obligation:
  Vested Benefit Obligation                                    $5,180,459    $5,771,869
---------------------------------------------------------------------------------------
Accumulated Benefit Obligation                                  5,180,459     5,771,869
---------------------------------------------------------------------------------------
Projected Benefit Obligation For Service Rendered
 Through December 31, 1994                                      5,180,459     5,771,869
Plan Assets                                                     6,778,159     6,835,057
---------------------------------------------------------------------------------------
Excess of Plan Assets Over Projected Benefit Obligation         1,597,700     1,063,188
Unrecognized Net Asset at January 1, 1987 Being Amortized
 over 13.4 Years                                                  (98,424)     (132,513)
Unrecognized Net Loss (Gain)                                     (368,941)       34,114
---------------------------------------------------------------------------------------
  Prepaid Pension Costs Included In Other Assets               $1,130,335    $  964,789
=======================================================================================
</TABLE>

<TABLE>
<CAPTION>

---------------------------------------------------------------------------------------------
                                                              1996         1995         1994
----------------------------------------------------------------------------------------------

<S>                                                         <C>          <C>          <C>
Net Pension Expense (Income) Included the Following
 Components:
  Service Cost - Earned During the Year                     $       0    $       0    $316,681
  Interest Cost on Projected Benefit Obligation               402,161      393,901     486,993
  Actual Return on Plan Assets                               (691,781)    (815,566)    100,004
  Net Amortization and Deferral                               119,074      172,099    (660,098)
----------------------------------------------------------------------------------------------
       Total                                                $(170,546)   $(249,566)   $243,580
==============================================================================================
</TABLE>

The actuarial present value of the projected  benefit  obligation was determined
using a weighted average discount rate of 7.6%, 7.5% and 8.5% as of December 31,
1996, 1995 and 1994,  respectively.  For 1996 and 1995 there was no assumed rate
of increase in future compensation due to the freeze on plan benefits.  The rate
of increase of future  compensation levels for 1994 (prior to the curtailment of
the plan) was 4% for the period 1994-1995,  4.5% for the period 1996-1997 and 5%
thereafter.  The expected long-term rate of return on assets used was 9% in 1996
and 8% in 1995 and 1994.

Employee Stock Ownership Plan/ 401(k) Plan

Under the terms of the Company's Employee Stock Ownership Plan (ESOP),  eligible
employees  are entitled to  contribute  up to 15% of their  compensation  to the
ESOP, and the Company contributes a percentage of the amounts contributed by the
employees,  as  authorized  by the  Company's  Board of  Directors.  The Company
contributed   approximately  120%  and  127%,   respectively,   of  the  amounts
contributed  by  the  employees  (200%  of up to  4.5%  of  individual  employee
compensation  in 1995) in 1996 and  1995 and  approximately  75% of the  amounts
contributed by employees (82% of up to 4.5% of individual employee compensation)
in 1994.  Substantially  all  contributions to the ESOP are funded with cash and
are used to purchase the Company's common stock.

Deferred Compensation Plans

Through December 1995, the Bank maintained an Executive Salary Continuation Plan
and a Deferred  Compensation Plan for Directors.  In December 1995, the Bank and
participants in its Executive Salary  Continuation  Plan and in the Fixed Growth
Program  of its  Deferred  Compensation  Plan for  Directors  agreed to amend or
terminate the existing plans.  In  satisfaction  of all liabilities  under those
plans,  the Bank agreed to make  payments to, or credits for, the  participants.
Pursuant to these  agreements,  the Bank established  several new plans (the New
Plans),  to which it made lump sum payments.  The New Plans used those payments,
in part,  to purchase  newly  issued  common  stock of the Company at its market
price.  The purchases have been accounted for as treasury stock  transactions in
the Company's  consolidated  financial statements.  The portions of the payments
made to the New Plans that were not  invested in the common stock of the Company
are included as investments  in the  consolidated  financial  statements and are
classified as trading.  In conjunction with the amendment and termination of the
existing  plans,  the Bank either sold or  surrendered  certain  life  insurance
policies and used the proceeds as a partial source to fund the lump sum payments
made to the New Plans.  As a result of these  transactions,  the Bank recognized
increased  earnings of $673,000 in 1995.  To the extent the  obligations  of the
Company under the New Plans are based on  investments  by the New Plans in other
than shares of the Company,  the investments  will be revalued at each reporting
date with a corresponding  adjustment to compensation expense. In addition,  the
obligation  related  to  certain  treasury  shares,   originally  purchased  for
$200,000,  will  be  revalued  at  each  reporting  date,  with a  corresponding
adjustment to compensation expense.

The Company  continues to maintain the floating growth (savings)  program of the
deferred  compensation  plan  for  Directors.   Benefits  accrue  based  on  the
Directors' fees deferred and a monthly  allowance for interest at a rate that is
fixed  from  time to time at the  discretion  of the  Board  of  Directors.  The
benefits  under  the  Savings  Program  of the  Deferred  Compensation  Plan for
Directors  and the New Plans are  generally  payable  starting  on the January 2
following  a  participant's   65th  birthday  or  earlier  death,  and  will  be
distributed  to  the  participant  (or  upon  the  participant's  death,  to the
participant's designated beneficiary) in accordance with the Plan.

Phantom Stock Plan

The Company maintained a Phantom Stock Plan, wherein certain key officers of the
Bank were entitled to receive an annual award of phantom  shares of stock for up
to five  consecutive  years.  All such awards were granted by June 30, 1993.  In
December 1995, the Bank entered into agreements with certain participants in the
Bank's  Phantom  Stock  Plan  (the  Plan).  The Bank  agreed  to pay,  and those
participants  agreed to accept,  lump sum  amounts in full  satisfaction  of the
Bank's obligations under the Plan.

A summary of expenses  relating to the Company's  various employee benefit plans
for each of the three years in the period ended December 31, 1996 is as follows:

<TABLE>
<CAPTION>

                                                    1996         1995        1994
-----------------------------------------------------------------------------------

<S>                                              <C>          <C>         <C>
Pension Plan                                     $(144,000)   $(249,566)   $243,580
Employee Stock Ownership Plan/401(k) Plan          653,017      807,605     348,468
Deferred Compensation Plans                         26,629       25,185     303,939
Phantom Stock Plan                                 (15,542)      67,677    (179,227)
-----------------------------------------------------------------------------------
Total                                             $520,104     $650,901    $716,760
===================================================================================
</TABLE>

Stock-Based Compensation Plan

In  October,  1995 the FASB issued  SFAS No.  123,  "Accounting  for Stock Based
Compensation"  which  establishes  a fair  value  based  method  of  recognizing
stock-based  compensation expense. As permitted by SFAS No. 123, the Company has
elected  to  continue  to  apply  APB No.  25 to  account  for  its  stock-based
compensation  plans.  Had  compensation  cost for  awards  under  the  Company's
stock-based  compensation  plans been determined  consistent with the method set
forth under SFAS No. 123,  the effect on the  Company's  net income and earnings
per share would have been as follows:

<TABLE>
<CAPTION>
                                          1996                       1995
                                -----------------------    ---------------------------
                                As Reported   Pro Forma    As Reported    Pro Forma
                                -----------   ---------    -----------    ------------

<S>                             <C>           <C>          <C>            <C>
Net Income (Loss):              $6,223,733    $6,062,733   $(3,841,939)   $(3,911,032)
Earnings (Loss) per share:           $1.45         $1.41        $(0.90)        $(0.92)
</TABLE>

Because the method  prescribed  by SFAS No. 123 has not been  applied to options
granted prior to January 1, 1995, the resulting pro forma  compensation  expense
may not be  representative  of the amount to be  expected in future  years.  Pro
forma  compensation  expense for options  granted is reflected  over the vesting
period;  therefore,  future  pro forma  compensation  expense  may be greater as
additional  options are  granted.  Compensation  expense for options  granted is
reflected over the vesting period; therefore, future compensation expense may be
greater as additional options are granted.

The Company  has granted  stock  options to certain key  employees.  The options
granted  vest  after two years and are  immediately  exercisable  upon  vesting.
Nonqualified  stock  options  may be  granted  at any  price  determined  by the
Compensation  Committee of the Board of  Directors.  All stock options have been
granted at fair market value at the date of grant.

The fair value of each  option  grant is  estimated  on the grant date using the
Black-Scholes   option-pricing   model  with  the   following   weighted-average
assumptions:

          Risk-free interest rate:                     6.00%
          Expected life of options:                   4 Years
          Expected volatility of stock:                31.4%

The Black-Scholes  option-pricing  model was developed for use in estimating the
fair value of traded  options  that have no vesting  restrictions  and are fully
transferable.  In addition,  option-pricing  models  require the input of highly
subjective  assumptions.  Because the  Company's  employee  stock  options  have
characteristics  significantly  different  from  those of  traded  options,  and
because changes in the subjective  input  assumptions can materially  affect the
fair  value  estimate,  in  management's  opinion,  the  existing  models do not
necessarily  provide a reliable single measure of the fair value of its employee
stock options.

Stock Option Plan Activity

     A summary of the Company's stock option activity is as follows:

<TABLE>
<CAPTION>
                                                   1996                 1995                 1994
-------------------------------------------------------------------------------------------------------
                                                     Weighted             Weighted               Option
                                            Number    Average    Number    Average     Number    Price
                                              Of     Exercise      of     Exercise       of       per
                                            Shares    Price      Shares    Price       Shares    Share
                                            -----------------------------------------------------------
                                                      (In thousands, except per share amounts)

<S>                                           <C>     <C>          <C>     <C>           <C>     <C>
Options outstanding, beginning Of year        40      $11.72       20      $11.00        --
Granted                                       10      $15.38       20      $12.44        20      $11.00
Exercised                                     --        --         --        --          --        --
-------------------------------------------------------------------------------------------------------
Options outstanding, end of year              50      $12.45       40      $11.72        20      $11.00
Options exercisable                           20      $11.00       --                    --
Weighted average fair value per option
 of options granted during year                       $ 6.83               $ 6.72
</TABLE>

As of December 31, 1996, the exercisable options outstanding were exercisable at
a price of $11.00 and had a weighted-average  remaining  contractual life of 4.8
years.


(6)  INCOME TAXES

The  provision  (benefit)  for income  taxes for each of the three  years in the
period ended December 31, 1996 consists of the following:

<TABLE>
<CAPTION>
                                1996          1995            1994
-----------------------------------------------------------------------

<S>                          <C>           <C>             <C>
Current                      $3,306,444    $(3,092,159)    $  (952,147)
Prepaid                      (1,474,913)      (692,726)     (1,890,304)
-----------------------------------------------------------------------
                             $1,831,531    $(3,784,885)    $(2,842,451)
-----------------------------------------------------------------------
</TABLE>

Prepaid and deferred  income taxes  result from  differences  between the income
(loss) for  financial  reporting  and tax  reporting  relating  primarily to the
provision  for  possible  loan losses.  The net  deferred tax asset  amounted to
approximately   $5,390,000  and  $3,793,000  at  December  31,  1996  and  1995,
respectively.  This tax asset is  included in other  assets in the  accompanying
consolidated balance sheets.

The  components  of the net  deferred tax asset as of December 31, 1996 and 1995
are as follows:

<TABLE>
<CAPTION>

                                         1996          1995
-----------------------------------------------------------------

<S>                                      <C>           <C>
Reserve for Possible Loan Losses         $6,261,000    $6,780,000
Deferred Compensation                     1,278,000     1,428,000
Unrealized Securities Gains                (129,000)     (251,000)
Loan Fees                                   191,000       193,000
Depreciation                               (481,000)     (393,000)
Accrued Liabilities                         291,000       524,000
Capital Loss Carryforwards                  937,000       431,000
Investments in Limited Partnerships        (668,000)     (542,000)
Excess Servicing Right                      (43,000)       (8,000)
Loan Market Adjustment                   (3,368,000)   (8,630,000)
Other                                    (1,526,000)     (706,000)
Tax Credit Carryforward                   3,150,000     3,276,000
NOL Carryforward                                  0     1,752,000
Core Deposit  Intangible                    434,000       370,000
-----------------------------------------------------------------
                                          6,327,000     4,224,000
Valuation Allowance                        (937,000)     (431,000)
-----------------------------------------------------------------
                                         $5,390,000    $3,793,000
=================================================================
</TABLE>

A  valuation  allowance  is  provided  when it is more likely than not that some
portion  of the net  prepaid  tax  asset  will  not be  realized.  The  Bank has
established  a valuation  allowance  for capital loss  carryforwards  since such
losses may only be utilized against future capital gains.

The following is a reconciliation of the federal income tax provision (benefit),
calculated at the statutory rate, to the recorded provision (benefit) for income
taxes:

<TABLE>
<CAPTION>
                                                            1996          1995           1994
--------------------------------------------------------------------------------------------------

<S>                                                      <C>           <C>            <C>
Applicable Statutory Federal Income Tax (Benefit)        $2,738,790    $(2,593,120)   $(1,949,042)
(Reduction) Increase in Taxes Resulting From:
  Loss on Investment Securities                              27,200       (114,226)       (24,780)
Tax-exempt Income                                           (73,953)       (86,879)      (187,301)
Tax Credits                                                (980,487)      (851,250)      (707,750)
Other, Net                                                  119,981       (139,410)        26,422
-------------------------------------------------------------------------------------------------
                                                         $1,831,531    $(3,784,885)   $(2,842,451)
=================================================================================================
</TABLE>

The state of Vermont  assesses a franchise  tax for banks in lieu of income tax.
The  franchise tax is assessed  based on deposits and amounted to  approximately
$255,000,  $277,000, and $290,000 in 1996, 1995, and 1994,  respectively.  These
amounts  are  included  in  other  expenses  in  the  accompanying  consolidated
statements of operations.  The Company  received  refunds of its 1995, 1994, and
1993 Vermont Franchise Taxes of $271,643, $284,738, and $240,332,  respectively,
during 1996.

(7)  OTHER BORROWED FUNDS

Other borrowed funds consist of the following at December 31, 1996 and 1995:

<TABLE>
<CAPTION>
                                                     1996         1995
                   ------------------------------------------------------

                   <S>                            <C>          <C>
                   Treasury Tax and Loan Notes    $3,598,712   $2,085,422
                   Federal Funds Purchased                 0    3,250,000
                   Short Term Borrowing            6,000,000            0
                   ------------------------------------------------------
                                                  $9,598,712   $5,335,422
                   ======================================================
</TABLE>

As of December 31, 1996,  the Bank may borrow up to $18,000,000 in federal funds
on  an  unsecured  basis.  The  following  table  provides  certain  information
regarding  other  borrowed  funds for the two years ended  December 31, 1996 and
1995:

<TABLE>
<CAPTION>
                                                                  Weighted
                                       Maximum                     Average    Weighted
                                      Month-End       Average      Annual    Average Rate
                                        Amount         Amount     Interest   on Amounts
           1996                      Outstanding    Outstanding     Rate     Outstanding
-----------------------------------------------------------------------------------------

<S>                                  <C>            <C>             <C>          <C>
Treasury Tax and Loan Notes          $ 4,571,734    $2,134,406      5.06%        5.37%
Federal Funds Purchased               11,500,000       703,419      4.59%          --
Short Term  Borrowing                 11,500,000       773,770      5.46%        5.90%
Repurchase Agreements                  7,660,000     2,365,722      5.79%          --

<CAPTION>
          1995
-----------------------------------------------------------------------------------------

<S>                                  <C>            <C>             <C>          <C>
Treasury Tax and Loan Notes          $ 4,957,123    $3,083,449      5.61%        5.16%
Federal Funds Purchased                9,500,000       975,555      5.96%        5.38%
</TABLE>


(8)  DEBT

Debt consists of the following at December 31, 1996 and 1995:

<TABLE>
<CAPTION>
                                                              1996          1995
------------------------------------------------------------------------------------

<S>                                                        <C>           <C>

9% Mortgage Note, Payable in Monthly Installments of
 $1,736 (Principal and Interest) Through 2020              $   202,991   $   205,441
1% Mortgage Note, payable in Monthly Installments of
 $2,542 (Principal and Interest) Through 2039                1,186,959     1,189,316
Federal Home Loan Bank Notes Payable, Interest Rates
 from 4.83% to 8.66% Due 1996 through 2001                   5,030,000    14,030,000
------------------------------------------------------------------------------------
                                                            $6,419,950   $15,424,757
------------------------------------------------------------------------------------
</TABLE>

Maturities  of debt  subsequent  to December  31,  1996 are as  follows:  1997 -
$5,288;  1998 -  $5,771;  1999  -  $6,293;  2000 -  $6,896;  2001 -  $7,533  and
$6,388,169 thereafter.

As of December 31, 1996, the Company is in compliance  with all of the covenants
of the Federal Home Loan Bank agreements.

On June 30, 1995, in accordance  with a specific plan  authorized by the Federal
Reserve,  the Bank prepaid the outstanding  $18 million of Capital Notes,  which
carried an interest  rate of 9.81%,  using funds from  operations.  The Bank was
released  from any further  obligations  under the Capital  Notes  Agreement.  A
prepayment  premium of  $701,400  was paid to the  noteholders.  The  prepayment
premium  is  reflected  in  interest  expense in the  accompanying  consolidated
statement of operations.

On December 20, 1995,  in  accordance  with a specific  plan  authorized  by the
Federal Reserve,  the Company prepaid $2,400,000 in obligations under the Senior
Subordinated  Debt Agreement  which carried an interest rate of 10%, using funds
provided by the issuance of common stock in  conjunction  with the settlement of
the deferred  compensation plans (see Note 6). The Company was released from any
further  obligations under the Senior Debt Agreement.  No prepayment premium was
required.


(9)  STOCKHOLDERS' EQUITY

Vermont  state law  requires  the Bank to  appropriate  a minimum  of 10% of net
income to surplus until such time as appropriated  amounts equal 10% of deposits
and other liabilities. The Company's stockholders' equity includes $7,189,562 as
of  December  31,  1996  and   $6,561,600  as  of  December  31,  1995  of  such
appropriations.  Vermont state law also restricts the payment of dividends under
certain circumstances.


(10)  REENGINEERING

The  Company  began  a  reengineering  project  during  1995 to  reduce  ongoing
operating  costs  and  increase  noninterest  income.  As  a  result,  the  Bank
implemented a plan to reduce its workforce by approximately  250 employees.  All
employees  were  offered  the   opportunity  to  voluntarily   terminate   their
employment,  which would entitle them to a severance package equal to one week's
pay for each year of service plus four  additional  weeks.  Employees  whose age
plus years of service  with the  Company  equalled  at least 60 were  offered an
early retirement option whereby, in lieu of the plan described above, five years
would be added to both their  years of  service  and their age for  purposes  of
determining  vested  benefits  through the  pension  plan.  The total  severance
charges  realized by the Company as a result of the  reengineering  project were
approximately  $1.3  million.   The  incremental  cost  of  the  enhanced  early
retirement benefit realized during 1995 was approximately $728,000.

In conjunction with the reengineering  project, the Company engaged a consulting
firm to assist in the  identification of possible  workforce  reductions and the
implementation  of the  reengineering  plan. The fee earned by these consultants
is, in part,  contingent  upon actual future  operating cost  reductions and the
increase  in  noninterest  income,  and  the  Company  recognized  all  expenses
associated with fees to these  consultants of  approximately $2 million in 1995.
Pursuant to an agreement with these consultants, the Company will make the final
payment to the consultants in 1997,  which has been fully accrued as of December
31, 1996.


(11)  COMMITMENTS AND CONTINGENCIES

During the fall of 1994,  lawsuits were brought  against the Company,  the Bank,
the Trust  Company  (collectively  referred to as "the  Companies")  and certain
directors  of the  Companies.  These  lawsuits  related to  certain  investments
managed for Trust Company clients and placed in the Piper Jaffray  Institutional
Government  Income Portfolio.  Separately,  and before the suits were filed, the
Companies  had  initiated  a review  of those  investments.  As a result  of the
review,  the Trust Company paid to the affected Trust Company clients a total of
approximately  $9.2 million in December  1994.  The payments do not constitute a
legal settlement of any claims in the lawsuits.  However,  based on consultation
with legal counsel,  management believes that further liability,  if any, of the
Companies on account of matters  complained  of in the lawsuits  will not have a
material  adverse effect on the consolidated  financial  position and results of
operations  of the  Company.  In December  1994,  the Trust  Company  received a
payment of  $6,000,000  from its  insurance  carriers in  connection  with these
matters, which was treated as a reduction in amounts reimbursed to Trust Company
customers  in  the  accompanying  consolidated  statement  of  operations.   The
Companies are separately  pursuing claims against Piper Jaffray Companies,  Inc.
and others on account of the losses that gave rise to the $9.2  million  payment
by the  Companies.  The claims of the Trust Company,  as trustee,  against Piper
Jaffray  Companies were joined with claims of other  investors in the Piper Fund
in a class  action in the  United  States  District  Court for the  District  of
Minnesota.  The class  action was settled by the  parties,  and on December  14,
1995, the settlement was approved by the Court. By order dated January 11, 1996,
the Court ordered the share of the  settlement  proceeds  attributable  to Trust
Company investments not be paid pending further order. On February 18, 1997, the
District Court entered an Order for Final Judgment.  That Order provides,  among
other  matters,  that  except to the  extent  (if at all) any other  court  with
jurisdiction  has given leave for some or all of the  proceeds  to be  deposited
with the court  pursuant to Vermont Rule of Civil  Procedure 67, Federal Rule of
Civil Procedure 67, or such other rule as may apply,  and absent an appeal,  the
entire net settlement proceeds attributable to the Trust Company investments are
to be paid to the Trust Company starting approximately  sixty-one days after the
date of the Order.  Any recovery of settlement  proceeds is subject to the terms
of an  agreement  between  the  Companies  and  their  insurance  carriers.  The
attorneys  representing  the plaintiffs in one of the lawsuits  discussed  above
have taken the position that amounts  recovered by the Companies on these claims
should be paid to the affected Trust Company clients (net of legal fees to those
attorneys), in addition to the $9.2 million already paid.

The attorneys representing the plaintiffs in one of the lawsuits discussed above
requested an award of  attorneys'  fees for  allegedly  causing the Companies to
make the $9.2 million  payment and asked the  District  Court to order the Trust
Company to withhold  payment of $500,000.  The Trust Company resisted claims for
payment of such fees and,  as a result,  has been  directed  to place the sum of
$500,000 into escrow pending a ruling by the Court.  On appeal by the Companies,
the  United  States  Court of Appeals  affirmed  in part,  vacated in part,  and
reversed for further  proceedings  the lower  court's  judgment.  The  attorneys
representing  the  plaintiffs in that lawsuit have indicated that they intend to
seek  damages as well as  attorneys'  fees.  There is the  possibility  that the
Companies will be required to remit all or part of the escrowed funds, or to pay
damages.  However,  based  upon  consultation  with  legal  counsel,  management
believes that on the facts of this case there is no substantial authority for an
award of such fees or damages in those proceedings.

The Bank is also  involved in various  legal  proceedings  arising in the normal
course of  business.  Based upon  consultation  with legal  counsel,  management
believes that the resolution of these matters will not have a material effect on
the consolidated financial position and results of operations of the Company.


(12)  PARENT COMPANY

The Parent  Company's  investments  in its  subsidiaries  are recorded using the
equity method of accounting.  Summarized  financial  information relative to the
Parent  Company only balance sheets at December 31, 1996 and 1995 and statements
of  operations  and cash flows for each of the three  years in the period  ended
December 31, 1996 is as follows:

<TABLE>
<CAPTION>
Balance Sheets - December 31,                               1996           1995
-----------------------------------------------------------------------------------

<S>                                                     <C>            <C>
Assets:
  Investment in and Advances to Subsidiaries *          $ 47,999,312   $ 41,843,980
  Other Assets                                               860,191        972,452
-----------------------------------------------------------------------------------
      Total Assets                                      $ 48,859,503   $ 42,816,432
===================================================================================

Liabilities and Equity Capital:
  Other Liabilities                                        2,609,735      2,567,569
  Equity Capital                                          46,249,768     40,248,863
-----------------------------------------------------------------------------------
      Total Liabilities and Equity Capital              $ 48,859,503   $ 42,816,432
===================================================================================
</TABLE>


<TABLE>
<CAPTION>

Statements of Operations for the Year Ended December 31,         1996           1995             1994
-------------------------------------------------------------------------------------------------------------

<S>                                                              <C>            <C>              <C>
Equity in Undistributed Earnings (Loss) of Subsidiaries*         $ 6,306,352    $ (4,021,297)    $ (2,679,429)
Other Income (Expense), Net                                         (125,180)         72,360         (374,142)
Benefit from Income Taxes                                             42,561         106,998          163,547
-------------------------------------------------------------------------------------------------------------
Net Income (Loss)                                                $ 6,223,733    $ (3,841,939)    $ (2,890,024)
=============================================================================================================

<CAPTION>
Statements of Cash Flows for the Year Ended December 31,         1996           1995             1994
-------------------------------------------------------------------------------------------------------------

<S>                                                              <C>            <C>              <C>
Cash Flows from Operating Activities:
  Net Loss                                                       $ 6,223,733    $ (3,841,939)    $ (2,890,024)
  Adjustments to Reconcile Net Income (Loss) to Net Cash 
   Provided by (Used in) Operating Activities:
    Amortization                                                 $         0    $          0     $      6,360
    Gains on Investment Securities                                         0        (309,020)         (91,780)
    (Increase) Decrease  in Miscellaneous Receivables                 98,754        (612,543)         (11,425)
    Increase (Decrease) in Miscellaneous Payables                          0       2,527,569         .(20,000)
    Equity in Undistributed  (Income) Losses of Subsidiaries      (6,306,352)      4,021,297        2,679,429
-------------------------------------------------------------------------------------------------------------
       Net Cash Provided by (Used in) Operating Activities       $    16,135    $  1,785,364     $   (327,440)
-------------------------------------------------------------------------------------------------------------

Cash Flows from Investing Activities:
  Repayment of Advances from Subsidiaries                        $         0    $  1,035,460     $  2,263,399
  Proceeds from Sales of Investment Securities                             0         643,931          682,030
-------------------------------------------------------------------------------------------------------------
      Net Cash Provided by Investing Activities                  $         0    $  1,679,391     $  2,945,429
-------------------------------------------------------------------------------------------------------------

Cash Flows From Financing Activities:
  Sale of Treasury Stock                                         $         0    $    178,730     $          0
  Acquisition of Treasury Stock                                            0      (2,082,525)               0
  Issuance of Common Stock                                                 0       2,553,802                0
  Principal Payments on Debt                                               0      (4,800,000)      (2,400,000)
-------------------------------------------------------------------------------------------------------------
      Net Cash Used in Financing Activities                      $         0    $ (4,149,993)    $ (2,400,000)
-------------------------------------------------------------------------------------------------------------

Increase (decrease) in Cash and Cash Equivalents                      16,135        (685,238)         217,989
Cash and Cash Equivalents at Beginning of Year                       301,495         986,733          768,744
-------------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents at End of Year                         $   317,630    $    301,495     $    986,733
=============================================================================================================
Total Interest Paid                                              $         0    $    333,333     $    580,000
Taxes Paid                                                       $         0    $          0     $     50,000


<F1>  *  Account balances are partially or fully eliminated in consolidation.
</TABLE>


(13)  FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK

Commitments and Off-Balance Sheet Risk

The Bank is a party to financial  instruments with off-balance sheet risk in the
normal course of business to meet the financing  needs of its  customers.  These
financial  instruments  primarily  include  commitments  to  extend  credit  and
financial guarantees.  Such instruments involve, to varying degrees, elements of
credit  and  interest  rate risk  that are not  recognized  in the  accompanying
consolidated balance sheets.

Exposure to credit loss in the event of nonperformance by the other party to the
financial  instruments for commitments to extend credit and financial guarantees
written is represented by the contractual amount of those instruments.  The Bank
uses the same credit  policies in making  commitments  as it does for on-balance
sheet  instruments.  The contractual  amounts of these financial  instruments at
December 31, 1996 and 1995 are as follows:

<TABLE>
<CAPTION>

     1996                                               Contractual Amount
     ---------------------------------------------------------------------

     <S>                                                   <C>
     Financial Instruments Whose Contract Amounts
      Represent Credit Risk:
     Commitments to Extend Credit                          $80,756,000
     Standby Letters of Credit                               6,104,000
     Loans Sold with Recourse                                1,219,000

<CAPTION>

     1995                                               Contractual Amount
     ---------------------------------------------------------------------

     <S>                                                   <C>
     Financial Instruments Whose Contract Amounts
      Represent Credit Risk:
     Commitments to Extend Credit                          $92,596,000
     Standby Letters of Credit                               6,550,000
     Loans Sold with Recourse                                1,832,000
</TABLE>


Commitments  to extend  credit are  agreements  to lend to a customer as long as
there is no violation of any condition established in the contract.  Commitments
generally  have fixed  expiration  dates or other  termination  clauses  and may
require  payment of a fee.  Since a portion of the  commitments  are expected to
expire  without  being  drawn  upon,  the  total  commitment   amount  does  not
necessarily  represent  a  future  cash  requirement.  The Bank  evaluates  each
customer's  creditworthiness  on a case-by-case  basis. The amount of collateral
obtained by the Bank upon  extension of credit is based on  management's  credit
evaluation  of the  counterparty,  and an  appropriate  amount  of  real  and/or
personal property is obtained as collateral.

Standby  letters of credit and  financial  guarantees  written  are  conditional
commitments issued by the Bank to guarantee performance of a customer to a third
party.  Those  guarantees  are  primarily  issued to support  public and private
borrowing arrangements.  Most guarantees extend for less than two years, and 75%
are for less than  $100,000.  The credit  risk  involved  in issuing  letters of
credit is essentially  the same as that involved in extending loan facilities to
customers.  The Bank obtains real and/or  personal  property as  collateral  for
those commitments for which collateral is deemed to be necessary.

The Bank may enter into  commitments  to sell  loans  which  involve  market and
interest  rate risk.  There were no such  commitments  at December 31, 1996.  At
December 31, 1995, the remaining commitments to deliver loans pursuant to master
commitments   with  secondary   market   investors   amounted  to  approximately
$8,947,000.

Interest Rate Floor Contracts

Interest  rate floor  transactions  generally  involve the exchange of fixed and
floating rate interest payments without the exchange of the underlying principal
amounts.  The Company has used a floor  contract to mitigate  the effects on net
interest income in the event interest rates on floating rate loans decline.  The
Company is exposed to risk should the counterparty default in its responsibility
to pay interest under the terms of the floor agreement,  but minimizes this risk
by  performing  normal  credit  reviews on the  counterparties,  by limiting its
exposure  to  any  one  counterparty,  and  by  utilizing  well  known  national
investment firms as counterparties.  Notional principal amounts are a measure of
the  volume  of  agreements  transacted,   but  the  level  of  credit  risk  is
significantly  less.  At December 31, 1996,  the  notional  principal  amount of
contracts  outstanding  was $20,000,000 and the amortized cost of such contracts
was  $73,900.  There  were no  outstanding  interest  rate floor  agreements  at
December 31, 1995.


(14)  FAIR VALUE OF FINANCIAL INSTRUMENTS

Investments

The carrying amounts  reported in the  consolidated  balance sheets for cash and
cash  equivalents  and stock in the  Federal  Home  Loan  Bank of Boston  (FHLB)
approximate fair values. Fair value for investment securities is determined from
quoted market prices, when available. If quoted market prices are not available,
fair values are based on quoted market prices of comparable instruments.

An analysis  of the  estimated  fair value of the  investment  securities  as of
December 31, 1996 and 1995 is as follows:

<TABLE>
<CAPTION>
                                             1996                      1995
------------------------------------------------------------------------------------
                                    Carrying    Calculated    Carrying    Calculated
                                     Amount     Fair Value     Amount     Fair Value
------------------------------------------------------------------------------------
                                                     (In Thousands)

<S>                                 <C>          <C>           <C>         <C>
Securites Available for Sale        $ 57,656     $ 57,656      $97,943     $97,943
Securities Held to Maturity           86,904       86,004           --          --
Marketable Equity Securities             230          230          310         310
----------------------------------------------------------------------------------
                                    $144,790     $143,890      $98,253     $98,253
==================================================================================
</TABLE>

Loans

The fair  value of  variable  rate  loans that  reprice  frequently  and have no
significant  credit  risk is based on carrying  values.  The fair value of fixed
rate (one-to-four family residential)  mortgage loans, and other consumer loans,
is based on quoted  market  prices of  similar  loans sold in  conjunction  with
securitization  transactions,  adjusted for differences in loan characteristics.
The fair value for other loans is estimated using discounted cash flow analyses,
using  interest  rates  currently  being offered for loans with similar terms to
borrowers of similar credit quality.

An  analysis  of the  estimated  fair  value  of the loan  portfolio  (including
Segregated  Assets as of December  31, 1995) as of December 31, 1996 and 1995 is
as follows:

<TABLE>
<CAPTION>

                                1996                    1995
      ---------------------------------------------------------------
                        Carrying   Calculated   Carrying   Calculated
                         Amount    Fair Value    Amount    Fair Value
      ---------------------------------------------------------------
                                        (In Thousands)

      <S>               <C>         <C>         <C>         <C>
      Net Loans         $371,533    $371,187    $433,490    $435,291
      ===============================================================
</TABLE>

Deposits

The fair  value of demand  deposits  approximates  the  amount  reported  in the
consolidated  balance  sheets.  The fair  value of  variable  rate,  fixed  term
certificates  of deposit also  approximate  the carrying  amount reported in the
consolidated  balance  sheets.  The  fair  value of fixed  rate and  fixed  term
certificates  of deposit is estimated using a discounted cash flow which applies
interest  rates  currently  being  offered  for  deposits  of similar  remaining
maturities.

An analysis of the estimated  fair value of deposits as of December 31, 1996 and
1995 is as follows:

<TABLE>
<CAPTION>
                                             1996                      1995
------------------------------------------------------------------------------------
                                    Carrying    Calculated    Carrying    Calculated
                                    Amount      Fair Value     Amount     Fair Value
------------------------------------------------------------------------------------
                                                     (In Thousands)

<S>                                 <C>          <C>          <C>          <C>
Demand Deposits                     $ 80,576     $ 80,576     $ 85,417     $ 85,804
Savings, NOW and Money Market        263,882      263,967      278,242      278,242
Time Deposits Over $100,000           20,369       20,522       20,473       20,792
Other Time                           143,452      144,516      160,382      162,881
-----------------------------------------------------------------------------------
                                    $508,279     $509,581     $544,514     $547,719
===================================================================================
</TABLE>

Debt

The fair value of debt is estimated using current market rates for borrowings of
similar remaining maturity.

An  analysis  of the  estimated  fair  value  of the debt of the  Company  as of
December 31, 1996 and 1995 is as follows:

<TABLE>
<CAPTION>

                       1996                    1995
      ------------------------------------------------------
               Carrying   Calculated   Carrying   Calculated
                Amount    Fair Value    Amount    Fair Value
      ------------------------------------------------------

      <S>       <C>         <C>         <C>         <C>
      Debt      $6,420      $6,732      $15,425     $15,990
      ------------------------------------------------------
</TABLE>

Commitments to Extend Credit And Standby Letters Of Credit

The fair  value of  commitments  to extend  credit is  estimated  using the fees
currently  charged to enter into  similar  agreements,  taking into  account the
remaining  terms  of the  agreements  and the  present  creditworthiness  of the
counterparties.  For fixed rate loan commitments,  fair value also considers the
difference between current levels of interest rates and the committed rates. The
fair value of  financial  standby  letters of credit is based on fees  currently
charged for similar  agreements  or on the estimated  cost to terminate  them or
otherwise  settle the  obligations  with the  counterparties.  The fair value of
commitments  to extend  credit and  standby  letters  of credit is  $88,000  and
$101,000 as of December 31, 1996 and 1995, respectively.


(15)  SUMMARY OF UNAUDITED QUARTERLY FINANCIAL INFORMATION (in thousands):


                           Merchants Bancshares, Inc.
                  Notes to Consolidated Financial Statements
                              December 31, 1996


<TABLE>
<CAPTION>
                                                        1996                                     1995
                                       -------------------------------------    -------------------------------------
                                       Q1        Q2        Q3        Q4         Q1        Q2        Q3        Q4
---------------------------------------------------------------------------------------------------------------------

<S>                                    <C>       <C>       <C>       <C>        <C>       <C>       <C>       <C>
Interest and Fee Income                $12,204   $11,990   $11,901   $11,909    $13,053   $13,362   $12,460   $12,440
Interest Expense                         4,858     4,642     4,573     4,599      5,872     6,647     5,407     5,076
---------------------------------------------------------------------------------------------------------------------

Net Interest Income                    $ 7,346   $ 7,348   $ 7,328   $ 7,310    $ 7,181   $ 6,715   $ 7,053   $ 7,364

Provision for Possible Loan Losses (A)     900       900       900       450      2,700     7,600       900       900
Non-Interest Income (B)                  2,913     2,174     1,897     1,972      2,210     2,094     3,524     1,987
Non-Interest Expense (C)                 7,646     6,639     6,215     6,582      7,180     7,992    11,116     7,367

Income (Loss) Before Provision 
 (Benefit) for Income Taxes            $ 1,713   $ 1,983   $ 2,110   $ 2,250    $  (489)  $(6,783)  $(1,439)  $ 1,084
Provision (Benefit) For Income Taxes       344       439       501       548       (528)   (2,732)     (717)      192
---------------------------------------------------------------------------------------------------------------------

Net Income (Loss)                      $ 1,369   $ 1,544   $ 1,609   $ 1,702    $    39   $(4,051)  $  (722)  $   892
=====================================================================================================================

Earnings (Loss) Per Share              $  0.32   $  0.36   $  0.37   $  0.40    $  0.01   $ (0.95)  $ (0.17)  $  0.21
=====================================================================================================================

Dividends Per Share                    $  0.00   $  0.00   $  0.00   $  0.00    $  0.00   $  0.00   $  0.00   $  0.00
=====================================================================================================================

<FN>
<F1>  (A)   During the second quarter of 1995, the Bank provided reserves for possible
            loan  losses of $5 million in  addition  to  planned  provisions  of $1.75
            million  to  cover   exposure   identified   during  loan   renewals   and
            restructures.

<F2>  (B)   The  Bank  recognized  a gain of $1.6  million  in  conjunction  with  the
            curtailment of its pension plan during the third quarter of 1995.

<F3>  (C)   During the third quarter of 1995 the Bank began a  reengineering  project.
            The Bank recognized total severance charges of $1.5 million and total fees
            to consultants of $2.2 million in conjunction with the reengineering.
</FN>
</TABLE>


(16)  REGULATORY ENVIRONMENT

The Bank and the Company are subject to various regulatory capital  requirements
administered  by the federal banking  agencies.  Failure to meet minimum capital
requirements   can   initiate   certain   mandatory--and   possible   additional
discretionary--actions  by regulators  that, if undertaken,  could have a direct
material  effect on the Bank's and the  Company's  financial  statements.  Under
capital adequacy guidelines, the Bank and the Company must meet specific capital
guidelines  that involve  quantitative  measures of the Bank's and the Company's
assets,  liabilities,  and certain  off-balance-sheet  items as calculated under
regulatory  accounting  practices.  The Bank is also  subject to the  regulatory
framework for prompt  corrective  action that requires the Bank to meet specific
capital  guidelines  to be  considered  well  capitalized.  The  Bank's  and the
Company's  capital  amounts and  classification  are also subject to qualitative
judgments by the regulators about components, risk weightings and other factors.

Quantitative  measures  established  by  regulation to ensure  capital  adequacy
require the Bank and the Company to  maintain  minimum  ratios (set forth in the
table  below) of total and Tier-1  capital  (as defined in the  regulations)  to
risk-weighted  assets (as defined) and of Tier-1 capital (as defined) to average
assets (as defined). Management believes, as of December 31, 1996, that the Bank
and the Company meet all capital adequacy requirements to which it is subject.

As of December 31, 1996, the most recent  notification from the FDIC categorized
the  Bank  as  well-capitalized   under  the  regulatory  framework  for  prompt
corrective  action.  There are no conditions  or events since that  notification
that  management  believes  have  changed  the  institution's  category.  To  be
considered well capitalized under the regulatory framework for prompt corrective
action, the Bank must maintain minimum Tier-1 Leverage,  Tier-1 Risk-Based,  and
Total Risk-Based Capital ratios as set forth in the table below.

<TABLE>
<CAPTION>
                                                                                      To Be Well-
                                                                                   Capitalized Under
                                                                For Capital        Prompt Corrective
                                              Actual         Adequacy Purposes     Action Provisions
-----------------------------------------------------------------------------------------------------
                                        Amount    Percent    Amount    Percent    Amount      Percent
-----------------------------------------------------------------------------------------------------

<S>                                     <C>       <C>        <C>        <C>       <C>         <C>
As of December 31, 1996:

Merchants Bancshares, Inc.:
  Tier 1 Risk-Based Capital             $43,814   11.08%     $15,811    4.00%             N/A
  Total Risk-Based Capital              $48,888   12.37%     $31,623    8.00%             N/A
  Tier 1 Leverage Capital               $43,814    7.50%     $23,381    4.00%             N/A
Merchants Bank:
  Tier 1 Risk-Based Capital             $45,517   11.56%     $15,757    4.00%     $23,635      6.00%
  Total Risk-Based Capital              $50,574   12.84%     $31,513    8.00%     $39,392     10.00%
  Tier 1 Leverage Capital               $45,517    7.80%     $23,330    4.00%     $29,163      5.00%

As of December 31, 1995 (Unaudited)
Merchants Bancshares, Inc.:
  Tier 1 Risk-Based Capital             $36,023    7.81%     $18,450    4.00%             N/A
  Total Risk-Based Capital              $41,777    9.06%     $36,900    8.00%             N/A
  Tier 1 Leverage Capital               $36,023    5.87%     $24,548    4.00%             N/A
Merchants Bank:
  Tier 1 Risk-Based Capital             $37,627    8.19%     $18,386    4.00%     $27,579      6.00%
  Total Risk-Based Capital              $43,420    9.45%     $36,772    8.00%     $45,965     10.00%
  Tier 1 Leverage Capital               $37,627    6.15%     $24,486    4.00%     $30,608      5.00%
</TABLE>

Discussion of Prior Regulatory Actions

In March  1993,  the  FDIC  and the  State of  Vermont  Department  of  Banking,
Insurance and Securities (the Commissioner)  conducted a joint field examination
of the Bank. As a result of this examination, the Bank entered into a Memorandum
of Understanding ("MOU") with the FDIC and the Commissioner.  Under the terms of
the MOU,  the Bank was  required  to,  among other  things,  maintain a leverage
capital ratio of at least 5.5% and refrain from  declaring  dividends.  The Bank
operated under the terms of the MOU until its removal on October 15, 1996.

In February 1994, the Company and the Federal Reserve entered into an agreement.
Under this  agreement,  among other  things,  the Company was not  permitted  to
declare or pay a dividend or incur any debt  without the approval of the Federal
Reserve. The Company operated under the terms of the agreement until its removal
on June 3, 1996.

In February  1995,  the Trust Company  entered into an MOU with the FDIC and the
Commissioner  to  put  into  effect  corrective   actions  relating  to  certain
operating, technical and regulatory issues. The Trust Company operated under the
terms of the MOU until its removal on August 8, 1996.


                           Merchants Bancshares, Inc. and Subsidiaries
                                  Interest Management Analysis


<TABLE>
<CAPTION>

(Taxable Equivalent, in thousands)                              1996                 1995                  1994
------------------------------------------------------------------------------------------------------------------------------

<S>                                                             <C>                  <C>                   <C>
Total Average Assets                                            $580,860             $642,487              $709,077
------------------------------------------------------------------------------------------------------------------------------
</TABLE>

<TABLE>
<CAPTION>

                                                                            % of                  % of                  % of
                                                                           Average               Average               Average
NET INTEREST INCOME:                                            1996       Assets    1995        Assets    1994        Assets

<S>                                                             <C>         <C>      <C>          <C>      <C>          <C>
Interest and Dividend Income                                    $ 45,807    7.89%    $ 48,988     7.62%    $ 50,041     7.06%
Fees on Loans                                                      2,333    0.40%       2,492     0.39%       3,571     0.50%
-----------------------------------------------------------------------------------------------------------------------------

Total                                                           $ 48,140    8.29%    $ 51,480     8.01%    $ 53,612     7.56%
Interest Expense                                                  18,672    3.21%      23,002     3.58%      22,377     3.16%

Net Interest Income Before Provision for Possible Loan Losses   $ 29,468    5.07%    $ 28,478     4.40%    $ 31,235     4.40%
Provision for Possible Loan Losses                                 3,150    0.54%      12,100     1.88%      10,000     1.41%
-----------------------------------------------------------------------------------------------------------------------------

      Net Interest Income                                       $ 26,318    4.53%    $ 16,378     2.55%    $ 21,235     2.99%

OPERATING EXPENSE ANALYSIS:
Non-Interest Expense
  Personnel                                                     $ 10,013    1.72%    $ 13,434     2.09%    $ 13,196     1.86%
  Occupancy Expense                                                2,054    0.35%       2,178     0.34%       2,324     0.33%
  Equipment Expense                                                2,024    0.35%       2,069     0.32%       2,004     0.28%
  Other                                                           12,991    2.24%      15,974     2.49%      17,939     2.53%
-----------------------------------------------------------------------------------------------------------------------------

Total Non-Interest Expense                                      $ 27,082    4.66%    $ 33,655     5.24%    $ 35,463     5.00%

Less Non-Interest Income Service Charges on Deposits            $  3,347    0.58%    $  3,184     0.50%    $  3,452     0.49%
Other, Including Securities Gains (Losses)                         5,580    0.96%       6,632     1.03%       5,337     0.75%
-----------------------------------------------------------------------------------------------------------------------------

Total Non-Interest Income                                       $  8,927    1.54%    $  9,816     1.53%    $  8,789     1.24%
-----------------------------------------------------------------------------------------------------------------------------

Net Operating Expense                                           $ 18,155    3.13%    $ 23,839     3.71%    $ 26,674     3.76%
=============================================================================================================================

SUMMARY:
  Net Interest Income                                           $ 26,318    4.53%    $ 16,378     2.55%    $ 21,235     2.99%
  Less: Net Overhead                                              18,155    3.13%      23,839     3.71%      26,674     3.76%
-----------------------------------------------------------------------------------------------------------------------------

Profit Before Taxes - Taxable Equivalent Basis                  $  8,163    1.41%    $ (7,461)   -1.16%    $ (5,439)   -0.77%
Net Profit (Loss) After Taxes                                   $  6,224    1.07%    $ (3,842)   -0.60%    $ (2,890)   -0.41%
=============================================================================================================================
</TABLE>


                           Merchants Bancshares, Inc.
                       Five Year Summary of Operations
           (Not Covered by Report of Independent Public Accountants)
                               (In Thousands)


<TABLE>
<CAPTION>

For the years ended                                     1996        1995        1994        1993        1992
-----------------------------------------------------------------------------------------------------------------

<S>                                                     <C>         <C>         <C>         <C>         <C>
Interest and Investment Income                          $  48,004   $  51,315   $  53,319   $  51,474   $  49,239
Interest Expense                                           18,672      23,002      22,377      21,956      24,051
-----------------------------------------------------------------------------------------------------------------

Net Interest Income                                     $  29,332   $  28,313   $  30,942   $  29,518   $  25,188
Provision for Possible Loan Losses                          3,150      12,100      10,000      23,822       8,050
-----------------------------------------------------------------------------------------------------------------

Net Interest Income after Provision for Loan Losses        26,182      16,213      20,942       5,696      17,138
-----------------------------------------------------------------------------------------------------------------

Other Income                                            $   9,362   $  12,766   $  15,038   $  12,128   $  10,195
Other Expense                                              27,489      36,606      41,712      28,016      21,081
-----------------------------------------------------------------------------------------------------------------

INCOME (LOSS) BEFORE INCOME TAXES                       $   8,055   $  (7,627)  $  (5,732)  $ (10,192)  $   6,252
Provision (benefit) for Income Taxes (Notes 2 and 4)        1,831      (3,785)     (2,842)     (4,410)        575
-----------------------------------------------------------------------------------------------------------------

NET INCOME (LOSS)                                       $   6,224   $  (3,842)  $  (2,890)  $  (5,782)  $   5,677
-----------------------------------------------------------------------------------------------------------------

SELECTED AVERAGE BALANCES (IN THOUSANDS)
Total Assets                                            $ 580,860   $ 642,487   $ 709,077   $ 705,516   $ 602,317
Average Earning Assets                                    533,192     575,551     620,070     627,049     542,157
Loans                                                     406,514     481,047     514,843     515,805     441,291
Total Deposits                                            513,923     556,242     598,305     570,957     490,908
Long-Term Debt                                              8,925      28,707      45,433      47,835      42,171
Shareholders' Equity                                       43,111      40,848      46,331      48,511      51,548

Shareholders' Equity plus Loan Loss Reserve                59,094      58,794      65,322      59,999      59,028

SELECTED RATIOS
Net Income (Loss) to:
  Average Stockholders' Equity                              14.44%      -9.41%      -6.24%     -11.92%      11.01%
  Average Assets                                             1.07%      -0.60%      -0.41%      -0.82%       0.94%
Average Stockholders' Equity to Average Total Assets         7.42%       6.36%       6.53%       6.88%       8.56%
Common Dividend Payout Ratio                                 0.00%       0.00%       0.00%       0.00%      58.48%
Loan Loss Reserve to Total Loans at Year End                 4.05%       3.61%       3.90%       3.50%       1.73%
Net Charge-Offs to Average Loans                             1.26%       3.28%       1.97%       1.95%       1.65%

PER SHARE (Note 1)
Net Income (Loss)                                       $    1.45   $   (0.90)  $   (0.68)  $   (1.37)  $    1.39
Cash Dividends                                               0.00        0.00        0.00        0.20        0.80
Year End Book Value                                         10.78        9.38       10.00       10.74       12.39
OTHER
Cash Dividends Paid (In Thousands)                      $       0   $       0   $       0   $     848   $   3,320
Stock Dividends Issued                                        0.0%        0.0%        0.0%        0.0%        3.0%

</TABLE>


(Note 1):  All stock dividends and splits are reflected retroactively.
See Note 9 of Notes to Consolidated Financial Statements.



                MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
                       CONDITION AND RESULTS OF OPERATIONS


Except for the historical  information  contained herein,  this Annual Report on
Form 10-K may contain  forward-looking  statements within the meaning of Section
27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act
of 1934. Investors are cautioned that forward-looking  statements are inherently
uncertain.  Actual  performance and results of operations may differ  materially
from those  projected  or  suggested in the  forward-looking  statements  due to
certain risks and uncertainties,  including,  without  limitation,  (i) the fact
that the  Company's  success is dependent to a  significant  extent upon general
economic  conditions in Vermont and  Vermont's  ability to attract new business,
(ii) the fact that the  Company's  earnings  depend to a great  extent  upon the
level of net interest income (the difference  between  interest income earned on
loans and  investments  and the  interest  expense  paid on  deposits  and other
borrowings) generated by the Bank, and the level of net interest income and thus
the Bank's  results of  operations  may be  adversely  affected by  increases or
decreases  in interest  rates,  and (iii) the fact that the banking  business is
highly  competitive and the profitability of the Company depends upon the Bank's
ability to attract loans and deposits in Vermont, where the Bank competes with a
variety of traditional  banking and  nontraditional  institutions such as credit
unions and finance  companies.  These factors,  as well as general  economic and
market  conditions,  may materially and adversely affect the market price of the
Company's  common  shares.  Because of these and other  factors,  past financial
performance  should not be  considered an indicator of future  performance.  The
forward-looking  statements contained herein represent the Company's judgment as
of the date of this Form 10-K,  and the  Company  cautions  readers not to place
undue reliance on such statements.

The  following  discussion  and analysis of financial  condition  and results of
operations  of the  Company  and its  subsidiaries  for the  three  years  ended
December 31, 1996 should be read in conjunction with the consolidated  financial
statements  and notes  thereto and selected  statistical  information  appearing
elsewhere in this annual report. The information is discussed on a fully taxable
equivalent  basis.   Particular  attention  should  be  given  to  the  INTEREST
MANAGEMENT ANALYSIS and OPERATING EXPENSE ANALYSIS TABLES immediately  preceding
this  discussion upon which this  discussion is primarily  based.  The financial
condition  and  operating  results  of  the  Company   essentially  reflect  the
operations of its principal subsidiary, the Merchants Bank.


RESULTS OF OPERATIONS:  OVERVIEW

The Company  recognized  net income of $6.2 million for the year ended  December
31, 1996.  Core  earnings  (pretax  earnings,  excluding  the provision for loan
losses and reengineering  expenses) increased from approximately $8.5 million in
1995 to $11.2 million in 1996. This increase is attributable to several factors.
The Company's  portfolio of nonperforming  loans decreased by $20.6 million from
$27.3  million at year-end  1995 to $6.7 at  year-end  1996.  Additionally,  the
Company's OREO portfolio decreased by $5.9 million from $7.8 million at year-end
1995 to $1.9 million at year-end 1996. These  reductions in nonperforming  asset
levels have allowed the Company to redeploy funds into earning assets and reduce
administrative  efforts associated with a nonperforming  asset portfolio.  Also,
the  Company  began  a  reengineering  project  during  1995 to  reduce  ongoing
operating  costs  through  a  reduction  in  workforce  and  improved  operating
efficiencies, and to increase noninterest income. The Company estimates that the
changes made as a result of the reengineering have reduced noninterest  expenses
by  approximately  $4.6 million,  and have had a marginal  effect on noninterest
income.

The Company  recognized a net loss of $3.8  million for the year ended  December
31, 1995, due primarily to the substantial provision for possible loan losses of
$12.1  million  (refer to the  discussion  under  "Provision  for Possible  Loan
Losses"  that  follows),  and $4 million in  reengineering  charges  and related
consultants fees.  Substantially all costs incurred and actions  associated with
the  reengineering  project occurred during 1995. Core earnings (pretax earnings
excluding  the  provision  for loan losses and  reengineering  expenses)  showed
slight   improvement   from  1994  to  1995  due   primarily  to  reductions  in
nonperforming assets.

The Company  recognized a net loss of $2.9  million for the year ended  December
31, 1994,  due primarily to the following  three items:  provisions for possible
loan  losses  of $10  million  (refer to the  discussion  under  "Provision  for
Possible  Loan  Losses"  that  follows),   an  increase  in  the  provision  for
write-downs  of other real estate  owned of $2.4  million,  and the net expenses
related to the  reimbursement  of Trust  Company  clients for losses  related to
investments  managed  by the Trust  Company  and  placed  in the  Piper  Jaffray
Institutional  Government  Income  Portfolio.  The net  Trust  Company  expenses
totaled  approximately  $3.2  million  after an  insurance  reimbursement  of $6
million.

Net income  (loss) on a per share  basis was $1.45,  $(0.90) and $(0.68) for the
years ended December 31, 1996,  1995 and 1994,  respectively.  No dividends were
paid in 1996,  1995 or 1994.  The Company  declared a dividend,  its first since
April of 1993,  of $0.10 per share on January 21, 1997,  payable on February 14,
1997 to shareholders of record as of February 4, 1997.

The net income  (loss) as a  percentage  of average  equity  capital was 14.44%,
(9.41%) and (6.24%) for 1996, 1995 and 1994, respectively.  The ten-year average
return on equity is 8.70% at  December  31,  1996.  The net  income  (loss) as a
percentage  of average  assets was  1.07%,  (.60%) and (.41%) in 1996,  1995 and
1994,  respectively.  The ten-year  average return on assets is .62% at December
31, 1996.


NET INTEREST INCOME

Net  interest  income  before the  provision  for  possible  loan  losses is the
difference  between total interest,  loan fees and investment  income, and total
interest  expense.  Net interest  income  before the provision for possible loan
losses is a key  indicator  of a bank's  performance  in managing its assets and
liabilities.  Maximization  and  stability of net  interest  income is a primary
objective of the Bank. From 1995 to 1996,  total interest income  decreased $3.3
million (6.45%), and total interest expense decreased $4.3 million (18.8%). This
resulted in an increase to net interest income before the provision for possible
loan losses on a fully taxable  equivalent basis of $1 million (4.2%) from $28.5
million  in 1995 to  $29.5  million  in 1996.  There  are a  number  of  factors
contributing to this change.  First, the Bank's overall loan portfolio decreased
by $62 million (13.8%),  while the Bank's investment  portfolio increased by $46
million (47%) (see "Balance Sheet Analysis" for a more comprehensive  discussion
of changes in the balance sheet). This shift of funds from the loan portfolio to
the lower  yielding  investment  portfolio  decreased  the  Bank's  overall  net
interest income. However, the impact of the shift from the loan portfolio to the
investment  portfolio  was  mitigated by three major  factors.  First,  the Bank
decreased its nonperforming loan portfolio by $20.6 million (75%), which created
earning  assets and increased the yield on the overall loan portfolio from 9.61%
to 9.86%.  Second,  during 1995, the Company paid off $20.4 million in long term
debt accruing at an average interest rate of 9.81%,  resulting in a reduction in
the Company's  cost of funds from 4.51% in 1995 to 4.14% in 1996.  Finally,  the
Bank  made  a   strategic   decision   to  lower  the  rates   paid  on  certain
interest-bearing  checking and money market accounts,  which reduced its cost of
deposits from 4.16% in 1995 to 4.07% in 1996. These factors combined to increase
the Company's net interest margin from 4.95% in 1995 to 5.53% in 1996.

Net interest  income before the  provision for possible  loans losses on a fully
taxable  equivalent  basis  decreased  8.5% from $31.2  million in 1994 to $28.5
million in 1995.  The  primary  cause for this net  decline  was a  decrease  in
average assets of $66.6 million (9.39%) from 1994 to 1995.  Continued  decreases
in the level of  nonperforming  assets increased net interest margin to 4.95% in
1995 from 4.89% in 1994 and the average yield on earning assets to 8.94% in 1995
from 8.39% in 1994.  Total interest income decreased 8.4% in 1995 from 1994. The
decrease in net interest  income is primarily due to a decrease in fees on loans
discussed above. Total interest expense increased 2.79% from 1994 to 1995 due to
a higher overall interest rate environment, which created a higher cost of funds
in 1995 as compared to 1994.

Total fees on loans changed by an immaterial  amount from 1995 to 1996 and had a
minimal  effect on the change in net interest  income.  Fees on loans  decreased
$1.1 million (30.2%) from 1994 to 1995 as a result of a less favorable  interest
rate  environment  during 1995 for refinancing of home mortgages.  Additionally,
over the last two years, the Bank has shifted its strategic focus, deemphasizing
the  commercial  and home mortgage  portfolio,  as it more actively  pursues the
small business and commercial portfolio.


NONINTEREST INCOME AND EXPENSES

Net operating  expense (net overhead) is total  noninterest  expense  reduced by
noninterest income.  Operating expense includes all costs associated with staff,
occupancy,  equipment, supplies and all other noninterest expenses.  Noninterest
income  consists  primarily of fee income on deposit  accounts,  trust services,
credit  card,  corporate  and data  processing  services  and gains or losses on
investment securities.

Excluding the FDIC assistance  received  pursuant to the loss sharing  agreement
(see "FDIC Assisted  Acquisition"),  the gain on the  curtailment of the pension
plan  recognized in 1995,  and net gains on investment  securities,  noninterest
income  increased  $1  million  (13.35%)  from  1995 to  1996.  There  were  two
nonrecurring  items  comprising the majority of the net increase:  a net gain on
the sale of a branch of $300,000 and refunds of Vermont  Franchise Taxes paid in
prior years of $800,000.

Noninterest expenses decreased $6.6 million (19.5%) in 1996 from 1995, excluding
losses and write-downs on Segregated Assets reimbursed by the FDIC. Contributing
significantly  to this  reduction were an absence of  reengineering  expenses in
1996 compared to $4 million in  reengineering  and related  costs  recognized in
1995 (see Note 10 and discussion following). Additionally, salaries and benefits
decreased  by  $3.4  million  (25.5%)  in 1996  from  1995  as a  result  of the
reengineering project begun in 1995.

Excluding  the  FDIC  assistance  received  from  loss-sharing,  the gain on the
curtailment  of the  pension  plan  and  net  gains  on  investment  securities,
noninterest  income earned in 1995 decreased  $815,000  (9.35%) from 1994.  This
decrease is due primarily to a $262,000 decrease in merchant discount fees and a
$268,000  decrease in service charge revenue.  The Bank's deposit base decreased
by $37 million (6.3%) during 1995, contributing to these decreases.

Noninterest  expenses decreased $1.8 million (5.1%), not including the amount of
losses and write-downs on Segregated Assets,  which were reimbursed by the FDIC,
in 1995 as compared to 1994. There are several large  transactions that occurred
during 1994 and 1995 which, on a combined  basis,  contributed to this decrease.
During 1995, the Bank began a reengineering  project to reduce ongoing operating
costs and increase  noninterest income. As a result, the Bank implemented a plan
to reduce its workforce by  approximately  250  employees.  All  employees  were
offered the opportunity to voluntarily  terminate their employment,  which would
entitle  them to a  severance  package  equal to one week's pay for each year of
service plus four  additional  weeks.  Employees whose age plus years of service
with the Company  equalled at least 60 were offered an early  retirement  option
whereby,  in lieu of the plan described above, five years would be added to both
their years of service and their age for purposes of determining vested benefits
through the pension plan.  The total charge for  severance  realized by the Bank
was $1.3 million.  The incremental cost of the enhanced early retirement benefit
realized  during  1995  was  approximately  $728,000.  In  conjunction  with the
reengineering  changes,  the Bank  engaged  a  consulting  firm to assist in the
identification of areas where the Bank could reduce expenses or enhance revenue.
The Bank  recognized  expenses  associated  with  fees to these  consultants  of
approximately  $2  million  in  1995.   Pursuant  to  an  agreement  with  these
consultants, the Company will make the final payment to the consultants in 1997,
which has been fully accrued as of December 31, 1996.  During 1994,  the Company
recognized  a net charge  related to the Trust  Company's  reimbursement  to its
clients due to investments in the Piper Jaffray Institutional  Government Income
Portfolio   totaling  $3.2  million  after  the  recognition  of  a  $6  million
reimbursement from insurance carriers.

Losses and Write-downs of Other Real Estate Owned (OREO) increased $413,000 from
1995 to 1996. This increase is due primarily to the Bank's aggressive  marketing
of its OREO  portfolio  and  necessary  adjustments  to bring  the  value of the
remaining  properties in line with the market.  Losses and  Write-downs  of OREO
decreased  $805,000 from 1994 to 1995, due primarily to a decrease in the amount
provided  for the  reserve on the  portfolio  from $2.3  million in 1994 to $1.4
million in 1995.  The change in  noninterest  expense from 1994 to 1995 was also
affected  by the  write-down  of the  core  deposit  intangible  related  to the
acquisition  of the NFNBV in the amount of  $458,000  and  $686,000  in 1995 and
1994, respectively.  Additionally,  during 1994, the Bank wrote off the carrying
value of one of its  investments  in real estate limited  partnerships  totaling
$546,000  due  to  significant  cash  flow   deficiencies   experienced  by  the
partnership, which caused the Bank to question the value of its investment.

The Company recognized $851,000 in low-income housing tax credits as a reduction
in the provision for income taxes during 1996, $851,000 during 1995 and $708,000
during 1994. As a consequence of the operating  losses  incurred during 1995 and
1994,  the Company  recognized  tax benefits of $3.8  million and $2.8  million,
including $851,000 and $708,000 in low-income housing tax credits, respectively.
Additionally,  as of December  31, 1996,  the Company has a cumulative  deferred
prepaid tax asset of approximately  $5.3 million arising from timing differences
between the Company's book and tax reporting.  The prepaid tax asset is included
in other assets.


CREDIT QUALITY AND RESERVE FOR POSSIBLE LOAN LOSSES

Improving  credit  quality  has been a major  strategic  focus of the Bank since
1994.  The  success  of this  program  is  evidenced  by the  Bank's  aggressive
reduction in the level of problem assets over the last two years.  Nonperforming
assets (loans past due 90 days or more and still  accruing,  nonaccruing  loans,
restructured  loans and other real estate owned)  decreased 75% to $8,635,000 at
December  31, 1996 from  $35,055,000  at December  31,  1995.  The 1995  figures
represent  a decrease of 31% from  $51,182,000  at  year-end  1994.  Of the 1995
amount,  $6,649,000  represents  Segregated  Assets  covered by the Loss Sharing
Agreement  with the FDIC,  which expired June 4, 1996.  Excluding the FDIC's 80%
exposure on the Segregated Assets  ($5,319,000),  adjusted  nonperforming assets
totaled  $29,736,000  at December  31, 1995, a decrease of 31% over the adjusted
1994 level.

The reserve for  possible  loan losses  (RPLL) was  $15,699,791  at December 31,
1996,  $16,234,000 at December 31, 1995 and $19,929,000 at December 31, 1994. As
a percentage  of loans  outstanding,  the reserve for  possible  loan losses was
4.05%,  3.61% and 3.90% at  year-end  1996,  1995 and  1994,  respectively.  The
provision for possible loan losses charged to operations was $3,150,000 in 1996,
$12,100,000 in 1995 and $10,000,000 in 1994. Net charge-offs  were $3,685,000 in
1996,  $15,794,000 in 1995 and  $10,131,000 in 1994. The continued high level of
the reserve for possible loan losses reflects  management's  current  strategies
and  efforts to  maintain  the  reserve at a level  adequate to provide for loan
losses based on an evaluation of known and inherent risks in the loan portfolio.
Among the factors that  management  considers in  establishing  the level of the
reserve are overall  findings from an analysis of individual  loans, the overall
risk  characteristics and size of the loan portfolio,  past credit loss history,
management's  assessment of current  economic and real estate market  conditions
and estimates of the current value of the underlying collateral.

The Company takes all appropriate  measures to restore  nonperforming  assets to
performing  status or otherwise  liquidate these assets in an orderly fashion so
as to maximize their value to the Company.  There can be no assurances  that the
Company will be able to complete the disposition of nonperforming assets without
incurring further losses.


RISK MANAGEMENT

Interest Rate Risk

Interest  rate risk is the exposure to a movement in interest  rates which could
effect the  Company's  net  interest  income.  It is the  responsibility  of the
Company's  Asset and Liability  Management  Committee  (ALCO) to manage interest
rate risk, which arises naturally from imbalances in repricing,  maturity and/or
cash flow characteristics of the Company's assets and liabilities. The Committee
is responsible for developing asset/liability management strategies and tactics,
and  for  ensuring  that  the  Board  of  Directors  receives  timely,  accurate
information regarding the Bank's interest rate risk position at least quarterly.
Techniques  used by the  Committee  take  into  consideration  the cash flow and
repricing  attributes  of balance  sheet and  off-balance  sheet items and their
relation to possible changes in interest rates.  Through the use of computerized
modeling systems, and with the assistance of outside consultants,  the effect on
the  Company's  net  interest  income of a possible  200 basis  point  change in
interest rates, in rising and declining  scenarios,  is determined and evaluated
by  management.  The Bank has  established  a target range for the change in net
interest  income,  given a 200 basis point change in interest  rates, of zero to
5%. As of December 31, 1996, through the use of such computer models, management
has determined  that the change in net interest  income for the 12 months ending
December 31, 1997 from the Company's  expected or "most likely"  forecast  under
any of the interest rate scenarios used in the analysis is less than 2%.

The Company's  interest rate  sensitivity gap ("gap") is pictured below.  Gap is
defined as the difference  between assets and liabilities  repricing or maturing
within specified periods.  An asset-sensitive  position (positive gap) indicates
that  there  are more  rate-sensitive  assets  than  rate-sensitive  liabilities
repricing  or  maturing  within a  specified  time  period,  which would imply a
favorable impact on net interest income during periods of rising interest rates.
Conversely,  a  liability-sensitive  position (negative gap) generally implies a
favorable  impact on net  interest  income  during  periods of falling  interest
rates.  The  Company's  balance  sheet is very  closely  matched on the one year
horizon, as shown below.

<TABLE>
<CAPTION>
                                                                Repricing Date
---------------------------------------------------------------------------------------------------
                                          One Day     Over Six    One Year
                                          To Six      Months to   to Five     Over Five
                                           Months     One Year      Years       Years        Total
---------------------------------------------------------------------------------------------------

<S>                                       <C>          <C>        <C>          <C>         <C>
Interest-Earning Assets:
Loans                                     $192,136     $38,616    $ 83,561     $ 57,220    $371,533
U.S. Treasury & Agency Securities           13,000      16,617      57,588       57,355     144,560
Other Securities                             3,341           0           0          230       3,571
Other Assets                                     0           0           0       59,372      59,372
---------------------------------------------------------------------------------------------------
Total Assets                              $208,477     $55,233    $141,149     $174,177    $579,036
===================================================================================================
Liabilities and Stockholders' Equity:
Noninterest-bearing Deposits                     0           0           0     $ 80,576    $ 80,576
Interest-bearing Deposits                 $200,170     $45,439    $175,412        6,683     427,704
Borrowed Funds                               9,598           0           0        6,420      16,018
Other Liabilities                                0           0           0        8,488       8,488
Stockholders' Equity                             0           0           0       46,250      46,250
---------------------------------------------------------------------------------------------------
Total Liabilities And Stockholders'
 Equity                                   $209,768     $45,439    $175,412     $148,417    $579,036
===================================================================================================
  Cumulative Gap                            (1,291)      8,503     (25,760)
  Gap as a % of Earning Assets                (.22%)      1.59%      (4.83%)
</TABLE>

Based on historical  experience,  and the Bank's internal repricing policies, it
is the Bank's  practice  to present  repricing  of  statement  savings,  savings
deposits and NOW account balances divided into two repricing  categories:  8% of
such  deposits  are repriced in the "six months to one year"  category,  and the
balance is repriced in the "one to five year"  category.  The Bank's  experience
has shown that the rates on these deposits tend to be less  rate-sensitive  than
other types of deposits.

Credit Risk

Credit risk is managed by a network of loan officers,  with review by the Bank's
Credit  Department  and  oversight  by the  Board  of  Directors.  The  Board of
Directors grants each loan officer the authority to originate loans on behalf of
the Bank and establishes  policies regarding loan portfolio  diversification and
loan  officer  lending  limits.   The  Bank's  loan  portfolio  is  continuously
monitored,  through  the use of a variety  of  management  reports  and with the
assistance of an external loan review firm,  for  performance,  creditworthiness
and strength of  documentation.  Credit ratings are assigned to commercial loans
and are routinely  reviewed.  When necessary,  loan officers or the loan workout
function  take  remedial  actions  to assure  full and  timely  payment  of loan
balances.  The Bank's policy is to discontinue  the accrual of interest on loans
when scheduled  payments become  contractually past due in excess of 90 days and
the ultimate  collectibility of principal or interest becomes  doubtful.  Credit
card  balances 90 days past due are charged off and consumer  installment  loans
are charged off when they reach 120 days past due.

Liquidity and Capital Resource Management

Liquidity,  as it pertains to banking, can be defined as the ability to generate
cash in the most economical way to satisfy loan and deposit  withdrawal  demand,
and to meet other business opportunities that require cash. Sources of liquidity
for banks include short-term liquid assets,  cash generated from loan repayments
and amortization, borrowing, deposit generation and earnings. The Merchants Bank
has a number of sources of liquid  funds,  including  $18,000,000  in  available
Federal Funds lines of credit at year-end 1996; an overnight line of credit with
the  Federal  Home Loan Bank  (FHLB) of $15  million;  an  estimated  additional
borrowing  capacity  with FHLB of $38  million;  and the  ability  to borrow $60
million through the use of repurchase  agreements,  collateralized by the Bank's
investments,  with certain  approved  counterparties.  Additionally,  the Bank's
investment  portfolio is actively  managed by the ALCO Committee and is a strong
source of cash flow for the Bank.  The  portfolio  is  liquid,  with an  average
duration  of 3.2 years,  and is  available  to be used as a source of funds,  if
needed.


BALANCE SHEET ANALYSIS

Total  assets at  December  31, 1996  decreased  $33  million  (5.43%)  from the
previous  year-end.  The net decrease is attributable to two major factors.  The
first factor is a decrease in the Bank's loan  portfolio  by $62.5  million over
the course of 1996. Of this amount,  $6.5 million  resulted from the sale of the
Bank's branch located in Danville,  VT in January of 1996.  Additionally,  loans
totaling $5.1 million were charged off, and the Bank sold loans  totaling  $13.2
million in bulk loan sales.  The remainder of the decrease  ($37.7  million) was
the result of payouts of  nonperforming  obligations and scheduled  amortization
greater than the level of new loan  originations  as the Bank moved  through the
last  phases of its  reengineering  project.  Over the past two  years,  we have
focused our efforts on training and developing the commercial  lending skills of
our loan officers. These efforts, coupled with a performance-based  compensation
program, will help to generate new high quality loan relationships.  Balances of
earning loans have  stabilized in the fourth  quarter of 1996. The second factor
contributing  to the net change in total  assets is the  increase  in the Bank's
investment  portfolio.  As dollars  previously  employed  in the loan  portfolio
became  available,   the  Bank  redeployed  these  assets  into  its  investment
portfolio,  resulting in a $46.5 million  increase in the  investment  portfolio
over the course of 1996. The Bank continued to take aggressive  steps to address
its  portfolio of  nonperforming  assets  during 1996,  the  nonperforming  loan
portfolio  decreased  by $20.6  million  (75%)  and the  Bank's  OREO  portfolio
decreased  by $5.8  million  (75%).  It is  important  to note  that the  Bank's
year-end  earning assets (net of  nonperforming  loans)  increased by $4 million
during  1996.  Total  deposit  balances  declined  during 1996 by $36.2  million
(6.65%).  This decrease in total assets is attributable to several  factors.  In
conjunction with the sale of the Bank's branch in Danville,  VT, $8.8 million in
deposits  was  assumed  by  the  buyer.  Additionally,  the  combination  of the
announced  reengineering  project and the existing regulatory  agreements,  from
which the Bank was  removed in  October,  1996,  also  contributed  to the total
deposit balance  decline.  Almost all (82%) of the decrease in deposit  balances
occurred in the first  quarter of this year;  the Bank's  deposit  balances have
remained  steady  through  the last two  quarters  of  1996.  Finally,  although
difficult to quantify, we are continuing to see the movement of savings balances
to nonbank competitors as interest rates remain low and the stock market remains
strong.

The Bank began a capital  improvement  project to upgrade its branch  facilities
and to make further  investments in technology during 1996.  Approximately  $4.1
million was capitalized and will be depreciated  over the estimated useful lives
of the individual improvements. Additionally, the Bank retired assets with a net
book value of approximately $600,000 in connection with the project; this amount
was charged to expense  during  1996.  The Bank plans to spend $3 million on the
branch upgrade project and $2.2 million for technology upgrades during 1997.

Total  assets at December  31, 1995  decreased  $79.8  million  (11.4%) from the
previous year-end.  Much of this shrinkage is attributable to steps taken by the
Bank to address its portfolio of troubled assets, as well as a low volume of new
loan  originations  due to the continued  sluggish  economy.  Of the $61 million
decrease in loans and Segregated Assets, $18 million was due to charge offs, and
$6.3 million was due to the sale of  nonperforming  loans.  The remainder of the
decrease ($36.7 million) was the result of payouts of nonperforming  obligations
and  scheduled  amortization  greater  than the level of new loan  originations.
Additionally,  during 1995, the Bank's OREO portfolio  decreased by $5.5 million
(41%) due to aggressive steps taken by the Bank to liquidate these assets. Total
deposit balances decreased during 1995 by $38 million,  as customers'  continued
to move  savings  balances  to other bank and nonbank  competitors,  partly as a
result of the continued low interest rate environment.


CAPITAL RESOURCES

Capital  growth is essential  to support  deposit and asset growth and to ensure
strength  and  safety of the  Company.  Net  income  increased,  and net  losses
reduced, the Company's capital by $6,224,000 in 1996,  ($3,842,000) in 1995, and
($2,890,000) in 1994.

The Bank and the Company are subject to various regulatory capital  requirements
administered  by  banking  regulatory  agencies.  To  be  considered  adequately
capitalized  under the regulatory  framework for prompt corrective  action,  the
Bank and the Company must maintain  minimum Tier-1 Leverage,  Tier-1  Risk-Based
and Total Risk-Based Capital. The Bank and the Company were above all regulatory
minimums and considered well-capitalized by the regulators at December 31, 1996.
The ratios for the Company are set forth below:

<TABLE>
<CAPTION>
                                            Amount       Percentage
                                           -------------------------

          <S>                               <C>             <C>
          Tier-1 Risk-Based Capital         $43,814         11.08%

          Total Risk-Based Capital          $48,888         12.37%

          Tier-1 Leverage Capital           $43,814          7.50%
</TABLE>

The Company declared a dividend,  its first since April 1993, of $0.10 per share
on January 21, 1997,  payable on February 14, 1997 to  shareholders of record as
of February 4, 1997.


REGULATORY MATTERS

The Bank,  Trust Company and Holding  Company were released from all  regulatory
agreements during 1996. Following is a discussion of the provisions and terms of
the various agreements.

In 1993, the Bank entered into a Memorandum of Understanding (MOU) with the FDIC
and the Commissioner.  Under the terms of the MOU, the Bank was required,  among
other things,  to maintain a leverage capital ratio of at least 5.5% and refrain
from declaring  dividends.  The Bank operated  under the MOU from October,  1993
until its removal on October 15, 1996.

In February 1994, the Company and the Federal Reserve entered into an agreement.
Under this agreement, among other things, the Company could not declare or pay a
dividend or incur any debt  without the  approval  of the Federal  Reserve.  The
Company  operated  under the  agreement  beginning  in  February  1994 until the
removal of the agreement on June 3, 1996.

In  1995,  the  Trust  Company  entered  into  an MOU  with  the  FDIC  and  the
Commissioner to correct certain operating,  technical and regulatory issues. The
Trust  Company  operated  under the MOU from  February 1995 until its removal on
August 8, 1996.


EFFECTS OF INFLATION

The financial nature of the Company's  balance sheet and statement of operations
is more clearly  affected by changes in interest  rates than by  inflation,  but
inflation  does affect the Company  because as prices  increase the money supply
tends to increase,  the size of loans  requested  tends to increase,  total bank
assets increase,  and interest rates are affected by inflationary  expectations.
In  addition,  operating  expenses  tend to  increase  without  a  corresponding
increase in productivity.  There is no precise method,  however,  to measure the
effects of inflation on the Company's  financial  statements.  Accordingly,  any
examination   or  analysis  of  the  financial   statements   should  take  into
consideration the possible effects of inflation.


FORM 10-K

The  following  is a copy,  except for the  exhibits,  of the  Annual  Report of
Merchants  Bancshares,  Inc.  (the  "Company")  on Form 10-K for the year  ended
December 31,  1996,  filed with the  Securities  and  Exchange  Commission  (the
"Commission").

Certain  information  included  herein is  incorporated  by  reference  from the
Company's  1996 Annual  Report to  Shareholders  ("Annual  Report") as indicated
below.  Except for those  portions  of the  Annual  Report  which are  expressly
incorporated  herein by  reference,  the Annual Report is not to be deemed filed
with the  Commission.  The Annual Report and Form 10-K have not been approved or
disapproved by the Commission,  nor has the Commission  passed upon the accuracy
or adequacy of the same.


                                TABLE OF CONTENTS

Part I                                                        Page Reference
----------------------------------------------------------------------------

    Item 1 - Business                                                38

    Item 2 - Properties                                              45

    Item 3 - Legal Proceedings                                       47

    Item 4 - Submission of Matters to a Vote of Security Holders     47

Part II
-------

    Item 5 - Market for Registrant's Common Equity and               48
             Related Stockholder  Matters

    Item 6 - Selected Financial Data                                 48-51

    Item 7 - Management's Discussion and Analysis of                31-37
             Financial Condition and Results of Operations

    Item 8 - Financial Statements and Supplementary Data             3-30

    Item 9 - Changes in and Disagreements with Accountants
             on Accounting and Financial Disclosures                 58

Part III *
----------

    Item 10 - Directors and Executive Officers of the Registrant

    Item 11 - Executive Compensation

    Item 12 - Security Ownership of Certain Beneficial
              Owners and Management

    Item 13 - Certain Relationships and Related Party
              Transactions

Part IV **

    Item 14 - Exhibits, Financial Statement
              Schedules, and Reports on Form 8-K



*     The information  required by Part III is incorporated  herein by reference
      from the Company's  Proxy Statement for the Annual Meeting of Shareholders
      to be held on April 29, 1997.

**    A list of  exhibits  in the Form  10-K is set forth on the  Exhibit  Index
      included  in the Form 10-K  filed  with the  Commission  and  incorporated
      herein  by  reference.  Copies  of any  exhibit  to the  Form  10-K may be
      obtained  from  the  Company  by  contacting  Shareholder  Communications,
      Merchants  Bancshares,  Inc.,  P.O. Box 1009,  Burlington,  VT 05401.  All
      financial statement  schedules are omitted since the required  information
      is included in the  consolidated  financial  statements of the Company and
      notes thereto in the Annual Report.


Signatures                                                           62



PART I


ITEM 1 - BUSINESS


Merchants  Bancshares,  Inc. is a one-bank holding company originally  organized
under  Vermont  law in 1983 for the  purposes  of owning all of the  outstanding
capital  stock  of  the  Merchants  Bank  (the  "Bank")  and  providing  greater
flexibility  in helping the Bank  achieve its business  objectives.  Its primary
subsidiary is Merchants Bank (the "Bank"),  a Vermont Bank with 33  full-service
offices.

The last two years have been a period of great  change for  Merchants  Bank.  We
have   undergone  a   reengineering   project  that  reduced  our  workforce  by
approximately  50%. At the same time, we have decreased our nonperforming  asset
portfolio to its lowest level in 7 years.  We have also  redefined the way we do
business and created a new image for our  institution.  We have closed corporate
headquarters  and  deployed  resources  to our branch  system.  We have  brought
technological innovations to our internal operations and to our customers. These
changes  have  allowed  us to meet our goals for 1996 and have set the stage for
future earnings growth.

A  chronology  of  events,   including   acquisitions,   relating  to  MERCHANTS
BANCSHARES, INC., (the Company) is as follows:

      July 1,  1983:  Merchants  Bancshares,  Inc.  was  organized  as a Vermont
      corporation,  for the purpose of acquiring,  investing in or holding stock
      in any subsidiary enterprise under the Bank Holding Company Act of 1956.

      January 24, 1984: Company acquired The Merchants Bank, a Vermont chartered
      commercial bank.

      June 2, 1987:  Company  shareholders  approved a resolution  to change the
      state of incorporation of the Company from Vermont to Delaware.

      October 4, 1988:  Company  organized  Merchants  Properties,  Inc.,  whose
      mission is described below.

THE MERCHANTS  BANK,  (the Bank) was  organized in 1849,  and assumed a national
bank  charter in 1865,  becoming  The  Merchants  National  Bank of  Burlington,
Vermont.  On September  6, 1974 the Bank  converted  its  national  charter to a
state-bank  charter,  becoming known as The Merchants Bank.  Since 1971 the Bank
has acquired by merger seven Vermont banking institutions,  and has acquired the
deposits  of an  eighth  bank  located  in St.  Johnsbury,  Vt.  The  last  such
acquisition  occurred  on June 4, 1993 at which time the Bank  acquired  the New
First National Bank of Vermont,  with thirteen banking offices, from the Federal
Deposit Insurance  Corporation Division of Liquidation.  As of December 31, 1996
the Bank was the fifth largest  commercial  banking  operation in Vermont,  with
deposits totaling $508.3 million,  net loans of $371.5 million, and total assets
of $579.0 million, on a consolidated basis.

Since  September 30, 1988,  the  Merchants  Bank has  participated  as an equity
partner in the development of several AFFORDABLE HOUSING PARTNERSHIPS which were
formed to provide residential housing units within the State of Vermont.  During
the past four years these  partnerships  have developed 727 units of residential
housing,  470 (65%) of which qualify as  "affordable  housing units for eligible
low-income  owners or renters",  and 257 (35%) of which are "market rate units."
These  partnerships  have invested in 16 affordable and elderly housing projects
within 13 Vermont  communities:  St. Albans,  Middlebury,  Williston,  Winooski,
Brattleboro,  Montpelier,  Burlington,  Springfield, St. Johnsbury,  Colchester,
Swanton, Bradford and Hardwick.

MERCHANTS  PROPERTIES,  INC., a wholly  owned  subsidiary  of the  Company,  was
organized for the purpose of developing  and owning  affordable  rental  housing
units  throughout  the state of  Vermont.  As of  December  31,  1996  Merchants
Properties,  Inc. owned one development located in Enosburg, Vermont, consisting
of a 24-unit  low-income family rental housing project,  which was completed and
rented during 1989.  This housing  development  is fully  occupied at this time.
Total assets of this corporation at December 31, 1996 were $1,276,665.

The Merchants Bank owns controlling  interest in the MERCHANTS TRUST COMPANY,  a
Vermont  corporation  chartered  in 1870 for the purpose of  offering  fiduciary
services  such  as  estate  settlement,   testamentary  trusts,   guardianships,
agencies,   intervivos  trusts,  employee  benefit  plans  and  corporate  trust
services.  The Merchants Trust Company also operates a discount brokerage office
through Olde Discount Corporation, enabling investors to purchase or sell stocks
and bonds on a discounted  commission  schedule.  As of December  31, 1996,  the
Merchants  Trust  Company had  fiduciary  responsibilities  for assets valued at
market in excess of $256  million,  of which more than $174 million were managed
assets.  Total revenue for 1996 was  $1,517,838;  total expense was  $1,297,445,
resulting  in pretax net  income of  $220,393  for the year.  This net income is
included in the  consolidated  tax return of its parent  company,  the Merchants
Bank.

QUENESKA  CAPITAL  CORPORATION,  a wholly owned subsidiary of the Merchants Bank
was established on April 4, 1988 as a Federal  licensee under the Small Business
Act of 1958 to provide small business  enterprises with loans and/or capital. As
of December 31, 1996, the corporation  had assets of $1,673,001,  liabilities of
$4,173 due to the parent company for accrued management fees, and equity capital
of $1,668,828.

Queneska  Capital  Corporation  has  no  employees,  relying  on  the  personnel
resources  of its parent  company to  operate.  As  compensation  for the Bank's
services,  Queneska  pays the Bank a  management  fee  ($25,361  in 1996) in the
amount of 1.5% on annual average assets. This fee is eliminated in the financial
statement consolidation of the parent company.


RETAIL SERVICES

The Bank offers a variety of consumer  financial  products and services designed
to satisfy the deposit and loan needs of its retail customers. The Bank's retail
products include  interest-bearing  and  noninterest-bearing  checking accounts,
money market  accounts,  passbook and  statement  savings,  club  accounts,  and
short-term and long-term certificates of deposit. The Bank also offers customary
check  collection  services,  wire  transfers,  safe  deposit box  rentals,  and
automated teller machine (ATM) cards and services.

Merchants  Bank  introduced a new checking  account in May of 1996.  FreedomLynx
checking is available  with no service  charges to customers  who have, at least
monthly,  an  automatic  deposit to the account or an  automatic  debit from the
account to pay a  Merchants  Bank loan.  The  account  pays  interest  on higher
balances  with a tiered  rate  structure.  Interest  accrues on any day that the
balance falls within one of the tiers. No minimum balance is required.

During  1996,  the Bank  worked to revise and  simplify  its retail  deposit and
investment products.  Beginning on January 1, 1997 the Bank will offer two basic
checking  accounts - FreedomLynx  Checking and Bottom Line Checking,  an account
that provides for a flat service charge up to a maximum number of checks.  Other
retail  checking  accounts will continue to be maintained  but will no longer be
available as new accounts.

In 1996, the Bank introduced electronic bill payment by telephone or by personal
computer. With these services, customers can pay any type of bill electronically
from their own PC or from a telephone at any time that fits their schedule.  The
Bank is committed to automation,  offering ATM cards, ATF (automatic transfer of
funds)  to  cover  overdrafts,  EFT  (electronic  funds  transfer)  to  automate
transfers  between  accounts,  PCLynx  bill  payment  services  and  the  PCLynx
telephone  banking  system.  In 1997,  the Bank  plans to expand  its  automated
services by introducing a debit card and a retail home banking system.

The Bank  continues  to  provide  strong  customer  support  with 34 ATMs and 34
on-line banking offices throughout the state of Vermont.  The Bank offers all of
its retail services and products at its 33 full-service banking offices.


COMMERCIAL SERVICES

The 1995-1996  restructuring of the Sales organization has been completed.  Each
branch office is led by a branch  president or manager who has consumer  lending
authority  for the full  range of  retail  credit  services.  Branch  presidents
additionally are being given small business lending authority up to a prescribed
limit.  There are 23 branch presidents and 9 managing customer  representatives.
The ten corporate  banking  officers and five corporate  banking  administrators
provide commercial credit services  throughout the state of Vermont to customers
requiring  business  credit  above  the  prescribed  authorities  of the  branch
presidents.

Merchants  Bank offers a variety of  commercial  checking  accounts.  Commercial
Checking  uses an earnings  credit rate to help offset  service  charges.  Small
Business  Checking is designed for the smaller business  carrying lower balances
and reduced account activity.

Investment  opportunities  are  available to  businesses  in the form of savings
accounts and money market accounts.  The Bank's cash management services provide
additional investment opportunities through the Cash Sweep Program.
Other cash management services include funds concentration.

The Bank offers on-line  banking  services  through PCLynx  Corporate and PCLynx
Small Business. These products allow businesses to view their account histories,
order stop payments,  transfer between accounts,  transmit ACH batches and order
both domestic and foreign wire transfers.

Other miscellaneous  commercial banking services include night depository,  coin
and currency handling, lockbox and balance reporting services. Employee benefits
management and related  fiduciary  services are available  through the Merchants
Trust Company.

Types of Credit Offerings:

Consumer Loans:
---------------

Financing  is  provided  for  new  or  used   automobiles,   boats,   airplanes,
recreational  vehicles and new mobile homes.  Home  improvement  and home equity
lines of credit,  Master Card  credit  cards and  various  collateral  loans and
personal loans are also available.

Real Estate Loans:
------------------

Financing is available for one-to-four-family residential mortgages; multifamily
mortgages;  residential  construction;  mortgages  for seasonal  dwellings;  and
commercial  real estate  mortgages.  Mortgages for  residential  properties  are
offered  on  a  long-term,  fixed-rate  basis;  alternatively,   adjustable-rate
mortgages are offered.  Biweekly  payment  mortgages  and  graduated  (two-step)
payment mortgages are offered. Loans under the Farmers Home Administration Rural
Guaranteed  Housing  Program  provide  up  to  100%  financing.  The  Bank  also
participates  with the  Vermont  Housing  Finance  Agency  (VHFA)  in  providing
mortgage  financing for low- to moderate-income  Vermonters.  Most mortgage loan
products are offered with as little as a 5% down payment to assist borrowers who
qualify, provided that the mortgagor(s) acquires private mortgage insurance.

Commercial Loans:
-----------------

Financing  for  business  inventory, accounts receivable, fixed assets, lines of
credit  for  working  capital,  community  development,  irrevocable  letters of
credit,  business  credit cards and U.S. Small Business Administration loans are
available.


EXPANSION EFFORTS

Merchants Bank operates  thirty-three  full-service  banking  facilities  within
Vermont,  one limited  service  facility,  and a remote ATM unit  located at the
Burlington International Airport. Since 1963, the Bank has established eleven de
novo  offices,  and since  1969 has  acquired  seven  Vermont  banks by  merger.
Merchants  Bank's  most  recent  acquisition  occurred  in June of 1993 with the
acquisition  of the assets and  assumption of deposits of the New First National
Bank of Vermont from the FDIC.

Each decision to expand the branch network has been based on strategic  planning
and analysis indicating that the new or acquired facility would provide enhanced
banking  resources within the community and insure the competitive  viability of
the Bank through potential growth of deposits and lending activities.

On January 12, 1996,  the Passumpsic  Savings Bank purchased  certain assets and
assumed  certain  liabilities  of the Bank's  branch  located in  Danville,  VT.
Merchants  Bank  received an 8% deposit  premium on deposits  sold in accordance
with the purchase and  assumption  agreement.  In the first quarter of 1996, the
Colchester  Avenue  branch in  Burlington  was closed,  with  customer  accounts
consolidated to the College Street and White Street offices.


COMPETITION

Competition  for  financial  services  remains  very  strong in  Vermont.  As of
December  31,  1996,  there  were  more  than  30  state  and  national  banking
institutions  operating  in  Vermont.  In  addition,  other  financial  services
providers such as brokerage firms,  credit unions,  and out-of-state  banks also
compete for deposit,  loan and  ancillary  services  customers.  Due to national
institutions'  use of aggressive  direct mail  marketing and the opening of more
satellite  offices  in  Vermont,  Merchants  Bank  can  expect  the  competitive
environment of financial services to become even more aggressive.

At year-end 1996,  Merchants Bank was the fifth largest state  chartered bank in
Vermont,  enjoying a strong  competitive  franchise  within  the state,  with 35
banking offices as identified in Item 2 (A).

Consolidation  within  the  overall  banking  industry  continues  to change the
competitive environment in which we operate.  Competition from nationwide banks,
as well as local institutions, is expected to be aggressive.  However, there may
be  opportunities  for  business  development  by  the  Bank  in  shared  market
communities as a result of the continued consolidation in the banking industry.

No  material  part of the  Bank's  business  is  dependent  upon one,  or a few,
customers,  or upon a particular market segment,  the loss of which would have a
materially adverse impact on the operations of the Bank.


NUMBER OF EMPLOYEES

As of December 31, 1996, Merchants Bancshares, Inc. had five officers: Joseph L.
Boutin,  President  and  Chief  Executive Officer; Jennifer L. Varin, Secretary;
Janet P. Spitler, Treasurer;  and Susan M. Verro and Janet L. Lussier, Assistant
Secretaries. No officer of the Company is on a salary basis.

As of December 31, 1996,  Merchants Bank employed 211 full-time and 49 part-time
employees,  representing a full-time equivalent complement of 237 employees; the
Merchants  Trust  Company  employed  13  full-time  and 1  part-time  employees,
representing a full-time equivalent  complement of 13.5 employees.  The Bank and
the Trust  Company  maintain  comprehensive  employee  benefits  programs  which
provide major medical insurance,  hospitalization,  dental insurance,  long-term
and short-term disability insurance,  life insurance and a 401(k) Employee Stock
Ownership Plan.  Employee benefits offered by the Bank and the Trust Company are
very competitive with comparable plans provided by similar Vermont institutions.


REGULATION AND SUPERVISION

General

As a bank holding company registered under the Bank Holding Company Act of 1956,
as amended (the "BHCA"),  the Company is subject to  substantial  regulation and
supervision by the Federal Reserve Board. As a state-chartered bank, the Bank is
subject  to  substantial  regulation  and  supervision  by the  Federal  Deposit
Insurance  Corporation (the "FDIC") and by applicable state regulatory agencies.
To the extent that the following  information  describes statutory or regulatory
provisions,  it is qualified  in its  entirety by reference to those  particular
statutory  provisions.  Any change in applicable  law or  regulation  may have a
material effect on the business and prospects of the Company and the Bank.

The Company is required  by the BHCA to file with the Federal  Reserve  Board an
annual  report and such  additional  reports as the  Federal  Reserve  Board may
require.  The  Federal  Reserve  Board also makes  periodic  inspections  of the
Company and its  subsidiaries.  The BHCA requires every bank holding  company to
obtain the prior  approval of the Federal  Reserve  Board  before it may acquire
substantially  all of the  assets of any bank,  or  ownership  or control of any
voting shares of an bank, if, after such  acquisition,  it would own or control,
directly or  indirectly,  more than 5 percent of the voting shares of such bank.
Additionally,  as a  bank  holding  company,  the  Company  is  prohibited  from
acquiring  ownership  or control of 5% or more of any company not a bank or from
engaging in activities other than banking or controlling  banks except where the
Federal Reserve Board has determined that such activities are so closely related
to banking as to be a "proper incident thereto."

Dividends

General.  The Company is a legal entity  separate and distinct from the Bank and
its other nonbank subsidiaries.  The revenue of the Company (on a parent company
only  basis) is  derived  primarily  from  interest  and  dividends  paid to the
corporation by its subsidiaries.  The right of the Company, and consequently the
right of stockholders of the Company,  to participate in any distribution of the
assets or earnings of any  subsidiary  through the payment of such  dividends or
otherwise  is  necessarily  subject  to the  prior  claims of  creditors  of the
subsidiary (including depositors,  in the case of banking subsidiaries),  except
to the extent that certain  claims of the Company in a creditor  capacity may be
recognized.

The payment of dividends by the Company is  determined by its board of directors
based on the Company's liquidity,  asset quality profile,  capital adequacy, and
recent  earnings  history,  as well as economic  conditions  and other  factors,
including  applicable  government  regulations  and  policies  and the amount of
dividends payable to the Company by its subsidiaries.

It is the  policy of the  Federal  Reserve  Board  that  banks and bank  holding
companies,  respectively,  should pay dividends only out of current earnings and
only if after  paying such  dividends  the bank or bank  holding  company  would
remain adequately capitalized. Federal banking regulators also have authority to
prohibit  banks and bank holding  companies  from paying  dividends if they deem
such payment to be unsafe or unsound practice.  In addition,  it is the position
of the Federal Reserve Board that a bank holding company is expected to act as a
source of financial strength to its subsidiary banks.

State law  requires  the approval of state bank  regulatory  authorities  if the
dividends  declared by state banks exceed prescribed  limits. The payment of any
dividends by the Company's  subsidiaries will be determined based on a number of
factors,  including the subsidiary's liquidity,  asset quality profile,  capital
adequacy and recent earnings history.

Legislation and Related Matters

General.  In addition to extensive existing government  regulation,  federal and
state statutes and regulations are subject to changes that may have  significant
impact on the way in which  banks  may  conduct  business.  The  likelihood  and
potential effects of any such changes cannot be predicted.  Legislation  enacted
in recent  years has  substantially  increased  the level of  competition  among
commercial banks,  thrift institutions and non-banking  institutions,  including
insurance  companies,  brokerage firms, mutual funds,  investment banks, finance
companies and major retailers. In addition, the existence of banking legislation
such as the Financial Institutions Reform,  Recovery and Enforcement Act of 1989
("FIRREA") and the Federal Deposit Insurance Corporation Improvement Act of 1991
("FDICIA") have affected the banking industry by, among other things, broadening
the regulatory  powers of the federal banking agencies in a number of areas. The
following  summary is  qualified  in its  entirety  by the text of the  relevant
statutes and regulations.

FIRREA.  As a result of the enactment of FIRREA on August 9, 1989,  the Bank can
be held liable for any loss incurred by, or  reasonably  expected to be incurred
by, the FDIC after  August 9, 1989,  in  connection  with (a) the default of the
Bank  or (b) any  assistance  provided  by the  FDIC to the  Bank in  danger  of
default.  "Default" is defined  generally as the appointment of a conservator or
receiver  and "in danger of default" is defined  generally  as the  existence of
certain  conditions  indicating  that a  "default"  is likely  to occur  without
regulatory assistance.

FDICIA. The FDICIA,  which was enacted on December 19, 1991, provides for, among
other things,  increased funding for the Bank Insurance Fund ("BIF") of the FDIC
and  expanded  regulation  of  depository  institutions  and  their  affiliates,
including parent holding companies.  A summary of certain material provisions of
FDICIA and its regulations is provided below.

Prompt Corrective  Action. The FDICIA provides the federal banking agencies with
broad  powers to take prompt  corrective  action to resolve  problems of insured
depository  institutions,  depending  upon a particular  institution's  level of
capital. The FDICIA establishes five tiers of capital measurement for regulatory
purposes ranging from  "well-capitalized"  to "critically  undercapitalized."  A
depository institution may be deemed to be in a capitalization  category that is
lower  than  is  indicated  by  its  actual   capital   position  under  certain
circumstances.   As  of  December  31,  1996,   the  Bank  was   classified   as
"well-capitalized" under the applicable prompt corrective action regulations.

Brokered  Deposits.   Under  the  FDICIA,  a  depository   institution  that  is
well-capitalized may accept brokered deposits. A depository  institution that is
adequately  capitalized may accept brokered deposits only if it obtains a waiver
from the  FDIC,  and may not offer  interest  rates on  deposits  "significantly
higher" than the prevailing rate in its market. An  undercapitalized  depository
institution may not accept brokered deposits.

Safety and Soundness  Standards.  The FDICIA,  as amended,  directs each federal
banking  agency to  prescribe  safety and  soundness  standards  for  depository
institutions relating to internal controls,  information systems, internal audit
systems, loan documentation,  credit underwriting, interest rate exposure, asset
growth, compensation, asset-quality, earnings and stock valuation. The Community
Development  and Regulatory  Improvement  Act of 1994 amended FDICIA by allowing
federal  banking  activities  to  publish  guidelines  rather  than  regulations
concerning safety and soundness.

The Federal Reserve Board has finalized  these safety and soundness  guidelines.
These guidelines relate to the management policies of financial institutions and
are designed,  in large part,  to implement  the safety and  soundness  criteria
outlined in FDICIA.  These  guidelines will be published after the other federal
bank regulatory  agencies have developed their  guidelines.  At this time, it is
not known  what  effect  the  applicable  guidelines  will  have on the  current
practices of the Company or the Bank.

FDICIA also contains a variety of other provisions that may affect the Company's
and  the  Bank's  operations,   including  reporting  requirements,   regulatory
guidelines  for real  estate  lending,  "truth in savings"  provisions,  and the
requirement  that a  depository  institution  give  90  days'  prior  notice  to
customers and regulatory  authorities before closing any branch.  Certain of the
provisions  in FDICIA  have  recently  been or will be  implemented  through the
adoption of regulations by the various federal banking agencies and,  therefore,
their precise impact cannot be assessed at this time.

Capital Guidelines.  Under the uniform capital guidelines adopted by the federal
banking agencies,  a  well-capitalized  institution must have a minimum ratio of
total capital to  risk-adjusted  assets  (including  certain  off-balance  sheet
items, such as standby letters of credit) of 10%, a minimum Tier 1 (comprised of
common equity,  retained earnings,  minority interests in the equity accounts of
consolidated  subsidiaries  and a  limited  amount  of  noncumulative  perpetual
preferred stock, less deductible intangibles) capital-to-total risk based assets
of 6% and a minimum leverage ratio (Tier 1 capital to average  quarterly assets,
net of goodwill), of 5%.

As of December 31, 1996, the Bank was classified as "well-capitalized."  Neither
the Company nor the Bank is subject to, or party to, any order or agreement with
any federal banking agency with respect to the capital maintenance.

The federal banking agencies  continue to indicate their desire to raise capital
requirements   applicable  to  banking  organizations,   and  recently  proposed
amendments  to  their  risk-based   capital   regulations  to  provide  for  the
consideration of interest rate risk in determination of a bank's minimum capital
requirements.  The  proposed  amendments  are  intended  to  require  that banks
effectively  measure and monitor their interest rate risk and that they maintain
capital  adequate  for that  risk.  Under the  proposed  amendments,  banks with
interest  rate  risk in  excess  of a  defined  supervisory  threshold  would be
required to maintain  additional  capital  beyond that  generally  required.  In
addition,  effective  January  17,1995,  the federal  banking  agencies  adopted
amendments   to  their   risk-based   capital   standards  to  provide  for  the
concentration  of credit  risk and certain  risks  arising  from  nontraditional
activities,  as well as a bank's  ability to manage  these  risks,  as important
factors in assessing a bank's overall capital adequacy.

Under  federal  banking  laws,  failure to meet the minimum  regulatory  capital
requirements  could subject a banking  institution  to a variety of  enforcement
remedies available to federal regulatory authorities,  including the termination
of deposit insurance by the FDIC and seizure of the institution.

Community Investment Act. Pursuant to the Community Reinvestment Act ("CRA") and
similar provisions of Vermont law, regulatory authorities review the performance
of the  Company  and the Bank in  meeting  the credit  needs of the  communities
served by the Bank. The applicable  regulatory  authorities  consider compliance
with this law in  connection  with the  applications  for,  among other  things,
approval of branches,  branch  relocations  and  acquisitions  of banks and bank
holding companies.  The Bank received a "satisfactory" rating at its most recent
CRA examination.

Interstate Banking Legislation.  The Interstate Banking and Branching Efficiency
Act of 1994  facilitates the interstate  expansion and  consolidation of banking
organizations  by  permitting  (i)  beginning  one year after  enactment  of the
legislation,  bank holding companies that are adequately capitalized and managed
to acquire  banks  located in states  outside  their home states  regardless  of
whether such  acquisitions are authorized under the law of the host state,  (ii)
the  interstate  merger of banks  after  June 1,  1997,  subject to the right of
individual states to "opt in" or "opt out" of this authority prior to such date,
(iii) banks to establish new branches on an interstate  basis provided that such
action is  specifically  authorized  by the law of the host state,  (iv) foreign
banks to establish,  with approval of the  appropriate  regulators in the United
States,  branches  outside their home states to the same extent that national or
state banks  located in such state would be authorized to do so and (v) banks to
receive deposits,  renew time deposits,  close loans,  service loans and receive
payment  on  loans  and  other  obligations  as  agent  for any  bank or  thrift
affiliate, whether the affiliate is located in the same or different state.

Other Proposals

Other legislative and regulatory proposals regarding changes in banking, and the
regulation of banks and other financial  institutions,  are regularly considered
by the executive  branch of the federal  government,  Congress and various state
governments, including Vermont, and state and federal regulatory authorities. It
cannot be predicted what additional legislative and/or regulatory proposals,  if
any,  will be  considered  in the  future,  whether any such  proposals  will be
adopted or, if adopted,  how any such proposals  would affect the Company or the
Bank.


ITEM 2 - PROPERTIES


A.    SCHEDULE OF BANKING OFFICES BY LOCATION

Merchants Bank operates  thirty-five banking facilities as indicated in Schedule
A below.  Corporate  administrative  offices and the operations  data processing
center are located at 275 Kennedy Drive, South Burlington, Vermont.

    Burlington          164 College Street                 Merchants Trust Co.
                        172 College Street                 Branch office
                        1014 North Avenue                  Branch office

    Essex Junction      54 Pearl Street                    Branch office

    South Burlington    50 White Street                    Branch office
                        929 Shelburne Road *1              Branch office
                        275 Kennedy Drive                  Operations Center
                                                           Corporate Offices
                                                           Branch office
                        Burlington Airport *1              ATM

    Bristol             15 West Street                     Branch office

    Barre               105 North Main Street              Branch office

    Northfield          47 Depot Square                    Branch office

    South Hero          South St. & Route 2                Branch office

    Hardwick            Wolcott Street                     Branch office

    Hinesburg           Route 116/Shelburne Falls Rd       Branch office

    Vergennes           Monkton Road                       Branch office

    Winooski            364 Main Street                    Branch office

    Shelburne           Wake Robin                         Branch office

    Johnson             Main Street, Route 15              Branch office

    Colchester          8 Porters Point Road *2            Branch office

    Jericho             Route 15                           Branch office

    Enosburg Falls      155 Main Street                    Branch office

    No. Bennington      Bank Street                        Branch office

    Manchester Ctr.     515 Main Street                    Branch office

    Brattleboro         205 Main Street *3                 Branch office

    Wilmington          West Main Street                   Branch office

    Bennington          Putnam Square *2                   Branch office

    Wallingford         Route 7 *2                         Branch office

    St. Johnsbury       90 Portland Street                 Branch office

    Bradford            1 Main Street &                    Branch office
                        Operations Building

    Fairlee             U.S. Route #5                      Branch office

    Groton              258 Scott Highway                  Branch office

    East Thetford       U.S. Route #5 & VT 113             Branch office

    Newbury             U.S. Route #5                      Branch office

    Fair Haven          97 Main Street                     Branch office
                        Washington Street Grand Union *1   ATM

    Springfield         Springfield Shopping Plaza         Branch office

    Windsor             160 Main Street                    Branch office


Notes:
         *1:      Facilities owned by the Bank are located on leased land.
         *2:      Facilities located on leased land with improvements also 
                  leased.
         *3:      As of December 31, 1996, a mortgage  with an unpaid  principal
                  balance of $202,991 is outstanding on the Brattleboro  office.
                  This  mortgage is being  amortized  at $1,736 per month,  at a
                  rate of 9% through the year 2020.


ITEM 3 - LEGAL PROCEEDINGS


LEGAL PROCEEDINGS

During the fall of 1994,  lawsuits were brought  against the Company,  the Bank,
the Trust  Company  (collectively  referred to as "the  Companies")  and certain
directors  of the  Companies.  These  lawsuits  related to  certain  investments
managed for Trust Company clients and placed in the Piper Jaffray  Institutional
Government  Income Portfolio.  Separately,  and before the suits were filed, the
Companies  had  initiated  a review  of those  investments.  As a result  of the
review,  the Trust Company paid to the affected Trust Company clients a total of
approximately  $9.2 million in December  1994.  The payments do not constitute a
legal settlement of any claims in the lawsuits.  However,  based on consultation
with legal counsel,  management believes that further liability,  if any, of the
Companies on account of matters  complained  of in the lawsuits  will not have a
material  adverse effect on the consolidated  financial  position and results of
operations  of the  Company.  In December  1994,  the Trust  Company  received a
payment of  $6,000,000  from its  insurance  carriers in  connection  with these
matters.  The Companies also intend to pursue all available claims against Piper
Jaffray  Companies,  Inc.  and others on account of the losses that gave rise to
the $9.2 million payment by the Companies.  The claims of the Trust Company,  as
trustee,  against  Piper  Jaffray  Companies  were  joined  with claims of other
investors  in the Piper  Fund in a class  action in the United  States  District
Court for the  District  of  Minnesota.  The class  action  was  settled  by the
parties,  and on December 14, 1995, the settlement was approved by the Court. By
order dated  January 11,  1996,  the Court  ordered the share of the  settlement
proceeds attributable to Merchants Trust Company investments not be paid pending
further  order.  On February 18, 1997,  the District  Court entered an Order for
Final  Judgment.  That Order provides,  among other matters,  that except to the
extent (if at all) any other court with jurisdiction has given leave for some or
all of the proceeds to be deposited  with that court pursuant to Vermont Rule of
Civil  Procedure 67,  Federal Rule of Civil  Procedure 67, or such other rule as
may apply, and absent an appeal, the entire net settlement proceeds attributable
to the Trust Company  investments  are to be paid to the Trust Company  starting
approximately  sixty-one  days  after the date of the  Order.  Any  recovery  of
settlement  proceeds  is  subject  to the  terms  of an  agreement  between  the
Companies  and  their  insurance  carriers.   The  attorneys   representing  the
plaintiffs in one of the lawsuits  discussed  above have taken the position that
amounts  recovered  by the  Companies  on  these  claims  should  be paid to the
affected  Trust  Company  clients  (net of legal  fees  paid to  attorneys),  in
addition to the $9.2 million already paid.

The attorneys representing the plaintiffs in one of the lawsuits discussed above
requested an award of  attorneys'  fees for  allegedly  causing the Companies to
make the $9.2 million  payment and asked the Court to order the Trust Company to
withhold  payment of  $500,000.  The Trust  Company has  resisted the claims for
payment of such fees by its  clients,  and, as a result,  the Trust  Company was
directed to place the sum of $500,000 into escrow pending a ruling by the Court.
On appeal by the Companies, the United States Court of Appeals affirmed in part,
vacated  in part,  and  reversed  for  further  proceedings  the  lower  court's
judgment.  The  attorneys  representing  the  plaintiffs  in that  lawsuit  have
indicated that they intend to seek damages as well as attorneys'  fees. There is
the  possibility  that the Companies may be required to remit all or part of the
escrowed funds, or to pay damages.  However,  based upon consultation with legal
counsel,  management  believes  that on the  facts  of  this  case  there  is no
substantial authority for an award of such fees or damages in those proceedings.

The Bank is also  involved in various  legal  proceedings  arising in the normal
course of  business.  Based upon  consultation  with legal  counsel,  management
believes that the resolution of these matters will not have a material effect on
the consolidated financial position and results of operations of the Company.


ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS


During the fourth  quarter of calendar year 1996 no matters were  submitted to a
vote of security holders through a solicitation of proxies or otherwise.


PART II


ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS


The common stock of the Company is traded on the over-the-counter market and the
price is quoted on the NASDAQ  National  Market Stock Exchange under the trading
symbol  MBVT.  Quarterly  stock  prices  during the last eight  quarters  are as
indicated below based upon quotations as provided by the National Association of
Securities Dealers, Inc. Prices of transactions between private parties may vary
from the ranges quoted below.

<TABLE>
<CAPTION>

         QUARTER ENDED                           HIGH         LOW
         ----------------------------------------------------------

         <S>                                     <C>        <C>
         March 31, 1995                          $11.750    $ 9.250

         June 30, 1995                            12.500     10.000

         September 30, 1995                       15.000     10.500

         December 31, 1995                        15.000     13.250

         March 31, 1996                           16.000     13.250

         June 30, 1996                            16.375     14.250

         September 30, 1996                       16.000     15.000

         December 31, 1996                        19.375     15.000
</TABLE>

As of January 29, 1997 Merchants  Bancshares,  Inc. had 1,366 shareholders.  The
Company did not declare or pay a dividend from April 1993 until  February  1997,
when the Board of Directors declared a fourth quarter,  1996 dividend payable on
February  14,  1997 to  shareholders  of  record at  February  4,  1997.  Future
dividends  will depend upon the financial  condition and earnings of the Company
and its  subsidiaries,  their  need  for  funds  and  other  factors,  including
applicable government regulations.

ITEM 6 - SELECTED FINANCIAL DATA

The supplementary financial data presented in the following tables and narrative
contain  information  highlighting  certain  significant trends in the Company's
financial condition and results of operations over an extended period of time.

The following  information  should be analyzed in conjunction  with the year-end
audited consolidated financial statements as contained in the 1996 Annual Report
to Shareholders, a copy of which is attached as an addendum to this Form 10-K.

The  five-year  summary  of  operations,   interest   management   analysis  and
management's discussion and analysis, all as contained on pages 29 through 37 of
the 1996 Annual Report to Shareholders, are herein incorporated by reference.

Tables included on the following pages 49 through 52 concern the following:

Deposits;  return on equity and assets;  short-term borrowings;  distribution of
assets,  liabilities,  and  stockholders'  equity;  analysis  of  changes in net
interest income; and the composition and maturity of the loan portfolio.


DEPOSITS

The following schedule shows the average balances of various  classifications of
deposits. Dollar amounts are expressed in thousands.

<TABLE>
<CAPTION>
                                                  1996       1995        1994
                                                -------------------------------

<S>                                             <C>        <C>         <C>
Demand Deposits                                 $ 78,873   $ 87,434    $ 91,853
Savings, Money Market and NOW Accounts           264,611    279,906     310,613
Time Deposits Over $100,000                       20,059     20,927      18,135
Other Time Deposits                              150,380    167,975     177,198
                                                -------------------------------
Total Average Deposits                          $513,923   $556,242    $597,799
                                                ===============================
</TABLE>

Time  Deposits  over  $100,000 at December  31, 1996 had the  following schedule
of maturities (in thousands):

  Three Months or Less                                             $ 3,137
  Three to Six Months                                                4,098
  Six to Twelve Months                                               3,673
  Over Twelve Months                                                 2,789
  Over Five Years                                                    6,672
                                                                   -------
    Total                                                          $20,369
                                                                   =======

RETURN ON EQUITY AND ASSETS

The return on average assets,  return on average  equity,  dividend payout ratio
and average  equity to average  assets ratio for the three years ended  December
31, 1996 were as follows:

<TABLE>
<CAPTION>
                                             1996     1995      1994
                                             --------------------------

<S>                                           <C>     <C>       <C>
Return on Average Total Assets                1.07%   (0.60%)   (0.41%)

Return on Average Stockholders' Equity       14.44%   (9.41%)   (6.24%)

Dividend Payout Ratio                         N/A       N/A       N/A

Average Stockholders' Equity to
 Average Total Assets                         7.42%    6.36%     6.53%
</TABLE>

SHORT-TERM BORROWINGS

Refer to Notes 7 and 8 to the Financial Statements for this information.


Distribution of Assets, Liabilities and Stockholders' Equity; Interest Rates and
Interest Differential.

The following  table presents the condensed  annual  average  balance sheets for
1996,  1995 and 1994. The total dollar amount of interest income from assets and
the subsequent  yields  calculated on a taxable  equivalent basis as well as the
interest paid on interest bearing  liablilities,  expressed in dollars and rates
are also shown in the table.


                           (Dollars are in Thousands)

<TABLE>
<CAPTION>

                                         1996                           1995                            1994
----------------------------------------------------------------------------------------------------------------------------------

                                                  Interest   Average             Interest   Average             Interest   Average
                                        Average   Income/    Yield/    Average   Income/    Yield/    Average   Income/    Yield/
ASSETS:                                 Balance   Expense     Rate     Balance   Expense     Rate     Balance   Expense     Rate
----------------------------------------------------------------------------------------------------------------------------------

<S>                                    <C>        <C>         <C>     <C>        <C>         <C>     <C>        <C>         <C>
Investment Securities:
  U.S. Treasury and Agencies           $ 117,908  $  7,588    6.44%   $  83,749  $  4,525    5.40%   $  89,183  $  3,508    3.93%
  Other, Including FHLB Stock              2,865       148    5.17%       4,416       357    8.08%       8,178       535    6.54%
----------------------------------------------------------------------------------------------------------------------------------
      Total Investment Securities      $ 120,773  $  7,736    6.41%   $  88,165  $  4,882    5.54%   $  97,361  $  4,043    4.15%
----------------------------------------------------------------------------------------------------------------------------------

Loans, Including Fees on Loans:
  Commercial (a) (b)                      68,783     7,281   10.59%      87,009     9,236   10.61%     117,948    10,128    8.59%
  Real Estate                            322,690    31,135    9.65%     378,433    35,094    9.27%     396,176    36,959    9.33%
  Consumer                                15,041     1,673   11.12%      15,605     1,902   12.19%      19,710     2,167   10.99%
----------------------------------------------------------------------------------------------------------------------------------
Total Loans                            $ 406,514  $ 40,089    9.86%   $ 481,047  $ 46,232    9.61%   $ 533,834  $ 49,254    9.23%
  Federal Funds Sold                   $   5,905  $    315    5.33%   $   6,339  $    366    5.77%   $   7,865  $    315    4.01%
----------------------------------------------------------------------------------------------------------------------------------
Total Earning Assets                   $ 533,192  $ 48,140    9.03%   $ 575,551  $ 51,480    8.94%   $ 639,060  $ 53,612    8.39%
----------------------------------------------------------------------------------------------------------------------------------
  Reserve for Possible Loan Losses       (15,984)                       (17,946)                       (18,991)
  Cash and Due From Banks                 28,907                         34,099                         31,910
  Premises and Equipment                  13,298                         15,365                         16,349
  Other Assets                            21,447                         35,418                         40,749
----------------------------------------------------------------------------------------------------------------------------------
Total Assets                           $ 580,860                      $ 642,487                      $ 709,077
==================================================================================================================================

LIABILITIES AND STOCKHOLDERS' EQUITY:
Time Deposits:
  Savings, Money Market & NOW 
   Accounts                            $ 264,611  $  8,217    3.11%   $ 279,906  $  9,077    3.24%   $ 309,490  $  8,420    2.72%
  Certificates of Deposit over 
   $100,000                               20,059     1,396    6.96%      20,927     1,433    6.85%      22,248     1,336    6.01%
  Other Time                             150,380     8,112    5.39%     167,975     8,981    5.35%     177,250     8,096    4.57%
----------------------------------------------------------------------------------------------------------------------------------
Total Time Deposits                    $ 435,050  $ 17,725    4.07%   $ 468,808  $ 19,491    4.16%   $ 508,988  $ 17,852    3.51%

  Federal Funds Purchased                    704        32    4.59%         975        58    5.95%       1,167        57    4.88%
  Securities Sold Under Agreement to 
   Repurchase                              3,139       160    5.09%           0         0    0.00%          19         1    5.26%
  Demand Notes Due U.S. Treasury           2,134       108    5.04%       3,229       173    5.36%       3,130       120    3.83%
  Other Interest Bearing Liabilities       1,067        45    4.25%       4,524        44    0.97%       4,555       303    6.65%
  Debt                                     8,925       602    6.75%      32,819     3,236    9.86%      50,575     4,044    8.00%
----------------------------------------------------------------------------------------------------------------------------------
Total Interest Bearing Liabilities     $ 451,019  $ 18,672    4.14%   $ 510,355  $ 23,002    4.51%   $ 568,434  $ 22,377    3.94%
----------------------------------------------------------------------------------------------------------------------------------
  Demand Deposits                         78,873                         87,434                         89,318
  Other Liabilities                        7,857                          3,850                          4,994
  Stockholders' Equity                    43,111                         40,848                         46,331
----------------------------------------------------------------------------------------------------------------------------------
Total Liabilities & Stockholders' 
 Equity                                $ 580,860                      $ 642,487                      $ 709,077
==================================================================================================================================

Net Interest Income (a)                           $ 29,468                       $ 28,478                       $ 31,235
==================================================================================================================================

Yield Spread                                                   4.89%                          4.44%                          4.45%
==================================================================================================================================

NET INTEREST INCOME TO EARNING ASSETS                          5.53%                          4.95%                          4.89%
==================================================================================================================================

<FN>
<F1> (a)   Tax exempt  interest has been  converted to a tax  equivalent  basis using
           Federal tax rate of 34%.

<F2> (b)   Includes non-accruing loans.
</FN>
</TABLE>


                           Merchants Bancshares, Inc
                   Analysis of Changes in Net Interest Income

The  following  table sets forth,  for each major  category of interest  earning
assets and interest  bearing  liabilities,  the dollar amounts (in thousands) of
interest income  (calculated on a taxable equivalent basis) and interest expense
and changes  therein for 1996 as  compared  with 1995 and 1995 as compared  with
1994.

<TABLE>
<CAPTION>

                                                 1996 vs 1995                                       1995 vs 1994
                               -----------------------------------------------    ---------------------------------------------
                                                                -Due to (a)-                                     -Due to (a)-
                                                  Increase    ----------------                     Increase    ----------------
                               1996     1995     (Decrease)  Volume    Rate      1995     1994     (Decrease)  Volume    Rate
-------------------------------------------------------------------------------------------------------------------------------

<S>                            <C>      <C>      <C>         <C>       <C>       <C>      <C>      <C>         <C>       <C>
Interest Income:
  Loans                        $40,089  $46,232  $(6,143)    $(7,371)  $1,228    $46,232  $49,254  $(3,022)    $(5,073)  $2,051
  Investment Income:
    Taxable                      7,736    4,882    2,854       2,090      764      4,882    4,043      839        (597)   1,436
    Non-Taxable                      0        0        0           0        0          0        0        0           0        0
    Federal Funds Sold             315      366      (51)        (23)     (28)       366      315       51         (88)     139
-------------------------------------------------------------------------------------------------------------------------------
      Total                    $48,140  $51,480  $(3,340)    $(5,304)  $1,964    $51,480  $53,612  $(2,132)    $(5,758)  $3,626
-------------------------------------------------------------------------------------------------------------------------------

Less Intereat Expense:
  Savings, Money Market & 
   Now Accounts                $ 8,217  $ 9,077  $  (860)    $  (474)  $  (386)  $ 9,077  $ 8,420  $   657     $  (959)  $1,616
  Certificates of Deposit 
   Over $100,000                 1,396    1,433      (37)        (60)       23     1,433    1,336       97         (90)     187
  Other Time                     8,112    8,981     (869)       (948)       79     8,981    8,096      885        (496)   1,381
  Federal Funds Purchased           32       58      (26)        (12)      (14)       58       57        1         (11)      12
  Securities Sold Under 
   Agreement to Repurchase         160        0      160         160        (0)        0        1       (1)         (1)      (0)
  Demand Note - U.S. Treasury      108      173      (65)        (55)      (10)      173      120       53           5       48
  Debt and Other Borrowings        647    3,280   (2,633)     (1,760)     (873)    3,280    4,347   (1,067)     (1,751)     684
-------------------------------------------------------------------------------------------------------------------------------
      Total                    $18,672  $23,002  $(4,330)    $(3,149)  $(1,181)  $23,002  $22,377  $   625     $(3,303)  $3,928
-------------------------------------------------------------------------------------------------------------------------------
      Net Interest Income      $29,468  $28,478  $   990     $(2,155)  $ 3,145   $28,478  $31,235  $(2,757)    $(2,455)  $ (302)
===============================================================================================================================

<FN>
<F1> (a)   The dollar  amount of  changes in  interest  income and  interest  expense
           attributable to changes in rate and volume has been allocated between rate
           and volume based upon the changes in rates times the first  year's  volume
           and the changes in volume times the current year's rate.

<F2> Note: Included in Interest Income are fees on loans totalling $2,333, $2,492 and
           $3,571 for the years ended December 31, 1996, 1995 and 1994, respectively.
</FN>
</TABLE>


LOAN PORTFOLIO

The following  tables  display the  composition of the Bank's loan portfolio for
the  consecutive  five year  period  1991  through  1995,  along with a schedule
profiling the loan maturity distribution over the next five years.


COMPOSITION OF LOAN PORTFOLIO

The table below presents the composition of the Bank's loan portfolio by type of
loan as of December 31 for each of the past five years.  All dollar  amounts are
expressed in  thousands.  Amounts are shown gross of net  deferred  loan fees of
$946,723 in 1996, $956,333 in 1995,  $1,132,494 in 1994,  $1,310,416 in 1993 and
$1,183,400 in 1992, which principally relate to real estate mortgages.


<TABLE>
<CAPTION>
                                                              As of December 31,
-------------------------------------------------------------------------------------------------
Type of Loan                                   1996        1995      1994        1993      1992
                                             ----------------------------------------------------

<S>                                          <C>        <C>        <C>        <C>        <C>
Commercial, Financial & Agricultural         $ 59,124   $ 73,915   $ 88,201   $ 98,936   $ 76,141
Industrial Revenue Bonds                        1,967      3,010      4,411      6,695      8,721
Real Estate--Construction                       3,420      9,644     21,992     30,526     18,776
Real Estate--Mortgage                         307,357    346,202    377,429    413,112    305,513
Installment                                    14,831     16,560     18,086     22,836     18,332
Lease Financing                                     0          0          0         42        630
All Other Loan                                    534        393        436      1,324      1,422
                                             ----------------------------------------------------
   Total Loans                               $387,233   $449,724   $510,555   $573,471   $429,535
                                             ====================================================
</TABLE>

PROFILE OF LOAN MATURITY DISTRIBUTION

The table below presents the distribution of the varying maturities or repricing
opportunities  of the loan  portfolio at December,  1996. All dollar amounts are
expressed in thousands.

<TABLE>
<CAPTION>
                                                Over One
                                    One Year    Through    Over Five
                                    Or Less     5 Years       Years     Total
-------------------------------------------------------------------------------

<S>                                 <C>         <C>          <C>       <C>
Commercial Loans, Industrial
Revenue Bonds, Lease Financing
 and All Other Loans                $ 46,818    $ 7,158      $ 7,649   $ 61,625
Real Estate Loans                    180,583     65,195       64,999   $310,777
Installment Loans                      3,351     11,208          272   $ 14,831
-------------------------------------------------------------------------------
                                    $230,752    $83,561      $72,920   $387,233
                                    ===========================================
</TABLE>

Loans  maturing or repricing  after one year which have  predetermined  interest
rates totaled  $155,109.  Loans maturing or repricing  after one year which have
floating or adjustable interest rates totaled $1,372.

In 1996,  a total of 425  one-to-four  family  residential  mortgage  loans were
closed  by  the  bank,  totaling  $33.4  million.  Approximately  33%  of  these
originations  were sold on the secondary  market and the remaining 67%, or $22.3
million were placed in the Bank's  portfolio.  The Bank currently  services $322
million in  residential  mortgage  loans,  $250 million of which it services for
other  investors  such as federal  government  agencies (FNMA and FHLMC) and for
financial  investors  such as  insurance  companies  and pension  funds  located
outside Vermont.

During 1996, the Bank remained an active  participant in the U.S. Small Business
Administration  guaranteed loan program.  Thirty-two new SBA loans totaling $4.7
million were originated during 1996 with SBA guarantees ranging from 70% to 85%.
This  volume of new  lending  activity  represents  a decrease  of 52% from that
experienced in 1995.

Approximately  27% of all new SBA  loans  originated  during  1996  were sold to
secondary  market investors  located outside Vermont.  This selling activity has
the positive  effect on Vermont of  importing  capital into the state from other
parts of the country.  SBA guarantees are  advantageous to the Bank because they
reduce risk in the Bank's  loan  portfolio  and allow the Bank to  increase  its
commercial loan base and market share with minimal impact on capital.

During 1996, the Bank originated 546 commercial  loans,  totaling $65.9 million.
This lending activity  represented a decrease of  approximately  15% of new loan
volume  from  that  experienced  in  1995.   Commercial  loans  were  originated
throughout Vermont.


LOAN PORTFOLIO MONITORING

The  Bank's  Board of  Directors  grants  each loan  officer  the  authority  to
originate loans on behalf of the Bank. The Board also  establishes  restrictions
regarding  the types of loans that may be granted and the  distribution  of loan
types  within the  portfolio,  and sets loan  authority  limits for each lender.
These authorized  lending limits are established at least annually and are based
upon the lender's knowledge and experience. Loan requests that exceed a lender's
authority  are referred to the Credit  Department.  All  extensions of credit of
$2.5 million to any one borrower,  or related party  interest,  are reviewed and
approved by the Directors Loan Committee.

By  using a  variety  of  management  reports,  the  Bank's  loan  portfolio  is
continuously monitored by the Board of Directors and Credit Department. The loan
portfolio  as a  whole,  as well as  individual  loans,  are  reviewed  for loan
performance, creditworthiness, and strength of documentation. The Bank has hired
an external loan review firm to assist in portfolio  monitoring.  Credit ratings
are assigned to commercial loans and are routinely reviewed.

All loan officers are required to service their own loan  portfolios and account
relationships.  As necessary,  loan officers or the loan workout  function takes
remedial actions to assure full and timely payment of loan balances.


LOAN QUALITY AND RESERVES FOR 
POSSIBLE LOAN LOSSES (RPLL)

Merchants Bancshares,  Inc. reviews the adequacy of the RPLL at least quarterly.
The  method  used  in  determining  the  amount  of the  RPLL  is not  based  on
maintaining a specific  percentage of RPLL to total loans or total nonperforming
assets,  but rather a comprehensive  analytical  process of assessing the credit
risk inherent in the loan portfolio.  This assessment incorporates a broad range
of factors  which are  indicative  of both general and specific  credit risk, as
well as a consistent methodology for quantifying probable credit losses. As part
of the Merchants Bancshares, Inc.'s analysis of specific credit risk, a detailed
and  extensive  review  is  done  on  larger  credits  and  problematic  credits
identified on the watched asset list,  nonperforming  asset  listings and credit
rating reports.

The Financial  Accounting  Standards  Board ("FASB")  issued revised  accounting
guidance which affected the RPLL.  Statement of Financial  Accounting  Standards
(SFAS) No. 114,  "Accounting by Creditors for  Impairment of a Loan,"  requires,
among other things,  that the creditors  measure  impaired  loans at the present
value of expected future cash flows, discounted at the loan's effective interest
rate or, as a practical expedient,  at the loan's observable market price or the
fair value of the collateral if the loan is  collateral-dependent.  For purposes
of this  statement,  a loan is  considered  impaired  when it is probable that a
creditor will be unable to collect all amounts due according to the  contractual
terms of the loan  agreement.  The FASB also issued SFAS No. 118,  which amended
SFAS No. 114, by allowing creditors to use their existing methods of recognizing
interest  income on  impaired  loans.  Merchants  Bancshares,  Inc.  adopted the
methodology  of SFAS No. 114,  incorporating  the amendments of SFAS No. 118, on
January 1, 1995.

The more significant factors considered in the evaluation of the adequacy of the
RPLL based on the  analysis of general  and  specific  credit  risk  include the
following:

Status of impaired loans as defined under SFAS No. 114

      *  Status of nonperforming loans
      *  Status of adversely classified credits
      *  Historic charge-off experience by major loan category
      *  Size and composition of the loan portfolio
      *  Concentrations of credit risk o Renewals and extensions
      *  Current local and general economic conditions and trends
      *  Loan growth trends in the portfolio
      *  Off-balance-sheet credit risk relative to commitments to lend

In  accordance  with SFAS No. 114,  management  has defined an impaired  loan as
meeting any of the following criteria:

      *  A loan that is 90 days past due and still accruing
      *  A loan that has been placed in nonaccrual and is 45 days past due
      *  A loan that is rated Substandard and is 45 days past due
      *  A loan that is rated Doubtful or Loss
      *  A loan that has been classified as a Troubled Debt Restructuring
      *  A loan that has been assigned a specific allocation

Loans deemed impaired  totaled $8.4 million.  Impaired loans have been allocated
$875,000 of the RPLL. On June 4, 1993, the Bank acquired New First National Bank
of Vermont  (NFNBV).  The terms of the Purchase and  Assumption  Agreement  (the
"Agreement")  required the FDIC to reimburse the Bank 80% of the net charge-offs
up to $41 million on any loans that qualify as loss-sharing  loans, for a period
of three  years from the date of  acquisition.  Losses in excess of $41  million
would be reimbursed at 95%. The Agreement  expired effective June 30, 1996, with
respect to the  reimbursement  of losses.  The Bank is required to return to the
FDIC  80% of any  reimbursed  losses  recovered,  during  the  two  year  period
following the  expiration  date. As of June 30, 1996,  the remaining  balance of
loss-sharing  loans  aggregated  $48,176,000;   included  in  that  balance  was
$2,928,000 in nonperforming loans.

Due to the expiration of the  loss-sharing  agreement,  management  adjusted the
analysis of the RPLL to account for 100% of the loss  exposure  associated  with
loans that  qualified as  loss-sharing.  The RPLL analysis  prepared the quarter
ended  March  31,  1996  showed  an  increase  in  the  reserve  requirement  of
approximately $1.4 million,  due to the expiration of the Agreement.  Management
maintained the RPLL at a level  adequate to offset the required  increase in the
reserve requirement; therefore, no additional provision was necessary due to the
expiration of the Agreement.

Overall,  management  maintains  the RPLL at a level deemed to be  adequate,  in
light of historical,  current and prospective  factors,  to reflect the level of
risk in the loan portfolio.  Loan loss experience and  nonperforming  asset data
are  presented  and discussed in relation to their impact on the adequacy of the
RPLL.


The table below  reflects  the Bank's loan loss  experience  and activity in the
RPLL for the past five years.

===============================================================================

<TABLE>
<CAPTION>

                       LOAN LOSSES AND RPLL RECONCILIATION
                                December 31, 1996
                                 (000's omitted)
----------------------------------------------------------------------------------------
                                  1996        1995        1994        1993        1992
----------------------------------------------------------------------------------------
<S>                             <C>         <C>         <C>         <C>         <C>

Average Loans Outstanding       $406,530    $481,047    $514,843    $515,805    $441,291
----------------------------------------------------------------------------------------
RPLL Beginning of Year            16,234      19,929      20,060       7,412       6,650
----------------------------------------------------------------------------------------
Charge-Off :
----------------------------------------------------------------------------------------
  Commercial, Lease Financing
   and all Other Loans              (907)     (3,671)     (3,356)     (5,567)     (2,938)
----------------------------------------------------------------------------------------
  Real Estate - Construction        (602)     (1,485)     (1,159)       (275)       (253)
----------------------------------------------------------------------------------------
  Real Estate - Mortgage          (3,206)    (12,942)     (7,673)     (7,651)     (4,096)
----------------------------------------------------------------------------------------
Installment & Credit Cards          (405)       (263)       (462)       (459)       (452)
----------------------------------------------------------------------------------------
    Total Loans Charged Off       (5,120)    (18,361)    (12,650)    (13,952)     (7,739)
----------------------------------------------------------------------------------------
Recoveries:
----------------------------------------------------------------------------------------
  Commercial, Lease Financing
   and all Other Loans               391       1,232       1,187         392         232
----------------------------------------------------------------------------------------
  Real Estate - Construction          63          32         400           0           0
----------------------------------------------------------------------------------------
  Real Estate - Mortgage             856       1,224         769         301         108
----------------------------------------------------------------------------------------
  Installment & Credit Cards         125          78         163          85         111
----------------------------------------------------------------------------------------
    Total Recoveries               1,435       2,566       2,519         778         451
----------------------------------------------------------------------------------------
Net Loan Losses                  ($3,685)   ($15,795)   ($10,131)   ($13,174)    ($7,288)
----------------------------------------------------------------------------------------
Provision for Loan Losses:
----------------------------------------------------------------------------------------
  Charged to Operations (NOTE 1)   3,150      12,100      10,000      23,882       8,050
----------------------------------------------------------------------------------------
  Loan Loss Reserve (NOTE 2)                                           2,000
----------------------------------------------------------------------------------------
RPLL End of Year                 $15,700     $16,234      $19,929    $20,060      $7,412
----------------------------------------------------------------------------------------
RPLL to Total Loans                 4.05%       3.61%        3.90%      3.50%       1.73%
----------------------------------------------------------------------------------------
Net Losses to Average Loans         0.91%       3.28%        1.97%      2.28%       1.63%
========================================================================================

<FN>
<F1>  NOTE 1:   The  loan loss provision is charged to operating expense.  When actual
                losses  differ from these estimates, and if adjustments are considered
                necessary,  they  are  reported  in operations in the periods in which
                they become known.

<F2>  NOTE 2:   See  Note 2  to  the  consolidated  financial statements regarding the
                acquisition of New First National Bank of Vermont.
</FN>
</TABLE>

The reserve for possible loan losses  decreased from $16,234,000 at December 31,
1995 to  $15,700,000  at December 31, 1996. At the same time,  the provision for
loan losses decreased from $12,100,000 to $3,150,000. The reduction in provision
and relative  stable reserve  balance is reflective of the  improvement in asset
quality.  These  improvements  are further  noted in the  reduction  of net loan
losses and nonperforming assets, as noted in the following tables:

NONPERFORMING ASSETS

The  following  tables  summarize the Bank's  nonperforming  assets (NPAs) as of
December 31, 1992 through 1996 (in thousands):

<TABLE>
<CAPTION>

===============================================================================
                                    1996      1995       1994       1993       1992
--------------------------------------------------------------------------------------

  <S>                               <C>       <C>        <C>        <C>        <C>
  Nonaccrual Loans                  $4,091    $25,617    $32,200    $47,069    $12,148
--------------------------------------------------------------------------------------
  Loans Past Due 90 Days or
  More and Still Accruing              217        237        668        715      7,251
--------------------------------------------------------------------------------------
  Restructured Loans                 2,403      1,430      5,083      2,841      1,838
--------------------------------------------------------------------------------------
    Total Nonperforming Loans:       6,711     27,284     37,951     50,625     21,237
--------------------------------------------------------------------------------------
  Other Real Estate Owned            1,925      7,772     13,231     13,674     12,662
--------------------------------------------------------------------------------------
    Total NonperformingAssets:      $8,636    $35,056    $51,182    $64,299    $33,899
--------------------------------------------------------------------------------------
  NPL to Total Loans                  1.70%      3.61%      3.90%      3.50%      1.73%
--------------------------------------------------------------------------------------
  NPA to Total Loans plus OREO        2.20%      3.28%      1.97%      2.28%      1.63%
======================================================================================
</TABLE>

Excluded  from  the  1996  balances  above  are  approximately  $11  million  of
internally classified loans. These loans have well-defined  weaknesses which, if
left  unattended,  could lead to collection  problems.  Management  maintains an
internal  listing,  which  includes  these loans,  which is reviewed and updated
monthly. The oversight process on these loans includes an active risk management
approach.  A management committee reviews the status of these loans each quarter
and determines or confirms the appropriate  risk rating and accrual status.  The
findings of this review process are  instrumental in determining the adequacy of
the loan loss reserve.


DISCUSSION OF 1996 EVENTS AFFECTING NONPERFORMING ASSETS

Historically,  the Company has worked  closely with  borrowers  and also pursued
vigorous  collection  efforts.  The  Company  continued  its  efforts to collect
troubled assets during 1996. The Company's  enhanced Credit  Department and Loan
Workout  functions  provided  resources  to address  collection  strategies  for
nonperforming assets.

<TABLE>
<CAPTION>

==============================================================================
                             12-31-96   9-30-96   6-30-96   3-31-96   12-31-95
------------------------------------------------------------------------------

<S>                           <C>       <C>       <C>       <C>       <C>
Nonaccrual Loans              $4,091    $11,235   $13,335   $16,988   $25,617
------------------------------------------------------------------------------
Loans Past Due 90 days or
 more  and still Accruing        217          3     1,159       192       237
------------------------------------------------------------------------------
Restructured Loans             2,403      2,475     2,604     2,642     1,430
------------------------------------------------------------------------------
Other Real Estate Owned        1,925      3,317     2,617     4,698     7,772
------------------------------------------------------------------------------
    Total                      $8,636    $17,030   $19,715   $24,520   $35,056
==============================================================================
</TABLE>

The more significant events affecting NPAs are discussed below.


NONACCRUAL LOANS:
-----------------

Nonaccrual loans declined from $25,617,000 at December 31, 1995 to $4,091,000 at
December 31, 1996.  Management continued its efforts to proactively identify and
resolve loans which present  significant risk of loss to the Bank.  During 1996,
management  identified   approximately  $4.8  million  in  accounts  which  were
transferred  to  nonaccrual  status.  These  transfers  were offset by continued
resolution  of  nonaccrual  accounts;  approximately  $8.0 million in loans were
returned to accrual status;  principal  payments of  approximately  $4.2 million
were  collected;  a  nonperforming  loan sale was  completed  during  the fourth
quarter reducing  nonaccruing loans by approximately $5.7 million.  In addition,
charges  of  approximately   $5.0  million  further  decreased  the  balance  of
nonaccruing loans.

LOANS PAST DUE 90 DAYS OR MORE AND STILL ACCRUING:
--------------------------------------------------

The  Bank  generally  places  loans  that  become  90 or more  days  past due in
nonaccrual  status. If the ultimate  collectibility of principal and interest is
assured, loans may continue to accrue and be left in this category.  Included in
this category are loans which have reached maturity and have not been renewed on
a timely basis,  for reasons other than  financial  capacity to pay.  During the
second  quarter  three  significant  accounts met this  definition;  renewal was
completed during the third quarter.

RESTRUCTURED LOANS:
-------------------

Restructured  loans (TDRs) increased during 1996 from $1,430,000 at December 31,
1995  to  $2,403,000   at  December  31,  1996.   The  increase  was  due  to  a
reclassification  of  restructured,  nonaccruing  loans to  accrual  status.  In
addition,  one large loan for  approximately  $1.0  million was removed from TDR
status.

OTHER REAL ESTATE OWNED AND IN-SUBSTANCE FORECLOSURE:
-----------------------------------------------------

The Bank  continued  its success in 1996 in disposing  of OREO and  continues to
aggressively  market such properties.  The balance of OREO decreased from $7.772
million at  December  31,  1995 to $1.925  million at  December  31,  1996.  The
decrease was due to a  combination  of sales of  approximately  $4.0 million and
write-downs of approximately $2.3 million.


POLICIES AND PROCEDURES RELATING TO THE ACCRUAL OF INTEREST INCOME

The Bank  normally  recognizes  income on earning  assets on the accrual  basis,
which calls for the  recognition  of income as earned,  as opposed to when it is
collected. The Company's policy is to classify a loan more than 90 days past due
with respect to principal or interest as a nonaccruing loan, unless the ultimate
collectibility  of  principal  and  interest is  assured.  Income  accruals  are
suspended on all nonaccruing  loans, and all previously  accrued and uncollected
interest  is  typically  charged  against  current  income.  A loan  remains  on
nonaccruing  status until the factors which suggest doubtful  collectibility  no
longer  exist,  the loan is  liquidated,  or when the loan is  determined  to be
uncollectible  and is charged off against the reserve for possible  loan losses.
In those cases where a nonaccruing  loan is secured by real estate,  the Company
can, and usually  does,  initiate  foreclosure  proceedings.  The result of such
action is to force  repayment of the loan through the proceeds of a  foreclosure
sale or to allow the Company to take  possession  of the  collateral in order to
manage a future  resale of the real estate.  Foreclosed  property is recorded at
the lower of its cost or estimated fair value, less any estimated costs to sell.
Any cost in excess of the  estimated  fair value on the transfer date is charged
to the reserve for possible loan losses, while further declines in market values
are  recorded as an expense in other  non-interest  expense in the  statement of
operations. As of December 31, 1996 and 1995, the Company had valuation reserves
against the other real estate owned portfolio  carrying values of $2,717,000 and
$2,430,000, respectively.


SUBSEQUENT EVENT

During January,  1997, OREO balances were reduced to approximately $1.0 million.
As a result,  nonperforming  assets were  reduced to $7.6 million or 2% of total
loans, plus OREO.


ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
         OF OPERATIONS

Please  refer to  pages  31-37  for  Management's  Discussion  and  Analysis  of
Financial Condition and Results of Operations.


ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The consolidated balance sheets of Merchants Bancshares, Inc. as of December 31,
1996 and 1995, and the related consolidated statements of operations, changes in
stockholders'  equity and cash  flows for each of the three  years in the period
ended  December 31,  1996,  together  with the related  notes and the opinion of
Arthur Andersen LLP, independent public accountants, all as contained on pages 2
through 30 of the Company's 1996 Annual Report to Shareholders, are incorporated
herein by reference.

ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
         FINANCIAL DISCLOSURES

None.


                                    Part III


ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT


ITEM 11 - EXECUTIVE COMPENSATION


ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT


ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS

Reference is hereby made to pages 7 through 13 and page 17of the Company's Proxy
Statement to Shareholders  dated March 25, 1997,  wherein pursuant to Regulation
14 A  information  concerning  the  above  subjects  (Items  10  through  13) is
incorporated by reference.

Pursuant to Rule 12b-23,  definitive copies of the Proxy Statement will be filed
within 120 days  subsequent to the end of the  Company's  fiscal year covered by
Form 10-K.


                                     PART IV

ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(1)   The following consolidated  financial statements,  as included in the 1996
      Annual Report to Shareholders, are incorporated herein by reference:

      Consolidated Balance Sheets, December 31, 1996 and December 31, 1995.

      Consolidated  Statements of Operations  for years ended December 31, 1996,
      1995 and 1994.

      Consolidated Statements of Changes in Stockholders' Equity for years ended
      December 31, 1996, 1995 and 1994.

      Consolidated  Statements  of Cash Flows for the years ended  December  31,
      1996, 1995 and 1994.

      Notes to Consolidated Financial Statements, December 31, 1996.


(2)   The  following  exhibits  are  either  filed or  attached  as part of this
      report, or are incorporated herein by reference.

      Exhibit              Description
      -------              -----------
       3.1        Restated   Certificate   of   Incorporation   of  the  Company
                  (Incorporated  by  reference  to  Exhibit  B to  Pre-Effective
                  Amendment No. 1 to Company's  Definitive  Proxy  Statement for
                  the Annual Meeting of the  Stockholders of the Company,  filed
                  on April 25, 1987)

       3.2        Amended By-Laws of the Company  (Incorporated  by reference to
                  Exhibit C to  Company's  Definitive  Proxy  Statement  for the
                  Annual Meeting of the  Stockholders  of the Company,  filed on
                  April 25, 1987).

       4          Instruments defining the rights of security holders, including
                  indentures:

       4.1        Specimen   of   the   Company's   Common   Stock   Certificate
                  (Incorporated  by  Reference  to  Exhibit  7 to the  Company's
                  Registration  Statement  on  Form  S-14  (Registration  Number
                  2-86108) filed on August 22, 1983)

       4.2        Description  of the rights of holders of the Company's  Common
                  Stock  (appearing  on  page  9 of the  Company's  Registration
                  Statement on Form S-14  (Registration  No.  2-86108)  filed on
                  August 22, 1983)

      10.1        Merchants  Bancshares,  Inc.  Dividend  Reinvestment and Stock
                  Purchase  Plan  (Incorporated  by  reference to Exhibit 4.1 to
                  Company's Registration Statement on Form S-3 (Registration No.
                  333-20375) filed on January 22, 1997)

      10.2        401(k)  Employee Stock  Ownership  Plan of the Company,  dated
                  January 1, 1990,  as amended  (Incorporated  by  reference  to
                  Company's  Registration  Statement  on Form S-8  (Registration
                  Number 33-3274) filed on November 16, 1989)

      10.3        Amended and Restated  Merchants  Bank Pension Plan dated as of
                  January 1, 1994  (Incorporated by Reference to Exhibit 10.6 to
                  Post-Effective  Amendment  Number 1 to Company's  Registration
                  Statement on Form S-8 (Registration Number 333-18845) filed on
                  December 26, 1996)

      10.4        Amended Employment Agreement,  dated as of October 31, 1994 by
                  and between the Company,  Merchants  Bank and Joseph L. Boutin
                  (Incorporated  by reference to Exhibit 10.1 to  Post-Effective
                  Amendment No.1 to Company's Registration Statement on Form S-8
                  (Registration  No.  333-18845)  filed  on  December  26,  1996
                  (Superseded by Exhibit 10.5)

      10.5        Employment  Agreement  dated as of  January  1,  1997,  by and
                  between the Company, Merchants Bank and Joseph L. Boutin.

      10.6        Amended Employment Agreement, dated as of January 23, 1995, by
                  and between Merchants Bank and Michael R. Tuttle (Incorporated
                  by reference to Exhibit 10.2 to Post-Effective Amendment No. 1
                  to  the   Company's   Registration   Statement   on  Form  S-8
                  (Registration   No.   333-18845)  filed  on  December  26,1996
                  (Superseded by Exhibit 10.7)

      10.7        Employment  Agreement  dated as of  January  1,  1997,  by and
                  between Merchants Bank and Michael R. Tuttle

      10.8        Employment  Agreement,  dated as of December 29, 1995,  by and
                  between  Merchants Bank and Thomas R. Havers  (Incorporated by
                  reference to Exhibit 10.3 to Post-Effective Amendment No. 1 to
                  Company's Registration Statement on Form S-8 (Registration No.
                  333-18845) filed on December 26, 1996)  (Superseded by Exhibit
                  10.9)

      10.9        Employment  Agreement  dated as of  January  1,  1997,  by and
                  between Merchants Bank and Thomas R. Havers.

      10.10       Employment  Agreement,  dated as of  February  1,1996,  by and
                  between Merchants Bank and Thomas S. Leavitt  (Incorporated by
                  reference to Exhibit 10.4 to Post-Effective Amendment No. 1 to
                  Company's Registration Statement on Form S-8 (Registration No.
                  333-18845) filed on December 26, 1996)  (Superseded by Exhibit
                  10.11)

      10.11       Employment  Agreement  dated as of  January  1,  1997,  by and
                  between Merchants Bank and Thomas S. Leavitt.

      10.12       Employment  Agreement,  dated as of December 29, 1995,  by and
                  between Merchants Bank and Merchants Trust Company and William
                  R.  Heaslip  (Incorporated  by  reference  to Exhibit  10.5 to
                  Post-Effective  Amendment No. 1 to the Company's  Registration
                  Statement on Form S-8  (Registration  No.  333-18845) filed on
                  December 26, 1996)(Superseded by Exhibit 10.13)

      10.13       Employment  Agreement,  dated as of January  1,  1997,  by and
                  between Merchants Bank and Merchants Trust Company and William
                  R. Heaslip

      10.14       The Merchants Bank Amended and Restated Deferred  Compensation
                  Plan for Directors

      10.14.1     Trust Under  the  Merchants Bank Amended and Restated Deferred
                  Compensation Plan for Directors

      10.15       Agreement  among the Merchants  Bank and Kathryn T.  Boardman,
                  Thomas R. Havers and Susan D. Struble dated as of December 20,
                  1995

      10.15.1     Trust  Under  the  Agreement  among  the  Merchants  Bank  and
                  Kathryn T.  Boardman,  Thomas R.  Havers and Susan D.  Struble
                  dated as of December 20, 1995

      10.16       Agreement between the Merchants Bank and Dudley H. Davis dated
                  December 20, 1995.

      10.16.1     Fixed  Trust  under  Agreement  between the Merchants Bank and
                  Dudley H. Davis dated December 20, 1995.

      10.16.2     Variable  Trust  under  Agreement  between  the Merchants Bank
                  and Dudley H. Davis dated December 21, 1995.

      11          Statement re: computation of per share earnings.

      13          1996 Annual Report to Shareholders

      21          Subsidiaries of the Company

      23          Consent of Arthur Andersen LLP

(3)   Reports on Form 8-K: NONE



                                   SIGNATURES

Pursuant to the  requirement of Section 13 or 15 (d) of the Securities  Exchange
Act of 1934 the  registrant  has duly  caused  this  report to be signed on it's
behalf by the undersigned, thereunto duly authorized.

Merchants Bancshares, Inc.


Date  February 20, 1997                   by  /s/ Joseph L. Boutin
      ---------------------------             ---------------------------------
                                              Joseph L. Boutin, President & CEO

      Pursuant to the  requirement of the Securities  Exchange Act of 1934, this
report has been signed  below by the  following  persons on behalf of  MERCHANTS
BANCSHARES, INC., and in the capacities and on the date as indicated.


by  /s/ Joseph L. Boutin                  by  /s/ Raymond C. Pecor, Jr.
    ---------------------------               ---------------------------------
   Joseph L. Boutin, Director, President      Raymond C. Pecor, Jr. Director
      & CEO of the Company and the Bank       Chairman of the Board of Directors


by  /s/ Peter A. Bouyea                   by
    ---------------------------               ---------------------------------
    Peter A. Bouyea, Director                 Charles A. Davis, Director


by                                        by  /s/ Jeffrey L. Davis
    ---------------------------               ---------------------------------
    Dudley H. Davis, Director                 Jeffrey L. Davis, Director


by  /s/ Michael G. Furlong                by
    ---------------------------               ---------------------------------
    Michael G. Furlong, Director              Thomas F. Murphy, Director


by  /s/ Janet P. Spitler                  by  /s/ Leo O'Brien, Jr
    ---------------------------               ---------------------------------
    Janet P. Spitler, Treasurer of the        Leo O'Brien, Jr, Director
    Company, Vice President, Controller
    and Treasurer of the Bank


by  /s/ Patrick S. Robins                 by
    ---------------------------               ---------------------------------
    Patrick S. Robins, Director               Benjamin F. Schweyer, Director



by  /s/ Robert A. Skiff
    ---------------------------
    Robert A. Skiff, Director