**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

**(MARK ONE)**

| **ý**                                         |   | **QUARTERLY REPORT PURSUANT TO SECTION  13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|----------------------------------------------------|--------|-----------------------------------------------------------------------------------------------|
|                                               |   |                                                                                          |
| **For the  quarterly period ended March 31, 2004** |
|                                               |
| **OR**                                             |
|                                               |
| **o**                                              |   | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |

 

**For thetransition period from             to             **

 

**Commissionfile number 0-5127**

 

**MERCANTILE BANKSHARES CORPORATION**

(Exactname of registrant as specified in its charter)

 

| **Maryland**                                                     |   | **52-0898572**                         |
|------------------------------------------------------------------|--------|----------------------------------------|
| (State  or other jurisdiction of  incorporation or organization) |   | (I.R.S.  Employer  Identification No.) |

 

#### **2 Hopkins Plaza**

**Baltimore, Maryland 21201**

(Addressof principal executive offices) (Zip Code)

 

**(410) 237-5900**

(Registrant’stelephone number, including area code)

 

**NONE**

(Formername, former address and former fiscal year, if changed since last report)

 

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter 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 ý  No o

 

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

 

**APPLICABLEONLY TO CORPORATE ISSUERS:**

Indicate the number of shares outstanding ofeach of the issuer’s classes of common stock, as of the latest practicaldate.  As of April 30, 2004, registranthad outstanding 78,993,784 shares of Common Stock.

 

----

 

# **PARTI – FINANCIAL INFORMATION**

**Item 1. FinancialStatements (Unaudited)**

 

**MERCANTILEBANKSHARES CORPORATION**

**CONSOLIDATEDBALANCE SHEETS**

 
| **(Dollars  in thousands, except per share data)**                                                                                                                                                                                           |   | **March 31,  2004** |           | **December 31,  2003** |   | **March 31,  2003** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|----------------|------------------------|--------|---------------------|--------|
| **ASSETS**                                                                                                                                                                                                                                   |   |                |           |                   |   |                |   |
| Cash and due from banks                                                                                                                                                                                                                      |   | **$**               | **296,077**    | ** **             | $      | 321,882             |   | $ | 307,404 |   |
| Interest-bearing deposits in  other banks                                                                                                                                                                                                    |   | **158**             | ** **     | 14,583                 |   | 358                 |   |
| Federal funds sold                                                                                                                                                                                                                           |   | **353,893**         | ** **     | 26,236                 |   | 245,513             |   |
| Total cash and cash equivalents                                                                                                                                                                                                              |   | **650,128**         | ** **     | 362,701                |   | 553,275             |   |
| Investment securities  available-for-sale (Note 4)                                                                                                                                                                                           |   | **3,090,089**       | ** **     | 3,123,514              |   | 2,641,976           |   |
| Investment securities  held-to-maturity (Note 4)                                                                                                                                                                                             |   | **52,524**          | ** **     | 49,417                 |   | 53,918              |   |
| Total investment securities                                                                                                                                                                                                                  |   | **3,142,613**       | ** **     | 3,172,931              |   | 2,695,894           |   |
| Loans held-for-sale                                                                                                                                                                                                                          |   | **38,741**          | ** **     | 14,925                 |   | —              |   |
| Loans:                                                                                                                                                                                                                                       |   |                | ** **     |                   |   |                |   |
| Commercial                                                                                                                                                                                                                                   |   | **5,403,538**       | ** **     | 5,315,853              |   | 4,403,330           |   |
| Construction                                                                                                                                                                                                                                 |   | **1,105,346**       | ** **     | 1,064,021              |   | 850,420             |   |
| Residential real estate                                                                                                                                                                                                                      |   | **1,387,647**       | ** **     | 1,335,375              |   | 1,087,207           |   |
| Consumer                                                                                                                                                                                                                                     |   | **1,473,491**       | ** **     | 1,482,860              |   | 1,011,637           |   |
| Lease financing                                                                                                                                                                                                                              |   | **64,398**          | ** **     | 74,051                 |   | 93,959              |   |
| Total loans                                                                                                                                                                                                                                  |   | **9,434,420**       | ** **     | 9,272,160              |   | 7,446,553           |   |
| Less: allowance for loan losses                                                                                                                                                                                                              |   | **(156,635**        | **)**          | (155,337               | )      | (140,427            | )      |
| Loans, net                                                                                                                                                                                                                                   |   | **9,277,785**       | ** **     | 9,116,823              |   | 7,306,126           |   |
| Bank premises and equipment,  less accumulated depreciation of $154,468 (2004), $152,771 (December 2003)  and $122,073 (March 2003)                                                                                                          |   | **141,482**         | ** **     | 140,922                |   | 103,847             |   |
| Other real estate owned, net                                                                                                                                                                                                                 |   | **134**             | ** **     | 191                    |   | 194                 |   |
| Goodwill, net                                                                                                                                                                                                                                |   | **522,226**         | ** **     | 522,173                |   | 115,407             |   |
| Other intangible assets, net  (Note 7)                                                                                                                                                                                                       |   | **54,223**          | ** **     | 56,223                 |   | 17,740              |   |
| Other assets                                                                                                                                                                                                                                 |   | **315,050**         | ** **     | 308,583                |   | 226,138             |   |
| Total assets                                                                                                                                                                                                                                 |   | **$**               | **14,142,382** | ** **             | $      | 13,695,472          |   | $ | 11,018,621 |   |
|                                                                                                                                                                                                                                         |   |                | ** **     |                   |   |                |   |
| **LIABILITIES**                                                                                                                                                                                                                              |   |                | ** **     |                   |   |                |   |
| Deposits:                                                                                                                                                                                                                                    |   |                | ** **     |                   |   |                |   |
| Noninterest-bearing deposits                                                                                                                                                                                                                 |   | **$**               | **2,769,189**  | ** **             | $      | 2,750,721           |   | $ | 2,121,444 |   |
| Interest-bearing deposits                                                                                                                                                                                                                    |   | **7,774,398**       | ** **     | 7,511,832              |   | 6,374,039           |   |
| Total deposits                                                                                                                                                                                                                               |   | **10,543,587**      | ** **     | 10,262,553             |   | 8,495,483           |   |
| Short-term borrowings                                                                                                                                                                                                                        |   | **904,327**         | ** **     | 809,021                |   | 768,476             |   |
| Accrued expenses and other  liabilities                                                                                                                                                                                                      |   | **149,052**         | ** **     | 134,735                |   | 111,792             |   |
| Long-term debt                                                                                                                                                                                                                               |   | **657,411**         | ** **     | 647,722                |   | 290,576             |   |
| Total liabilities                                                                                                                                                                                                                            |   | **12,254,377**      | ** **     | 11,854,031             |   | 9,666,327           |   |
|                                                                                                                                                                                                                                         |   |                | ** **     |                   |   |                |   |
| **SHAREHOLDERS’  EQUITY**                                                                                                                                                                                                               |   |                | ** **     |                   |   |                |   |
| Preferred stock, no par value;  authorized 2,000,000 shares; issued and outstanding - None                                                                                                                                                   |   |                | ** **     |                   |   |                |   |
| Common stock, $2 par value;  authorized 130,000,000 shares; issued shares - 79,974,797 (2004), 79,772,705  (December 2003) and 68,919,397 (March 2003); restricted shares - 112,485 (2004),  101,932 (December 2003) and 91,127 (March 2003) |   | **159,950**         | ** **     | 159,545                |   | 137,839             |   |
| Capital surplus                                                                                                                                                                                                                              |   | **553,955**         | ** **     | 548,664                |   | 124,029             |   |
| Retained earnings                                                                                                                                                                                                                            |   | **1,139,360**       | ** **     | 1,110,748              |   | 1,038,143           |   |
| Accumulated other comprehensive  income                                                                                                                                                                                                      |   | **34,740**          | ** **     | 22,484                 |   | 52,283              |   |
| Total shareholders’ equity                                                                                                                                                                                                              |   | **1,888,005**       | ** **     | 1,841,441              |   | 1,352,294           |   |
| Total liabilities and  shareholders’ equity                                                                                                                                                                                             |   | **$**               | **14,142,382** | ** **             | $      | 13,695,472          |   | $ | 11,018,621 |   |

 

See notes to consolidatedfinancial statements

 

2

----

 

**MERCANTILEBANKSHARES CORPORATION**

**STATEMENTSOF CONSOLIDATED INCOME**

 
|                                                     |   | **For the 3 Months Ended  March 31,** |        |
|----------------------------------------------------------|--------|---------------------------------------|-------------|
| **(Dollars  in thousands, except per share data)**       |   | **2004**                              |        | **2003** |   |
| **INTEREST INCOME**                                      |   |                                  |        |   |   |
| Interest and fees on loans                               |   | **$**                                 | **129,060** |   | $ | 110,992 |   |
| Interest and dividends on  investment securities:        |   |                                  |        |   |   |
| Taxable interest income                                  |   | **27,401**                            |        | 27,184 |   |
| Tax-exempt interest income                               |   | **877**                               |        | 467 |   |
| Dividends                                                |   | **261**                               |        | 229 |   |
| Other investment income                                  |   | **3,341**                             |        | 564 |   |
| Total interest and dividends on  investment securities   |   | **31,880**                            |        | 28,444 |   |
| Other interest income                                    |   | **175**                               |        | 726 |   |
| Total interest income                                    |   | **161,115**                           |        | 140,162 |   |
| **INTEREST EXPENSE**                                     |   |                                  |        |   |   |
| Interest on deposits                                     |   | **20,767**                            |        | 25,129 |   |
| Interest on short-term  borrowings                       |   | **1,419**                             |        | 1,545 |   |
| Interest on long-term debt                               |   | **5,255**                             |        | 2,362 |   |
| Total interest expense                                   |   | **27,441**                            |        | 29,036 |   |
| **NET INTEREST INCOME**                                  |   | **133,674**                           |        | 111,126 |   |
| Provision for loan losses                                |   | **2,426**                             |        | 3,016 |   |
| **NET INTEREST INCOME AFTER PROVISION FOR  LOAN LOSSES** |   | **131,248**                           |        | 108,110 |   |
| **NONINTEREST INCOME**                                   |   |                                  |        |   |   |
| Investment and wealth management                         |   | **21,983**                            |        | 17,365 |   |
| Service charges on deposit  accounts                     |   | **10,119**                            |        | 8,060 |   |
| Mortgage banking related fees                            |   | **2,940**                             |        | 2,388 |   |
| Investment securities gains and  (losses)                |   | **(55**                               | )           | 815 |   |
| Other income                                             |   | **14,898**                            |        | 9,225 |   |
| Total noninterest income                                 |   | **49,885**                            |        | 37,853 |   |
| **NONINTEREST EXPENSES**                                 |   |                                  |        |   |   |
| Salaries                                                 |   | **44,788**                            |        | 34,415 |   |
| Employee benefits                                        |   | **12,513**                            |        | 9,428 |   |
| Net occupancy expense of bank  premises                  |   | **6,060**                             |        | 4,096 |   |
| Furniture and equipment  expenses                        |   | **7,364**                             |        | 6,799 |   |
| Communications and supplies                              |   | **4,304**                             |        | 3,436 |   |
| Other expenses                                           |   | **18,357**                            |        | 11,607 |   |
| Total noninterest expenses                               |   | **93,386**                            |        | 69,781 |   |
| Income before income taxes                               |   | **87,747**                            |        | 76,182 |   |
| Applicable income taxes                                  |   | **32,050**                            |        | 27,196 |   |
| **NET INCOME**                                           |   | **$**                                 | **55,697**  |   | $ | 48,986 |   |
| **NET INCOME PER SHARE OF COMMON STOCK**(Note 3):        |   |                                  |        |   |   |
| Basic                                                    |   | **$**                                 | **0.70**    |   | $ | 0.71 |   |
| Diluted                                                  |   | **$**                                 | **0.69**    |   | $ | 0.71 |   |
| **DIVIDENDS PAID PER COMMON SHARE**                      |   | **$**                                 | **0.33**    |   | $ | 0.30 |   |

 

See notes to consolidatedfinancial statements

 

3

----

 

**MERCANTILEBANKSHARES CORPORATION**

**STATEMENTSOF CHANGES IN CONSOLIDATED SHAREHOLDERS’ EQUITY**

 

**For The Three MonthsEnded March 31, 2004 and 2003**

 
| **(Dollars in thousands, except  per share data)**                                                             |   | **Total** |          | **Common  Stock** |   | **Capital  Surplus** |       | **Retained  Earnings** |        | **Accumulated  Other  Comprehensive  Income (Loss)** |   |
|----------------------------------------------------------------------------------------------------------------|--------|-----------|---------------|-------------------|--------|----------------------|------------|------------------------|-------------|------------------------------------------------------|--------|
| BALANCE, DECEMBER 31, 2002                                                                                     |   | $         | 1,324,358     |              | $      | 137,672              |       | $                      | 120,577     |                                                 | $      | 1,010,248 |   | $ | 55,861 |   |
|                                                                                                           |   |      |          |              |   |                 |       |                   |        |                                                 |   |
| Net income                                                                                                     |   | 48,986    |          |              |   |                 |       | 48,986                 |        |                                                 |   |
| Unrealized gains (losses) on  securities available-for-sale, net of reclassification adjustment, net of  taxes |   | (3,578    | )             |              |   |                 |       |                   |        | (3,578                                               | )      |
| Comprehensive income                                                                                           |   | 45,408    |          |              |   |                 |       |                   |        |                                                 |   |
| Cash dividends paid:                                                                                           |   |      |          |              |   |                 |       |                   |        |                                                 |   |
| Common stock ($.30 per share)                                                                                  |   | (20,637   | )             |              |   |                 |       | (20,637                | )           |                                                 |   |
| Issuance of 31,759 shares for  dividend reinvestment and stock purchase plan                                   |   | 1,029     |          | 64                |   | 965                  |       |                   |        |                                                 |   |
| Issuance of 5,728 shares for  employee stock purchase dividend reinvestment plan                               |   | 207       |          | 11                |   | 196                  |       |                   |        |                                                 |   |
| Issuance of 31,023 shares for  employee stock option plan                                                      |   | 656       |          | 62                |   | 594                  |       |                   |        |                                                 |   |
| Issuance of 20,295 shares for  restricted stock awards                                                         |   | 750       |          | 41                |   | 709                  |       |                   |        |                                                 |   |
| Deferred compensation -  restricted stock awards                                                               |   | (454      | )             |              |   |                 |       | (454                   | )           |                                                 |   |
| Purchase of 5,500 shares under  stock repurchase plan                                                          |   | (212      | )             | (11               | )      | (201                 | )          |                   |        |                                                 |   |
| Vested stock options                                                                                           |   | 1,189     |          | —            |   | 1,189                |       | —                 |        | —                                               |   |
| BALANCE, MARCH 31, 2003                                                                                        |   | $         | 1,352,294     |              | $      | 137,839              |       | $                      | 124,029     |                                                 | $      | 1,038,143 |   | $ | 52,283 |   |
| BALANCE, DECEMBER 31, 2003                                                                                     |   | $         | 1,841,441     |              | $      | 159,545              |       | $                      | 548,664     |                                                 | $      | 1,110,748 |   | $ | 22,484 |   |
| Net income                                                                                                     |   | 55,697    |          |              |   |                 |       | 55,697                 |        |                                                 |   |
| Unrealized gains (losses) on  securities available-for-sale, net of reclassification adjustment, net of  taxes |   | 12,256    |          |              |   |                 |       |                   |        | 12,256                                               |   |
| Comprehensive income                                                                                           |   | 67,953    |          |              |   |                 |       |                   |        |                                                 |   |
| Cash dividends paid:                                                                                           |   |      |          |              |   |                 |       |                   |        |                                                 |   |
| Common stock ($.33 per share)                                                                                  |   | (26,335   | )             |              |   |                 |       | (26,335                | )           |                                                 |   |
| Issuance of 31,674 shares for  dividend reinvestment and stock purchase plan                                   |   | 1,298     |          | 63                |   | 1,235                |       |                   |        |                                                 |   |
| Issuance of 5,873 shares for  employee stock purchase dividend reinvestment plan                               |   | 257       |          | 12                |   | 245                  |       |                   |        |                                                 |   |
| Issuance of 138,251 shares for  employee stock option plan                                                     |   | 2,431     |          | 277               |   | 2,154                |       |                   |        |                                                 |   |
| Issuance of 26,294 shares for  restricted stock awards                                                         |   | 1,199     |          | 53                |   | 1,146                |       |                   |        |                                                 |   |
| Deferred compensation -  restricted stock awards                                                               |   | (750      | )             |              |   |                 |       | (750                   | )           |                                                 |   |
| Vested stock options                                                                                           |   | 511       |          | —            |   | 511                  |       | —                 |        | —                                               |   |
| **BALANCE, MARCH 31, 2004**                                                                                    |   | **$**     | **1,888,005** | ** **        | **$**  | **159,950**          | ** ** | **$**                  | **553,955** | ** **                                           | **$**  | **1,139,360** | ** ** | **$** | **34,740** | ** ** |

 

See notes to consolidatedfinancial statements

 

4

----

 

**MERCANTILEBANKSHARES CORPORATION**

#### **STATEMENTSOF CONSOLIDATED CASH FLOW**

 
| ** **

**Increase (decrease) in cash and cash  equivalents**                  |   | **For the 3 Months Ended March 31,** |        |
|------------------------------------------------------------------------------------|--------|--------------------------------------|-------------|
| **(Dollars in thousands)**                                                         |   | **2004**                             |        | **2003** |   |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                          |   |                                 |        |   |   |
| Net income                                                                         |   | **$**                                | **55,697**  |   | $ | 48,986 |   |
| Adjustments to reconcile net  income to net cash provided by operating activities: |   |                                 |        |   |   |
| Provision for loan losses                                                          |   | **2,426**                            |        | 3,016 |   |
| Depreciation and amortization                                                      |   | **3,900**                            |        | 3,122 |   |
| Amortization of other  intangible assets                                           |   | **2,032**                            |        | 560 |   |
| Investment securities losses  and (gains)                                          |   | **55**                               |        | (815 | ) |
| (Income) write-downs of  investments in private equity funds                       |   | **(141**                             | **)**       | 103 |   |
| Gains on sales of other real  estate owned                                         |   | **(13**                              | **)**       | (268 | ) |
| Gains on sales of buildings                                                        |   | **(564**                             | **)**       | (142 | ) |
| Net (increase) decrease in  assets:                                                |   |                                 | ** **  |   |   |
| Interest receivable                                                                |   | **(1,939**                           | **)**       | 238 |   |
| Other receivables                                                                  |   | **2,991**                            | ** **  | (1,817 | ) |
| Bank owned life insurance                                                          |   | **(794**                             | **)**       | (429 | ) |
| Other assets                                                                       |   | **(11,126**                          | **)**       | 807 |   |
| Loans held-for-sale                                                                |   | **(23,816**                          | **)**       | — |   |
| Net increase (decrease) in  liabilities:                                           |   |                                 | ** **  |   |   |
| Interest payable                                                                   |   | **6,052**                            | ** **  | 3,189 |   |
| Accrued expenses                                                                   |   | **(25,110**                          | **)**       | (2,654 | ) |
| Taxes payable                                                                      |   | **37,273**                           | ** **  | 18,721 |   |
| Net cash provided by operating  activities                                         |   | **46,923**                           | ** **  | 72,617 |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                          |   |                                 | ** **  |   |   |
| Proceeds from maturities of  investment securities held-to-maturity                |   | **1,658**                            | ** **  | 71 |   |
| Proceeds from maturities of  investment securities available-for-sale              |   | **297,156**                          | ** **  | 245,816 |   |
| Proceeds from sales of  investment securities   available-for-sale            |   | **8**                                | ** **  | 107,995 |   |
| Purchases of investment  securities held-to-maturity                               |   | **(4,765**                           | **)**       | (598 | ) |
| Purchases of investment  securities available-for-sale                             |   | **(244,497**                         | **)**       | (414,155 | ) |
| Net increase in customer loans                                                     |   | **(163,394**                         | **)**       | (135,778 | ) |
| Proceeds from sales of other  real estate owned                                    |   | **75**                               | ** **  | 268 |   |
| Capital expenditures                                                               |   | **(702**                             | **)**       | (4,603 | ) |
| Proceeds from sales of  buildings                                                  |   | **1,169**                            | ** **  | 205 |   |
| Business acquisitions                                                              |   | **—**                           | ** **  | (24,211 | ) |
| Other investing activity                                                           |   | **(183**                             | **)**       | (810 | ) |
| Net cash used in investing  activities                                             |   | **(113,475**                         | **)**       | (225,800 | ) |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                          |   |                                 | ** **  |   |   |
| Net increase in  noninterest-bearing deposits                                      |   | **18,468**                           | ** **  | 34,699 |   |
| Net increase in checking plus  interest and savings accounts                       |   | **268,332**                          | ** **  | 41,788 |   |
| Net (decrease) increase in  certificates of deposit                                |   | **(5,766**                           | **)**       | 158,056 |   |
| Net increase (decrease) in  short-term borrowings                                  |   | **95,306**                           | ** **  | (54,909 | ) |
| Repayment of long-term debt                                                        |   | **(12**                              | **)**       | — |   |
| Proceeds from issuance of  shares                                                  |   | **3,986**                            | ** **  | 1,892 |   |
| Repurchase of common shares                                                        |   | **—**                           | ** **  | (212 | ) |
| Dividends paid                                                                     |   | **(26,335**                          | **)**       | (20,637 | ) |
| Net cash provided by financing  activities                                         |   | **353,979**                          |        | 160,677 |   |
| Net increase in cash and cash  equivalents                                         |   | **287,427**                          |        | 7,494 |   |
| Cash and cash equivalents at  beginning of period                                  |   | **362,701**                          |        | 545,781 |   |
| Cash and cash equivalents at  end of period                                        |   | **$**                                | **650,128** |   | $ | 553,275 |   |
| **SUPPLEMENTAL INFORMATION**                                                       |   |                                 |        |   |   |
| Cash payments for interest                                                         |   | **$**                                | **21,389**  |   | $ | 25,847 |   |
| Cash payments for income taxes                                                     |   | **2,579**                            |        | 8,271 |   |

 

See notes to consolidatedfinancial statements

 

5

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**MERCANTILEBANKSHARES CORPORATION**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

 

1. Basis of Presentation

 

The consolidated financial statements, which include the accounts ofMercantile Bankshares Corporation (“Bankshares”) (Nasdaq: MRBK) and all of itsaffiliates, are prepared in conformity with accounting principles generallyaccepted in the United States of America and follow general practice within thebanking industry.  In the opinion ofmanagement, the consolidated financial statements include all adjustmentsnecessary for a fair presentation of the interim period.  These adjustments are of a normal nature andinclude adjustments to eliminate all significant intercompanytransactions.  In view of the changingconditions in the national economy, the effect of actions taken by regulatoryauthorities and normal seasonal factors, the results for the interim period arenot necessarily indicative of annual performance.  For comparability, certain prior period amounts have beenreclassified to conform with current period presentation.

 

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and contingent assets and liabilities in thefinancial statements, and the disclosure of revenue and expenses during thereporting period.  These assumptions arebased on information available as of the date of the financial statements andcould differ from actual results.  SeeForm 10-K for more detail.

 

2. Business Combinations

 

The following provides information concerning acquisitions; Theseacquisitions were accounted for as purchases. The results of operations ofthese acquisitions subsequent to the acquisition dates are included inBankshares’ Statements of Consolidated Income. Individually, the results ofoperations of these acquisitions prior to the acquisition dates were not materialto Bankshares’ results of operations.

 

 In March and April 2003,Bankshares acquired in separate transactions, Boyd Watterson Asset ManagementLLC (“BW”), an investment management firm, and Peremel & Company, Inc.(“Peremel”), a directed and discount brokerage company.  In the aggregate, the companies werepurchased for approximately $29 million in cash.  The BW acquisition has a potential additional contingent paymentof up to $8.6 million which, if paid, will be recorded as goodwill.  The contingent payment will be recordedassuming certain metrics are met and become payable three years from theacquisition date.  Bankshares finalizedand recorded approximately $10.1 million of identified intangibles, mostly clientrelationships, as a result of these acquisitions.  These intangibles are being amortized on a straight-line basisover a range of three to eight years. Goodwill recorded on these transactions totaled approximately $18.0million at March 31, 2004.

 

 On August 12, 2003, Banksharescompleted its acquisition of F&M Bancorp (“F&M”), a bank holdingcompany headquartered in Frederick, Maryland. The total consideration paid to F&M shareholders in connection withthe acquisition was $124.1 million in cash and 10.4 million shares ofBankshares common stock.  F&Mtransactions have been included in Bankshares’ financial results since August13, 2003.  Acquired assets on August 12,2003 totaled $2.2 billion, including $1.4 billion of loans and leases;liabilities assumed were $2.0 billion, including $1.7 billion of deposits. Asof March 31, 2004, Bankshares had recorded $400.3 million of goodwill, $36.0million of core deposit intangible, $5.8 million of mostly client relationshipintangibles (relating to the two insurance subsidiaries) and $1.1 million in atrademark intangible. The weighted average amortization period for thenewly-acquired core deposit intangible is nine years, and theclient-relationship identified intangible ranges from three to fifteen years.On October 24, 2003, certain assets and liabilities of F&M were transferredto other Bankshares affiliates in order to align customers’ accounts with theBankshares’ affiliate serving the geographic area where those customers reside.

 

6

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3. Earnings Per Share

 

Basic earnings per share (“EPS”) are computed by dividing incomeavailable to common shareholders by weighted average common sharesoutstanding.  Diluted EPS are computedusing the same components as basic EPS with the denominator adjusted for thedilutive effect of stock awards.  Thefollowing tables provide reconciliation between the computation of basic EPSand diluted EPS for the quarter ended March 31, 2004 and 2003, respectively.

 
|                                                          |   | **For the 3 Months Ended March 31, 2004** |       |
|---------------------------------------------------------------|--------|-------------------------------------------|------------|
| **2004 (In thousands, except per share data)**                |   | **Net  Income**                           |       | **Weighted Average  Common Shares** |   | **EPS** |   |
| Basic EPS                                                     |   | **$**                                     | **55,697** | ** ** | **79,725** | ** ** | **$** | **0.70** |   |
| Dilutive effect of stock  options and restricted stock awards |   |                                      | ** ** | **533** | ** ** |   |   |
| Diluted EPS                                                   |   | **$**                                     | **55,697** | ** ** | **80,258** | ** ** | **$** | **0.69** |   |

 
|                                                          |   | **For the 3 Months Ended March 31, 2003** |   |
|---------------------------------------------------------------|--------|-------------------------------------------|--------|
| **2003 (In thousands, except per share data)**                |   | **Net  Income**                           |   | **Weighted Average  Common Shares** |   | **EPS** |   |
| Basic EPS                                                     |   | $                                         | 48,986 |   | 68,769 |   | $ | 0.71 |   |
| Dilutive effect of stock  options and restricted stock awards |   |                                      |   | 421 |   |   |   |
| Diluted EPS                                                   |   | $                                         | 48,986 |   | 69,190 |   | $ | 0.71 |   |

 

Antidilutive options and awards excluded from the computation ofdiluted earnings per share were 298,319 and 265,505 for the three months endedMarch 31, 2004 and 2003, respectively.

 

# **4. Investment Securities**

 

The amortized cost and fair value of investment securities at March 31,2004, December 31, 2003 and March 31, 2003 are shown below:

 
|                               |   | **March 31, 2004**  |          | **December 31, 2003** |       | **March 31, 2003**  |       |
|------------------------------------|--------|---------------------|---------------|-----------------------|------------|---------------------|------------|
| **(Dollars  in thousands)**        |   | **Amortized  Cost** |          | **Fair  Value**       |       | **Amortized  Cost** |       | **Fair  Value** |   | **Amortized  Cost** |   | **Fair  Value** |   |
| Securities available-for-sale      |   |                |          |                  |       |                |       |   |   |   |   |   |   |
| U.S. Treasury                      |   | **$**               | **745,330**   | ** **            | **$**      | **767,902**         | ** ** | $ | 823,356 |   | $ | 845,754 |   | $ | 1,076,879 |   | $ | 1,117,943 |   |
| U.S. Government agencies           |   | **792,237**         | ** **    | **809,771**           | ** ** | 778,916             |       | 793,611 |   | 665,629 |   | 693,685 |   |
| Mortgage-backed securities         |   | **1,292,191**       | ** **    | **1,303,352**         | ** ** | 1,288,109           |       | 1,283,630 |   | 732,123 |   | 741,955 |   |
| States and political  subdivisions |   | **74,665**          | ** **    | **76,931**            | ** ** | 77,897              |       | 79,870 |   | 549 |   | 576 |   |
| Other investments                  |   | **130,080**         | ** **    | **132,133**           | ** ** | 118,948             |       | 120,649 |   | 83,199 |   | 87,817 |   |
| Total                              |   | **$**               | **3,034,503** | ** **            | **$**      | **3,090,089**       | ** ** | $ | 3,087,226 |   | $ | 3,123,514 |   | $ | 2,558,379 |   | $ | 2,641,976 |   |
|                               |   |                | ** **    |                  | ** ** |                |       |   |   |   |   |   |   |
| Securities held-to-maturity        |   |                | ** **    |                  | ** ** |                |       |   |   |   |   |   |   |
| States and political  subdivisions |   | **$**               | **26,555**    | ** **            | **$**      | **28,436**          | ** ** | $ | 28,213 |   | $ | 30,115 |   | $ | 38,231 |   | $ | 41,040 |   |
| Other investments                  |   | **25,969**          | ** **    | **25,969**            | ** ** | 21,204              |       | 21,204 |   | 15,687 |   | 15,687 |   |
| Total                              |   | **$**               | **52,524**    | ** **            | **$**      | **54,405**          | ** ** | $ | 49,417 |   | $ | 51,319 |   | $ | 53,918 |   | $ | 56,727 |   |

 

# **5. Impaired Loans**

 

When scheduled principal or interest paymentsare past due 90 days or more at quarter-end on any loan, the accrual ofinterest income is discontinued and subsequent receipts on these loans arerecorded as a reduction of principal, and interest income is recorded only onceprincipal recovery is reasonably assured. Previously accrued but uncollectedinterest on these loans is charged against interest income. Generally a loanmay be restored to accruing status when all past due principal, interest andlate charges have been paid and the bank expects repayment of the remainingcontractual principal and interest.

 

7

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Under Statements of Financial AccountingStandards (SFAS) Nos. 114 and 118, “Accounting by Creditors for Impairment of aLoan-an amendment of FASB Statements No. 5 and 15,” a loan is consideredimpaired, based on current information and events, if it is probable thatBankshares will not collect all principal and interest payments according tothe contractual terms of the loan agreement. The impairment of a loan ismeasured based on the present value of expected future cash flows discounted atthe loan’s effective interest rate, or the fair value of the collateral if therepayment is expected to be provided predominantly by the underlyingcollateral. A majority of Bankshares’ impaired loans are measured by referenceto the fair value of the collateral. Information with respect toimpaired loans and the related valuation allowance (if the measure of theimpaired loan is less that the recorded investment) at March 31, 2004, December31, 2003, and March 31, 2003 are shown below. See Form 10-K for more detail.

 
| **(Dollars  in thousands)**                                                      |   | **March 31,  2004** |        | **December 31,  2003** |   | **March 31,  2003** |   |
|----------------------------------------------------------------------------------|--------|---------------------|-------------|------------------------|--------|---------------------|--------|
| Impaired loans with a specific  valuation allowance                              |   | **$**               | **25,971**  | ** **             | $      | 26,715              |   | $ | 8,189 |   |
| All other impaired loans                                                         |   | **16,508**          | ** **  | 18,692                 |   | 15,865              |   |
| Total impaired loans                                                             |   | **$**               | **42,479**  | ** **             | $      | 45,407              |   | $ | 24,054 |   |
|                                                                             |   |                | ** **  |                   |   |                |   |
| Specific allowance for loan  losses applicable to impaired loans                 |   | **$**               | **14,094**  | ** **             | $      | 14,925              |   | $ | 4,857 |   |
| General allowance for loan  losses applicable to other than impaired loans       |   | **142,541**         | ** **  | 140,412                |   | 135,570             |   |
| Total allowance for loan losses                                                  |   | **$**               | **156,635** | ** **             | $      | 155,337             |   | $ | 140,427 |   |
|                                                                             |   |                | ** **  |                   |   |                |   |
| Year-to-date interest income on  impaired loans recorded on the cash basis       |   | **$**               | **103**     | ** **             | $      | 443                 |   | $ | 97 |   |
| Year-to-date average recorded  investment in impaired loans during the period    |   | **$**               | **42,479**  | ** **             | $      | 31,241              |   | $ | 24,054 |   |
| Quarter-to-date interest income  on impaired loans recorded on the cash basis    |   | **$**               | **103**     | ** **             | $      | 223                 |   | $ | 97 |   |
| Quarter-to-date average  recorded investment in impaired loans during the period |   | **$**               | **42,479**  | ** **             | $      | 37,382              |   | $ | 24,054 |   |

 

**Note:**Impaired loans do not include large groups of smaller balance homogeneous loansthat are evaluated collectively for impairment (e.g., residential mortgages andconsumer installment loans).  Theallowance for loan losses related to these loans is included in the allowancefor loan losses applicable to other than impaired loans.

 

6. Commitments

 

Bankshares is a party to financial instruments that are not reflectedin the balance sheet, which include commitments to extend credit and standbyletters of credit. Various commitments to extend credit (lines of credit) aremade in the normal course of banking business. Letters of credit are issued forthe benefit of customers by affiliated banks. These commitments are subject toloan underwriting standards and geographic boundaries consistent withBankshares’ loans outstanding. Bankshares’ lending activities are concentratedin Maryland, Delaware and Virginia.

 

 Commitments to extend credit are agreements to lend to a customeras long as there is no violation of any condition established in the contract.Commitments generally have fixed expiration dates or other termination clausesand may require payment of a fee. Since many of the commitments are expected toexpire without being drawn upon, the total commitment amounts do notnecessarily represent future cash requirements. Total commitments to extendcredit were $3.6 billion at March 31, 2004 and December 31, 2003,  and $3.0 billion at March 31, 2003.

 

 Standby letters of credit are commitments issued to guarantee theperformance of a customer to a third party. Outstanding letters of credit were$303.3 million at March 31, 2004, $281.4 million at December 31, 2003 and$243.5 million at March 31, 2003.  Feesreceived for issuing letters of credit are deferred and amortized over the lifeof the commitment.  The fees on lettersof credit at March 31, 2004 and December 31, 2003 had a carrying value of $1.1million and $1.0 million, respectively, representing unamortized fees.

 

 Bankshares’ mortgage banking subsidiary is a Fannie Mae DelegatedUnderwriting and Servicing lender, and has a loss sharing arrangement for loansoriginated on behalf of and sold to Fannie Mae.  The unamortized principal balance of the underlying loans totaled$148.6 million and $149.4 million at March 31, 2004 and December 31, 2003,respectively.  No allowance has beenestablished for possible losses on loans originated and sold in the secondarymarket since there have been no losses recognized during the history of thisarrangement and no losses were incurred at March 31, 2004.  The mortgage subsidiary also has originatedand sold loans with recourse in the event of foreclosure on the underlying realestate.  The unamortized amount ofprincipal balance of loans sold with recourse totaled $2.2 million and $2.3million at March 31, 2004 and December 31, 2003, respectively.  These mortgages are generally in goodstanding, are well-collateralized and no loss has ensued and no future loss isexpected.

 

 Bankshares has committed toinvest funds in third-party private equity investments. At March 31, 2004,December 31, 2003 and March 31, 2003, $20.9 million, $16.1 million and $18.0million, respectively, remained unfunded.

 

8

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# **7. Other Intangible Assets**

 

The following table discloses the gross carrying amount and accumulatedamortization of intangible assets subject to amortization at March 31, 2004 andDecember 31, 2003:

 
|                        |   | **March 31, 2004**         |       | **December 31, 2003**         |   |
|-----------------------------|--------|----------------------------|------------|-------------------------------|--------|
| **(Dollars  in thousands)** |   | **Gross carrying  amount** |       | **Accumulated  amortization** |   | **Net  amount** |   | **Gross carrying  amount** |   | **Accumulated  amortization** |   | **Net  amount** |   |
| Deposit intangibles         |   | **$**                      | **49,881** | ** **                    | **$**  | **(10,913** | **)** | **$** | **38,968** |   | $ | 49,881 |   | $ | (9,546 | ) | $ | 40,335 |   |
| Mortgage servicing rights   |   | **2,086**                  | ** ** | **(1,577**                    | **)**  | **509** |   | 2,351 |   | (1,790 | ) | 561 |   |
| Customer lists and others   |   | **17,010**                 | ** ** | **(2,264**                    | **)**  | **14,746** |   | 17,010 |   | (1,683 | ) | 15,327 |   |
| Total                       |   | **$**                      | **68,977** | ** **                    | **$**  | **(14,754** | **)** | **$** | **54,223** |   | $ | 69,242 |   | $ | (13,019 | ) | $ | 56,223 |   |

 

The projections of amortization expense shown for mortgage servicingrights are based on asset balances and the interest rate environment as ofMarch 31, 2004. Future amortization expense may be significantly differentdepending upon changes in the mortgage servicing portfolio, mortgage interestrates and market conditions.

 

The following table shows the current period and estimated futureamortization expense for amortized intangible assets. Core deposit intangiblesare amortized based on estimated lives of up to nine years. Bankshares recorded$36.0 million of core deposit intangibles in conjunction with the F&Macquisition. Management reviews other intangible assets for impairment yearlyor whenever events or changes in circumstances indicate that their carryingamounts may not be recoverable. For those intangible assets subject toamortization, impairment is indicated if the sum of undiscounted estimatedfuture net cash flow is less than the carrying amount of the asset. Impairmentis recognized by accelerating the write off of the asset to the extent that thecarrying value exceeds the estimated fair value.

 
| **(Dollars  in thousands)**                        |   | **Core  deposit  intangibles** |      | **Mortgage  servicing  intangibles** |   | **Customer lists  and other  intangibles** |       | **Total** |    |
|----------------------------------------------------|--------|--------------------------------|-----------|--------------------------------------|--------|--------------------------------------------|------------|-----------|---------|
| Three months ended March 31,  2004 (actual)        |   | **$**                          | **1,367** | ** **                           | **$**  | **79**                                     | ** ** | **$**     | **586** | ** ** | **$** | **2,032** | ** ** |
| Nine months ended December 31,  2004 (estimated)   |   | 4,100                          |      | 238                                  |   | 1,744                                      |       | 6,082     |    |
| Twelve months ended December  31, 2004 (estimated) |   | 5,467                          |      | 317                                  |   | 2,330                                      |       | 8,114     |    |
|                                               |   |                           |      |                                 |   |                                       |       |      |    |
| Estimate for year ended  December 31,              | 2005   |                           | 5,467     |                                 | 192    |                                       | 2,326      |      | 7,985   |   |
|                                               | 2006   |                           | 5,467     |                                 |   |                                       | 2,083      |      | 7,550   |   |
|                                               | 2007   |                           | 5,321     |                                 |   |                                       | 1,890      |      | 7,211   |   |
|                                               | 2008   |                           | 4,605     |                                 |   |                                       | 1,708      |      | 6,313   |   |
|                                               | 2009   |                           | 4,004     |                                 |   |                                       | 985        |      | 4,989   |   |
|                                                    |        |                                |           |                                      |        |                                            |            |           |         |  |  |  |  |  |

 

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# **8. Comprehensive Income**

 

The following table summarizes the related tax effect of unrealizedgains (losses) on securities available-for-sale for the three months endedMarch 31, 2004 and 2003.  The net amountis included in accumulated other comprehensive income (loss) in the Statementof Changes in Consolidated Shareholders’ Equity.

 
|                                                         |   | **For the 3 Months Ended March 31,** |       |
|--------------------------------------------------------------|--------|--------------------------------------|------------|
|                                                         |   | **2004**                             |       | **2003** |   |
| **(Dollars  in thousands)**                                  |   | **Pretax  Amount**                   |       | **Tax  (Expense)  Benefit** |   | **Net  Amount** |   | **Pretax  Amount** |   | **Tax  (Expense)  Benefit** |   | **Net  Amount** |   |
| Unrealized gains (losses) on  securities available-for-sale: |   |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Unrealized holding gains  (losses) arising during the period |   | **$**                                | **19,243** | ** ** | **$** | **(7,020** | **)** | **$** | **12,223** |   | $ | (5,073 | ) | $ | 1,988 |   | $ | (3,085 | ) |
| Reclassification adjustment for  (gains)                     |   |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Losses included in net income                                |   | **55**                               | ** ** | **(22** | **)** | **33** |   | (815 | ) | 322 |   | (493 | ) |
| Total                                                        |   | **$**                                | **19,298** | ** ** | **$** | **(7,042** | **)** | **$** | **12,256** |   | $ | (5,888 | ) | $ | 2,310 |   | $ | (3,578 | ) |

 

# **9. Capital Adequacy**

 

Bankshares and its bank affiliates are subject to various regulatorycapital adequacy requirements administered by federal and state bankingagencies.  These requirements includemaintaining certain capital ratios above minimum levels.  These capital ratios include tier I capitaland total risk-based capital as percents of net risk-weighted assets and tier Icapital as a percent of adjusted average total assets (leverage ratio).  The minimum ratios for capital adequacypurposes are 4.00%, 8.00% and 4.00%, for the tier I capital, total capital andleverage ratios, respectively.  To becategorized as *well capitalized,* a bank must maintain minimum ratios of6.00%, 10.00% and 5.00%, for its tier I capital, total capital and leverageratios, respectively.  As of March 31,2004, Bankshares and all of its bank affiliates exceeded all capital adequacyrequirements to be considered well capitalized.

 

Capital ratios and the amounts used to calculate them are presented inthe following table for Bankshares and Mercantile-Safe Deposit & TrustCompany (MSD&T), the lead bank, as of March 31, 2004 and December 31, 2003.

 
|                          |   | **March 31, 2004** |          | **December 31, 2003** |   |
|-------------------------------|--------|--------------------|---------------|-----------------------|--------|
| **(Dollars  in thousands)**   |   | **Bankshares**     |          | **MSD&T**         |   | **Bankshares** |   | **MSD&T** |   |
|                          |   |               |          |                  |   |   |   |   |   |
| Tier I capital                |   | **$**              | **1,283,922** | ** **            | $      | 402,057 |   | $ | 1,248,492 |   | $ | 396,186 |   |
| Total risk-based capital      |   | **1,709,187**      | ** **    | 447,399               |   | 1,666,064 |   | 440,479 |   |
| Net risk-weighted assets      |   | **10,336,236**     | ** **    | 3,612,085             |   | 10,020,487 |   | 3,529,223 |   |
| Adjusted average total assets |   | **12,960,988**     | ** **    | 4,307,838             |   | 13,011,399 |   | 4,353,713 |   |
|                          |   |               | ** **    |                  |   |   |   |   |   |
| Tier I capital ratio          |   | **12.42**          | **%**         | 11.13                 | %      | 12.46 | % | 11.23 | % |
| Total capital ratio           |   | **16.54**          | **%**         | 12.39                 | %      | 16.63 | % | 12.48 | % |
| Leverage ratio                |   | **9.91**           | **%**         | 9.33                  | %      | 9.60 | % | 9.10 | % |
|                               |        |                    |               |                       |        |  |  |  |  |  |  |  |  |

 

Bankshares has an ongoing share repurchaseprogram.  As of March 31, 2004 thereremain 1,476,327 shares of the 2,000,000 shares previously authorized by theBoard of Directors on December 11, 2001. For the three months ended March 31, 2004 and the twelve months endedDecember 31, 2003, -0- and 5,500 shares, respectively, were repurchased byBankshares in open market transactions.  In April 2004, management resumed the repurchase of shares by enteringinto a privately negotiated agreement for the accelerated purchase of onemillion shares.

 

10

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10. Segment Reporting

 

Operating segments as defined by SFAS No. 131 *Disclosures about Segments of anEnterprise and Related Information* are components of an enterprisewith separate financial information. The component engages in business activities from which it derivesrevenues and incurs expenses and whose operating results management relies onfor decision-making and performance assessment. Bankshares has three reportablesegments – its 19 Community Banks, MSD&T Banking and Investment and WealthManagement  (IWM).

 

The following tables present selected segment information for the threemonths ended March 31, 2004 and 2003. The components in the “Other” column consist of amounts for thenonbanking affiliates and intercompany eliminations.   Certain expense amounts such as operations overhead have beenreclassified from internal financial reporting in order to provide for fullcost absorption.  Thesereclassifications are shown in the “Adjustments” line.  F&M is included in the column “CommunityBanking” whereas BW and Peremel are included in the column “IWM”.

 

 
|                               |   | **For the 3 Months Ended March 31, 2004** |          |
|------------------------------------|--------|-------------------------------------------|---------------|
|                               |   | **Banking**                               |          |   |   |   |   |   |   |
| **(Dollars  in thousands*****)***  |   | **Community**                             |          | **MSD&T** |   | **Total (1)** |   | **IWM** |   | **Other** |   | **Total** |   |
| Net interest income                |   | **$**                                     | **95,762**    | ** ** | **$** | **34,843** | ** ** | **$** | **130,605** | ** ** | **$** | **—** | ** ** | **$** | **3,069** | ** ** | **$** | **133,674** | ** ** |
| Provision for loan losses          |   | **(159**                                  | **)**         | **(2,267** | **)** | **(2,426** | **)** | **—** | ** ** | **—** | ** ** | **(2,426** | **)** |
| Noninterest income                 |   | **20,817**                                | ** **    | **11,059** | ** ** | **26,835** | ** ** | **22,382** | ** ** | **668** | ** ** | **49,885** | ** ** |
| Noninterest expenses               |   | **(55,785**                               | **)**         | **(24,783** | **)** | **(75,527** | **)** | **(17,379** | **)** | **(480** | **)** | **(93,386** | **)** |
| Adjustments                        |   | **(1,898**                                | **)**         | **5,129** | ** ** | **3,231** | ** ** | **(796** | **)** | **(2,435** | **)** | **—** | ** ** |
| Income (loss) before income  taxes |   | **58,737**                                | ** **    | **23,981** | ** ** | **82,718** | ** ** | **4,207** | ** ** | **822** | ** ** | **87,747** | ** ** |
| Income tax (expense) benefit       |   | **(20,395**                               | **)**         | **(8,651** | **)** | **(29,046** | **)** | **(1,683** | **)** | **(1,321** | **)** | **(32,050** | **)** |
| Net income (loss)                  |   | **$**                                     | **38,342**    | ** ** | **$** | **15,330** | ** ** | **$** | **53,672** | ** ** | **$** | **2,524** | ** ** | **$** | **(499** | **)** | **$** | **55,697** | ** ** |
| Average loans                      |   | **$**                                     | **6,370,303** | ** ** | **$** | **2,967,933** | ** ** | **$** | **9,338,236** | ** ** | **—** | ** ** | **$** | **197** | ** ** | **$** | **9,338,433** | ** ** |
| Average earning assets             |   | **8,706,230**                             | ** **    | **4,003,020** | ** ** | **12,370,034** | ** ** | **—** | ** ** | **105,817** | ** ** | **12,475,851** | ** ** |
| Average assets                     |   | **9,168,590**                             | ** **    | **4,350,122** | ** ** | **13,069,701** | ** ** | **—** | ** ** | **548,492** | ** ** | **13,618,193** | ** ** |
| Average deposits                   |   | **7,238,415**                             | ** **    | **3,022,107** | ** ** | **10,138,846** | ** ** | **—** | ** ** | **(72,201** | **)** | **10,066,645** | ** ** |
| Average equity                     |   | **930,920**                               | ** **    | **442,227** | ** ** | **1,373,147** | ** ** | **—** | ** ** | **475,314** | ** ** | **1,848,461** | ** ** |

 
|                               |   | **For the 3 Months Ended March 31, 2003** |      |
|------------------------------------|--------|-------------------------------------------|-----------|
|                               |   | **Banking**                               |      |   |   |   |   |   |   |
| **(Dollars  in thousands)**        |   | **Community**                             |      | **MSD&T** |   | **Total (1)** |   | **IWM** |   | **Other** |   | **Total** |   |
| Net interest income                |   | $                                         | 76,252    |   | $ | 35,185 |   | $ | 111,437 |   | $ | — |   | $ | (311 | ) | $ | 111,126 |   |
| Provision for loan losses          |   | (1,612                                    | )         | (1,404 | ) | (3,016 | ) | — |   | — |   | (3,016 | ) |
| Noninterest income                 |   | 13,296                                    |      | 10,444 |   | 20,230 |   | 17,359 |   | 264 |   | 37,853 |   |
| Noninterest expenses               |   | (38,384                                   | )         | (21,677 | ) | (56,551 | ) | (13,953 | ) | 723 |   | (69,781 | ) |
| Adjustments                        |   | (1,611                                    | )         | 3,760 |   | 2,149 |   | (808 | ) | (1,341 | ) | — |   |
| Income (loss) before income  taxes |   | 47,941                                    |      | 26,308 |   | 74,249 |   | 2,598 |   | (665 | ) | 76,182 |   |
| Income tax (expense) benefit       |   | (16,599                                   | )         | (9,476 | ) | (26,075 | ) | (1,039 | ) | (82 | ) | (27,196 | ) |
| Net income (loss)                  |   | $                                         | 31,342    |   | $ | 16,832 |   | $ | 48,174 |   | $ | 1,559 |   | $ | (747 | ) | $ | 48,986 |   |
| Average loans                      |   | $                                         | 4,462,827 |   | $ | 2,896,537 |   | $ | 7,359,364 | ** ** | **—** |   | $ | 281 |   | $ | 7,359,645 |   |
| Average earning assets             |   | 6,225,782                                 |      | 3,867,355 |   | 9,908,894 | ** ** | **—** |   | 84,339 |   | 9,993,233 |   |
| Average assets                     |   | 6,539,154                                 |      | 4,145,799 |   | 10,405,827 | ** ** | **—** |   | 118,382 |   | 10,524,209 |   |
| Average deposits                   |   | 5,275,024                                 |      | 2,947,659 |   | 8,111,078 | ** ** | **—** |   | (41,740 | ) | 8,069,338 |   |
| Average equity                     |   | 834,837                                   |      | 451,004 |   | 1,285,841 | ** ** | **—** |   | 9,499 |   | 1,295,340 |   |

 

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(1)  Amounts do not necessarilyadd due to eliminations.

 

11

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11. Derivative Instruments and Hedging Activities

 

FASB Statement No. 133 (SFAS No. 133), *Accounting for Derivative Instrumentsand Hedging Activities,*FASB Statement No. 138 (SFAS No. 138), *Accountingfor Certain Derivative Instruments and Certain Hedging Activities – anamendment to FASB Statement No. 133 and*FASB Statement No. 149 (SFASNo. 149), *Amendmentof Statement 133 on Derivative Instruments and Hedging Activities *(collectively referred to asderivatives), establishes accounting and reporting standards for derivativeinstruments and for hedging activities. Bankshares maintains an overallinterest rate risk management strategy that incorporates the use of derivativeinstruments to minimize significant unplanned fluctuations in earnings that arecaused by interest rate volatility. Derivative instruments that are used as part of the interest rate riskmanagement strategy have been restricted to interest rate swaps.  Interest rate swaps generally involve theexchange of fixed-rate and variable-rate interest payments between two parties,based on a common notional principal amount and maturity date. Banksharesentered into interest rate swaps to convert fixed-rate loans made to borrowersto floating-rate loans and to convert its nonprepayable fixed-rate debt tofloating-rate debt.

 

The fair value of derivative instruments recorded in other assets was$12.9 million (notional $250.0 million) and $6.6 million (notional $203.1million) at March 31, 2004 and December 31, 2003, respectively.  The fair value of derivative instrumentsrecorded in other liabilities was $4.3 million (notional $103.1 million) and$8.0 million (notional $150.0 million) at March 31, 2004 and December 31, 2003,respectively.  For the three monthsended March 31, 2004, Bankshares recognized a net gain of $6 thousand, whichrepresented the ineffective portion of the fair-value hedge of fixed-rate loansmade to borrowers.  For the year endedDecember 31, 2003, Bankshares recognized a net gain of $70 thousand.  The impact of the hedge decreased interestincome $42 thousand in the first three months of 2004 and $167 thousand in2003.  The fair-value hedges ofnonprepayable fixed-rate debt were effective for the reported periods.  The impact of the hedges decreased interestexpense $2.8 million in the first three months of 2004 and $8.5 million in2003.

 

The following tables summarize the gross position of derivatives atMarch 31, 2004 and December 31, 2003:

 
|                                                |   |                     |       |                 |        | **Weighted Average**   |       |           |       |
|-----------------------------------------------------|--------|--------------------------|------------|----------------------|-------------|------------------------|------------|----------------|------------|
| **March 31, 2004 (Dollars in thousands)**           |   | **Number  of Contracts** |       | **Notional  Amount** |        | **Years to  Maturity** |       | **Fixed Rate** |       | **Variable Rate** |   | **Fair  Value** |   |
| Gross Position Summary:                             |   |                     | ** ** |                 | ** **  |                   | ** ** |           | ** ** |   | ** ** |   | ** ** |
| Pay Fixed/Receive Variable  Interest Rate Swaps (1) |   | **1**                    | ** ** | **$**                | **3,091**   | ** **             | **0.12**   | ** **     | **9.38**   | **%** | **4.00** | **%** | **$** | **(18** | **)** |
| Receive Fixed/Pay Variable  Interest Rate Swaps (2) |   | **3**                    | ** ** | **350,000**          | ** **  | **8.24**               | ** ** | **5.21**       | **%**      | **1.93** | **%** | **8,609** | ** ** |
| Total                                               |   | **4**                    | ** ** | **$**                | **353,091** | ** **             | **8.17**   | ** **     |       | ** ** |   | ** ** | **$** | **8,591** | ** ** |

 
|                                                |   |             |   |         |    | **Weighted Average** |   |           |   |
|-----------------------------------------------------|--------|------------------|--------|--------------|---------|----------------------|--------|----------------|--------|
|                                                |   | **Number**       |   | **Notional** |    | **Years to**         |   |           |   |   |   | **Fair** |   |
| **December 31, 2003 (Dollars in thousands)**        |   | **of Contracts** |   | **Amount**   |    | **Maturity**         |   | **Fixed Rate** |   | **Variable Rate** |   | **Value** |   |
| Gross Position Summary:                             |   |             |   |         |    |                 |   |           |   |   |   |   |   |
| Pay Fixed/Receive Variable  Interest Rate Swaps (1) |   | 1                |   | $            | 3,108   |                 | 0.33   |           | 9.38   | % | 4.00 | % | $ | (64 | ) |
| Receive Fixed/Pay Variable Interest  Rate Swaps (2) |   | 3                |   | 350,000      |    | 8.44                 |   | 5.21           | %      | 1.98 | % | (1,366 | ) |
| Total                                               |   | 4                |   | $            | 353,108 |                 | 8.37   |           |   |   |   |   | $ | (1,430 | ) |

 

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(1)  Hedges fixed-ratecommercial loan.

(2)  Hedges fixed-rate long-termdebt.

 

Mortgage loans held-for-sale have inherent forward contract (agreementsto sell or purchase loans at a specific rate or yield) characteristics. Riskmay arise from the corresponding parties’ inability to meet the term of theircontracts and from movement in interest rates. Bankshares had forwardcommitments to sell and fund individual fixed-rate and variable-rate mortgageloans that are reported at fair value. The fair value adjustment were notmaterial at March 31, 2004 and December 31, 2003.

 

12

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12. Stock-based Compensation Expense

 

Bankshares has several stock-based compensation programs for itsdirectors, management and employees. Compensation costs for stock options andrestricted stock awards are included in salary expense.  Another form of stock-based compensation isphantom stock, which is used for Bankshares’ Directors’ Deferred CompensationPlan.  The compensation cost for thephantom stock, which fluctuates with changes in Bankshares’ stock price, isincluded in other expenses.  Stock-basedcompensation amounts for the three months ended March 31, 2004 and 2003 aresummarized in the following table:

 
|                                    |   | **For the 3 Months Ended  March 31,** |    |
|-----------------------------------------|--------|---------------------------------------|---------|
| **(Dollars  in thousands)**             |   | **2004**                              |    | **2003** |   |
| Stock options expense                   |   | **$**                                 | **406** |   | $ | 459 |   |
| Restricted stock awards expense         |   | **487**                               |    | 318 |   |
| Subtotal included in salaries  expense  |   | **893**                               |    | 777 |   |
| Phantom stock expense                   |   | **(378**                              | **)**   | (675 | ) |
| Total stock-based compensation  expense |   | **$**                                 | **515** |   | $ | 102 |   |

 

# **13.**         Pension & Other Postretirement Benefit Plans

 

Bankshares sponsors qualified and nonqualified pension plans and otherpostretirement benefit plans for its employees.  The following table summarizes the components of the net periodicbenefit cost for the pension plans for the three months ended March 31, 2004and 2003.

 
|                                  |   | **For the 3 months ended March 31, 2004** |       | **For the 3 months ended March 31, 2003** |       |
|---------------------------------------|--------|-------------------------------------------|------------|-------------------------------------------|------------|
|                                  |   | **Qualified**                             |       | **Nonqualified**                          |       | **Total** |   | **Qualified** |   | **Nonqualified** |   | **Total** |   |
|                                  |   |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| Service cost                          |   | **$**                                     | **1,572**  | ** **                                | **$**      | **141** | ** ** | **$** | **1,713** | ** ** | $ | 1,280 |   | $ | 115 |   | $ | 1,395 |   |
| Interest cost                         |   | **2,549**                                 | ** ** | **101**                                   | ** ** | **2,650** | ** ** | 2,498 |   | 78 |   | 2,576 |   |
| Expected return on plan assets        |   | **(3,845**                                | **)**      | **—**                                | ** ** | **(3,845** | **)** | (3,099 | ) | — |   | (3,099 | ) |
| Amortization of prior service  cost   |   | **195**                                   | ** ** | **6**                                     | ** ** | **201** | ** ** | 195 |   | 6 |   | 201 |   |
| Recognized net actuarial (gain)  loss |   | **153**                                   | ** ** | **29**                                    | ** ** | **182** | ** ** | 605 |   | 8 |   | 613 |   |
| Amortization of transition  asset     |   | **—**                                | ** ** | **24**                                    | ** ** | **24** | ** ** | — |   | 25 |   | 25 |   |
| Net periodic benefit cost             |   | **$**                                     | **624**    | ** **                                | **$**      | **301** | ** ** | **$** | **925** | ** ** | $ | 1,479 |   | $ | 232 |   | $ | 1,711 |   |

 

The following table summarizes the components of the net periodicbenefit cost for the other postretirement benefit plans for the three months endedMarch 31, 2004 and 2003.

 
|                                  |   | **For the 3 months ended March 31,** |    |
|---------------------------------------|--------|--------------------------------------|---------|
|                                  |   | **2004**                             |    | **2003** |   |
|                                  |   |                                 |    |   |   |
| Service cost                          |   | **$**                                | **65**  |   | $ | 29 |   |
| Interest cost                         |   | **214**                              |    | 121 |   |
| Expected return on plan assets        |   | **—**                           |    | — |   |
| Amortization of prior service  cost   |   | **—**                           |    | — |   |
| Recognized net actuarial (gain)  loss |   | **38**                               |    | 21 |   |
| Amortization of transition  asset     |   | **—**                           |    | — |   |
| Net periodic benefit cost             |   | **$**                                | **317** |   | $ | 171 |   |

 

As previously disclosed in its financial statements for the year endedDecember 31, 2003, Bankshares generally makes cash contributions to the pensionplan in amounts equal to the maximum permitted by Employee Retirement IncomeSecurities Act guidelines.  Under thoseguidelines, Bankshares could contribute up to approximately $20 million to thepension plan during 2004. As of March 31, 2004, no contributions had been made.

 

13

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# **14.**         Recent Accounting Standards

 

In December 2003, the American Institute of Certified PublicAccountants issued Statement of Position (“SOP”) 03-3, “Accounting for CertainLoans or Debt Securities Acquired in a Transfer,” which addresses theaccounting for differences between contractual cash flows and expected cashflows for loans acquired in a transfer when those differences are attributableat least in part to credit quality.  Itincludes such loans acquired in purchase business combinations where there isevidence of deterioration in credit quality since origination. This SOPrequires the difference between expected cash flows and the purchase price tobe accreted as an adjustment to yield over the life of the acquired loans; thedifference between contractual cash flows and expected cash flows is notsubject to accretion. This SOP would represent a change from current practicewhere the allowance for loan losses is carried over in purchase accounting. TheSOP is effective for loans acquired beginning after December 15, 2004.Bankshares is currently evaluating the impact it will have on operations andfinancial statements.

 

In March 2004, the Emerging Issues Task Force published Issue No. 03-6(“EITF 03-6”) “*Participating Securities and the Two-Class Method under FASB StatementNo. 128, ‘Earnings Per Share’.”* Statement No. 128 indicates thatparticipating securities should be included in basic earnings per share(“EPS”), if the effect is dilutive, using either the two-class method or theif-converted method. The issue clarifies how to determine whether a security(other than common stock) should be considered a “participating security” forpurposes of computing EPS and how earnings should be allocated to aparticipating security when using the two-class method for computing basic EPS.This issue does not have an impact on Bankshares’ financial statements.

 

In March 2004, the SEC amendedStaff Accounting Bulletin: No. 105 (“SAB 105”) “*Application of Accounting Principles toLoan Commitments*”. SAB 105 adds Section DD to Topic 5 whichsummarizes the views of the staff regarding the application of generallyaccepted accounting principles to loan commitments accounted for as derivativeinstruments. SAB 105 provides guidance on mortgage loan commitments that areentered into with customers at a specified rate and are intended to be soldafter they are funded. Bankshares is currently evaluating the impactthis bulletin will have on the financial statements.

 

# **15.**         Subsequent Event

 

On April 30, 2004, Bankshares announced that it has initiated asignificant reorganization within its Community Banking network.  In a move designed to create banks ofsufficient size and depth to compete more effectively today and in the future,Bankshares will combine 11 affiliate banks to create four new organizations,all with a more prominent Mercantile identity. This reorganization will enableBankshares to operate more effectively and efficiently in the face of increasedcompetitive and regulatory pressures. Fewer, larger banks will better leverage our branch network, reduceadministrative and operational redundancies and increase the breadth and depthof expertise among our associates. All banks being combined are geographicallycontiguous, share increasingly common market dynamics and offer the opportunityto create scale efficiencies. Pending regulatory approval, the banks areanticipated to be combined in July.

 

Thebanks currently range in asset size from $110 million to $850 million and arelocated in the southern and eastern portions of Bankshares’ market.  The four resulting banks will range in assetsize from $580 million to $1.5 billion. The resulting banks will consist of:

 

•                  **MercantilePeninsula Bank,** with 39 branches and proforma assets of $1.5billion, loans of $1.2 billion and deposits of $1.2 billion at March 31, 2004,will be formed by combining Baltimore Trust Company, headquartered inSelbyville, Del.; Farmers & Merchants Bank-Eastern Shore, headquartered inOnley, Va.; and Peninsula Bank, headquartered in Princess Anne, Md.

 

•                  **MercantileSouthern Maryland Bank,** with 17 branches and proforma assets of $930million, loans of $530 million and deposits of $790 million at March 31, 2004,will be formed by combining Bank of Southern Maryland, headquartered inLaPlata, Md.; Calvert Bank and Trust Company, headquartered in PrinceFrederick, Md.; and The First National Bank of St. Mary’s, headquartered inLeonardtown, Md.

 

•                  **MercantileCounty Bank,** with 17 branches and proforma assets of $790 million,loans of $620 million and deposits of $640 million at March 31, 2004, will beformed by combining County Banking & Trust Company, headquartered inElkton, Md., and The Forest Hill State Bank, headquartered in Bel Air, Md.

 

•                  **MercantileEastern Shore Bank,** with 19 branches and proforma assets of $580million, loans of $500 million and deposits of $440 million at March 31, 2004,will be formed by combining The Chestertown Bank of Maryland, headquartered inChestertown, Md.; The Peoples Bank of Maryland, headquartered in Denton, Md.;and St. Michaels Bank, headquartered in St. Michaels, Md.

 

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Upon completion of legal consolidation, Bankshares will have a total of13 banking affiliates including the lead bank, MSD&T.  Management anticipates the operationalconversions to the four new banks will occur late in the third quarter andearly in the fourth quarter of 2004.

 

In tandem with the Community Banking initiative, Bankshares previouslyannounced a more unified, regional approach to the Washington, D.C. market andthat most all of the MSD&T Banking resources currently operating in thatregion, including the K Street branch, would be combined into Potomac ValleyBank.  In light of the regionalstrategy, the expanded Potomac affiliate will be renamed **Mercantile Potomac Bank**.  We anticipate that the name change will becompleted by the end of summer.

 

 

# **Item2.   Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

#### **MERCANTILEBANKSHARES CORPORATION**

 

**Consolidated Financial Results**

 

In March, April and August of 2003, Bankshares acquired in separatetransactions, Boyd Watterson Asset Management, LLC (“BW”), Peremel &Company (“Peremel”), and F&M Bancorp (“F&M”), respectively, which arecollectively referred to herein as, “the Acquisitions”.  The Acquisitions were accounted for underthe purchase method of accounting and have been included in Bankshares’financial results since their respective closings. On October 24, 2003, certainassets and liabilities of F&M were transferred to other Bankshares’affiliates in order to align customers’ accounts with the Bankshares’ affiliateserving the geographic area where those customers reside. (See Footnote No. 2to the Consolidated Financial Statements included in this report.)

 

Net income for the quarter ended March 31, 2004 was $55.7 million, a14% increase from net income of $49.0 million for the same period in 2003 and a10% increase over the $50.6 million reported for the fourth quarter of2003.  For the quarter ended March 31,2004, diluted net income per share was $.69, a decrease of 3% from the $.71reported for the first quarter of last year and an increase of 10% over the$.63 reported for the fourth quarter last year.  Adjusted weighted average shares outstanding increased from 69.2million for the quarter ended March 31, 2003, to 80.3 million for the quarterended March 31, 2004 as a result of the Acquisitions.  The results of operations for the Acquisitions are included fromtheir respective merger dates forward.

 

Factors affecting earnings for the first quarter included: $0.2 millionof after-tax expenses related to the merger of F&M compared to $2.8 millionin the fourth quarter of 2003 and continued compression of the net interestmargin to 4.37% in the first quarter of 2004 from 4.57% in the first quarter of2003.

 

Bankshares also reports cash operatingearnings, defined as “GAAP” (Generally Accepted Accounting Principles) earningsexcluding the amortization of intangible assets associated with purchaseaccounting for business combinations; securities gains and losses; and othersignificant gains, losses or expenses (such as those associated withintegrating acquired entities’ operations into Bankshares).  Cash operating earnings totaled $56.8million for the first quarter of 2004, an increase of 16% over the $48.8million for the same period for 2003 and an increase of 4% over the $54.5million for the fourth quarter of 2003. Diluted cash operating earnings per share for the first quarter of 2004and 2003 were $.71, and $.70, respectively, and $.69 per share for the fourthquarter of 2003.  Areconciliation of net income (GAAP basis) to cash operating earnings can befound on pages 30 and 31 of this filing.

 

Management believes that reporting several key measures based on cashoperating earnings and tangible equity (equity less intangible assets and theirrelated amortization expense) is important, as this is the basis for measuringthe adequacy of capital for regulatory purposes.  For the three months ended March 31, 2004, return on averagetangible assets was 1.76%, return on average tangible equity was 18.01% andaverage tangible equity to average tangible assets was 9.75%.  Comparable ratios for the three months endedMarch 31, 2003 were 1.92%, 16.99% and 11.31%, respectively.  A reconciliation of these ratios from theirrespective GAAP basis ratios can be found on pages 30 and 31 of this filing.

 

15

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**Segment Reporting**

 

As noted in Footnote No. 10 “Segment Reporting”, Bankshares hashistorically reported on three distinct business segments for which financialinformation is segregated for use in assessing performance and allocating resourceswhen reporting to the Board of Directors. Segment financial information issubjective and, unlike financial accounting, is not necessarily based on GAAP.As a result, the financial information of the reporting segments is notnecessarily comparable with similar information reported by others and may notbe comparable with Bankshares’ consolidated results.

 

BANKING

 

On a combined basis, Community Banks and MSD&T continue to be theprimary contributors to Bankshares’ earnings, accounting for 96% of Bankshares’net income. Historically, Bankshares has distinguished between two operatingunits, Community and MSD&T, with the former focused on small business andretail banking and the latter on commercial and specialty lending. With theF&M acquisition and the announced plan to consolidate 11 affiliate banksinto 4 banks (see Footnote No. 15 “Subsequent Event” for more information),this distinction is becoming less apparent. Increased house lending authorityat the Community Banks has resulted in additional loan growth within theirfootprint and less referral and overline business to MSD&T.

 

*Community Banking*

 

Net income for the quarter ended March 31, 2004, was $38.3 million.This represented a $7.0 million, or 22% increase over the same quarter lastyear. Community Banking was the primary beneficiary of the F&M acquisition.For the first quarter of 2004 compared to the same period last year, netinterest income increased by $19.5 million, or 26%, to $95.8 million. Growth inaverage earning assets of $2.5 billion, largely attributable to the F&Macquisition, more than offset the effect of a 55 bp reduction in the netinterest margin. Contributing to the net interest margin compression was thecapital restructuring of the Community Banks during the third quarter lastyear. $300 million of subordinated debt issued by Bankshares in April 2003 wasinvested in a like amount of subordinated debt issued by the Community Banks.Excess equity capital was paid to Bankshares in the form of a special cashdividend. The $3.1 million in interest expense incurred during the firstquarter of 2004 related to this subordinated debt reduced the Community Banks’net interest margin by 14 bp. The Community Banks had a modest provision forloan losses compared to the first quarter of 2003 as credit quality remainedstable. Net income for the fourth quarter of 2003 was $40.1 million. During thefourth quarter of last year the Community Banks reversed $5.0 million of theirallowance for loan losses, reflective of the improving economy and creditquality. The net interest margin decreased 1 bp for the current quartercompared to the 4.48% level of the fourth quarter of 2003.

 

The year-over-year increases in noninterest income and noninterestexpenses for the first quarter of 2004 compared to the same period of 2003, areattributable to the F&M acquisition and branch / market expansion programsat several Community Banks. Noninterest income increased year-over-year by $7.5million; with deposit service charges increasing $2.0 million, and insurancefees increasing $3.7 million, accounting for the largest gains. Noninterestexpenses increased by $17.4 million in the first quarter of 2004 compared tothe first quarter of 2003. Over 50% of this increase is related to salaries andbenefits, which grew by $8.9 million. Occupancy expense increased by $1.7million and furniture and equipment expenses increased by $0.7 million. At theclose of this quarter, the integration of F&M had been substantiallycompleted. Management expects to complete the sale of one branch to a thirdparty and the consolidation of the mortgage banking operations during thesecond quarter. Noninterest income increased $0.4 million while noninterestexpenses decreased $2.5 million from the fourth quarter of 2003.

 

*MSD&T*

 

The net income contribution from MSD&T declined by $1.5 millionfrom the first quarter of 2003 to $15.3 million for the current quarter,compared to the same period last year. Contributing to the decline were reducednet interest income, a higher provision for loan losses and increasednoninterest expenses. Partially offsetting these items was an increase innoninterest income. Net income for the fourth quarter of 2004 was $11.1million.

 

The decline in net interest income in the first quarter of 2004compared to the same period in 2003 was attributable to a 20 basis point (“bp”)decline in the net interest margin from 3.75% to 3.55%. This decline isconsistent with the overall decline experienced by Bankshares. Partiallyoffsetting the reduction in the net interest margin was 4% growth in averageearning assets. The provision for loan losses increased by more than 60% to$2.3 million. The increased provision is reflective of the level ofnonperforming loans at MSD&T. For additional information, see discussion ofnonperforming assets under “Nonperforming Assets” below. The net interestmargin increased 1 bp in the first quarter of 2004 compared to the 3.54% levelof the fourth quarter of 2003.

 

The increase in noninterest income was spread across numerous categories.Noninterest income increased $0.6 million in the first quarter of 2004 comparedto the first quarter of 2003, and increased $1.1 million over the fourthquarter of 2003. Noninterest expense increased by $3.1 million from the firstquarter of 2003 to $24.8 million. This represents a 14% increase over the prioryear. Increased personnel costs accounted for approximately $2.6 million of theincrease. Staffing levels increased from 844 full time equivalent to 908 fulltime equivalent year-over-year. Expansion of banking services, including onebranch acquired from F&M, added 32 to the

 

16

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staff levels, corporate support (primarily compliance, loan review,treasury and accounting support) increased staff levels by 28, and technologyand operations added 5 to the staff levels. Certain of these costs areallocated to IWM and Community Banking as reflected in the “adjustments” line.Noninterest expense decreased $0.9 million, or 3% from the fourth quarter of2003.

 

INVESTMENT & WEALTH MANAGEMENT

 

Net income increased nearly $1.0 million or 62% to $2.5 million for thequarter ended March 31, 2004 as compared to the $1.6 million reported in thesame period last year. IWM reported net income of $2.0 million for the quarterended December 31, 2003.

 

Revenues for the first quarter of 2004 increased $5.0 million, or 29%,over the prior year’s first quarter, with $2.2 million of the increase relatedto the BW and Peremel acquisitions. Total assets under administration increasedfrom $39.1 billion at March 31, 2003 to $46.8 billion at March 31, 2004 withassets under management increasing from $19.0 billion to $22.5 billion.  Revenues increased $1.3 million from $21.0million in the fourth quarter of 2003 due to rising equity markets andincreased new sales.

 

Noninterest expenses increased by $3.4 million or 25% to $17.4 millionfor the first quarter of 2004 from $14.0 million for the prior year firstquarter. The previously referenced acquisitions accounted for $2.1 million ofthe increase. Noninterest expenses increased $0.8 million or 5% from the fourthquarter of 2003. Full time equivalent staff levels have increased from 267 atMarch 31, 2003 to 301 at March 31, 2004. Expansion of the BW operations coupledwith the Peremel acquisition and the assumption of F&M’s brokerageoperation accounted for 25 of the full time equivalent increase. During thefirst quarter of 2004, Bankshares entered into a 7 year service contract withSunGard Wealth Management Services to provide a new core accounting system andassume management of IWM’s back-office operations. Post conversion, which isexpected late in 2004, Bankshares expects to achieve net savings in excess of$1.0 million in 2005. Management expects to incur conversion and exit costs inthe range of $1.5 million to $2.0 million in the second half of 2004.

 

17

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**CONSOLIDATED RESULTS**

**Net Interest Incomeand Net Interest Margin**

 

**Analysis of InterestRates and Interest Differentials**

The following table presents the distribution of the averageconsolidated balance sheet, interest income/expense and annualized yieldsearned and rates paid through the three months ended March 31, 2004 and 2003.

 
|                                              |   | **2004**             |           | **2003**              |        |
|---------------------------------------------------|--------|----------------------|----------------|-----------------------|-------------|
| **(Dollars in thousands)**                        |   | **Average  Balance** |           | **Income*/  Expense** |        | **Yield*/  Rate** |   | **Average  Balance** |   | **Income*/  Expense** |   | **Yield*/  Rate** |   |
| Earning assets                                    |   |                 |           |                  |        |   |   |   |   |   |   |   |   |
| Loans:**                                          |   |                 |           |                  |        |   |   |   |   |   |   |   |   |
| Commercial                                        |   | **$**                | **5,401,384**  | ** **            | **$**       | **74,280** | ** ** | **5.53** | **%** | $ | 4,449,636 |   | $ | 66,059 |   | 6.02 | % |
| Construction                                      |   | **1,103,901**        | ** **     | **14,209**            | ** **  | **5.18** | ** ** | 823,547 |   | 11,386 |   | 5.61 |   |
| Residential real estate                           |   | **1,358,975**        | ** **     | **20,488**            | ** **  | **6.06** | ** ** | 1,077,721 |   | 18,313 |   | 6.89 |   |
| Consumer                                          |   | **1,474,173**        | ** **     | **21,229**            | ** **  | **5.79** | ** ** | 1,008,741 |   | 16,449 |   | 6.61 |   |
| Total loans                                       |   | **9,338,433**        | ** **     | **130,206**           | ** **  | **5.61** | ** ** | 7,359,645 |   | 112,207 |   | 6.18 |   |
| Federal funds sold, et al                         |   | **47,791**           | ** **     | **175**               | ** **  | **1.47** | ** ** | 56,500 |   | 723 |   | 5.19 |   |
| Securities:***                                    |   |                 | ** **     |                  | ** **  |   | ** ** |   |   |   |   |   |   |
| Taxable securities                                |   |                 | ** **     |                  | ** **  |   | ** ** |   |   |   |   |   |   |
| U.S. Treasury securities                          |   | **798,980**          | ** **     | **7,786**             | ** **  | **3.92** | ** ** | 1,241,058 |   | 13,027 |   | 4.26 |   |
| U.S. Agency securities                            |   | **761,720**          | ** **     | **7,308**             | ** **  | **3.86** | ** ** | 686,987 |   | 8,168 |   | 4.82 |   |
| Mortgage-backed securities                        |   | **1,277,802**        | ** **     | **12,307**            | ** **  | **3.87** | ** ** | 511,513 |   | 5,989 |   | 4.75 |   |
| Other stocks & bonds                          |   | **146,592**          | ** **     | **3,607**             | ** **  | **9.90** | ** ** | 98,378 |   | 821 |   | 3.38 |   |
| Tax-exempt securities                             |   |                 | ** **     |                  | ** **  |   | ** ** |   |   |   |   |   |   |
| States & political subdivisions               |   | **104,375**          | ** **     | **1,451**             | ** **  | **5.59** | ** ** | 38,794 |   | 772 |   | 8.07 |   |
| Total securities                                  |   | **3,089,469**        | ** **     | **32,459**            | ** **  | **4.23** | ** ** | 2,576,730 |   | 28,777 |   | 4.53 |   |
| Interest-bearing deposits in other banks          |   | **158**              | ** **     | **—**            | ** **  | **1.09** | ** ** | 358 |   | 3 |   | 3.89 |   |
| Total earning assets                              |   | **12,475,851**       | ** **     | **162,840**           | ** **  | **5.25** | ** ** | 9,993,233 |   | 141,710 |   | 5.75 |   |
| Cash and due from banks                           |   | **285,524**          | ** **     |                  |        |   | ** ** | 225,975 |   |   |   |   |   |
| Bank premises and equipment, net                  |   | **141,632**          | ** **     |                  |        |   | ** ** | 103,706 |   |   |   |   |   |
| Other assets                                      |   | **871,583**          | ** **     |                  |        |   | ** ** | 341,538 |   |   |   |   |   |
| Less: allowance for loan losses                   |   | **(156,397**         | **)**          |                  |        |   | ** ** | (140,243 | ) |   |   |   |   |
| Total assets                                      |   | **$**                | **13,618,193** | ** **            |        |   |   | ** ** | $ | 10,524,209 |   |   |   |   |   |
| Interest-bearing liabilities                      |   |                 | ** **     |                  |        |   | ** ** |   |   |   |   |   |   |
| Deposits:                                         |   |                 | ** **     |                  | ** **  |   | ** ** |   |   |   |   |   |   |
| Savings                                           |   | **$**                | **1,364,181**  | ** **            | **984**     | ** ** | **0.29** | ** ** | $ | 1,029,033 |   | 1,370 |   | 0.54 |   |
| Checking plus interest accounts                   |   | **1,236,552**        | ** **     | **461**               | ** **  | **0.15** | ** ** | 953,243 |   | 558 |   | 0.24 |   |
| Money market                                      |   | **1,590,460**        | ** **     | **2,362**             | ** **  | **0.60** | ** ** | 1,185,071 |   | 2,637 |   | 0.90 |   |
| Time deposits $100,000 and over                   |   | **1,287,695**        | ** **     | **6,379**             | ** **  | **1.99** | ** ** | 1,223,688 |   | 7,968 |   | 2.64 |   |
| Other time deposits                               |   | **1,979,433**        | ** **     | **10,581**            | ** **  | **2.15** | ** ** | 1,716,941 |   | 12,596 |   | 2.98 |   |
| Total interest-bearing deposits                   |   | **7,458,321**        | ** **     | **20,767**            | ** **  | **1.12** | ** ** | 6,107,976 |   | 25,129 |   | 1.67 |   |
| Short-term borrowings                             |   | **919,388**          | ** **     | **1,419**             | ** **  | **0.62** | ** ** | 779,200 |   | 1,545 |   | 0.80 |   |
| Long-term debt                                    |   | **649,058**          | ** **     | **5,255**             | ** **  | **3.26** | ** ** | 275,838 |   | 2,362 |   | 3.47 |   |
| Total interest-bearing funds                      |   | **9,026,767**        | ** **     | **27,441**            | ** **  | **1.22** | ** ** | 7,163,014 |   | 29,036 |   | 1.64 |   |
| Noninterest-bearing deposits                      |   | **2,608,324**        | ** **     |                  | ** **  |   | ** ** | 1,961,362 |   |   |   |   |   |
| Other liabilities and accrued expenses            |   | **134,641**          | ** **     |                  | ** **  |   | ** ** | 104,493 |   |   |   |   |   |
| Total liabilities                                 |   | **11,769,732**       | ** **     |                  | ** **  |   | ** ** | 9,228,869 |   |   |   |   |   |
| Shareholders’ equity                         |   | **1,848,461**        | ** **     |                  | ** **  |   | ** ** | 1,295,340 |   |   |   |   |   |
| Total liabilities & shareholders’ equity |   | **$**                | **13,618,193** | ** **            |        | ** ** |   | ** ** | $ | 10,524,209 |   |   |   |   |   |
| Net interest rate spread                          |   |                 | ** **     | **$**                 | **135,399** | ** ** | **4.03** | **%** |   |   | $ | 112,674 |   | 4.11 | % |
| Effects of noninterest-bearing funds              |   |                 | ** **     |                  | ** **  | **0.34** | ** ** |   |   |   |   | 0.46 |   |
| Net interest margin on earning assets             |   |                 | ** **     |                  |        | **4.37** | **%** |   |   |   |   | 4.57 | % |
| Taxable-equivalent adjustment included in:        |   |                 | ** **     |                  | ** **  |   | ** ** |   |   |   |   |   |   |
| Loan income                                       |   |                 | ** **     | **$**                 | **1,146**   | ** ** |   | ** ** |   |   | $ | 1,215 |   |   |   |
| Investment securities income                      |   |                 | ** **     | **579**               | ** **  |   | ** ** |   |   | 333 |   |   |   |
| Total                                             |   |                 | ** **     | **$**                 | **1,725**   | ** ** |   | ** ** |   |   | $ | 1,548 |   |   |   |

 

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* Presented on a tax-equivalent basis using the statutory federalcorporate income tax rate of 35% (see reconciliation of non-GAAP measures onpages 30 and 31)

** Nonaccrual loans are included in average loans

*** Balances reported at amortized cost; excludes pretax unrealizedgains (losses) on securities available-for-sale

 

18

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**Rate / VolumeAnalysis**

A rate/volume analysis, which demonstrates changes in interest incomeand expense for significant assets and liabilities, appears below:

 
|                                       |   | **For the three months ended March 31,  2004 vs. 2003** |    |
|--------------------------------------------|--------|---------------------------------------------------------|---------|
|                                       |   | **Due to variances in**                                 |    |
| **(Dollars in thousands)**                 |   | **Rates**                                               |    | **Volumes (4)** |   | **Total** |   |
| Interest earned on:                        |   |                                                    |    |   |   |   |   |
| Loans:                                     |   |                                                    |    |   |   |   |   |
| Commercial (1)                             |   | $                                                       | (5,909  | ) | $ | 14,130 |   | $ | 8,221 |   |
| Construction (2)                           |   | (1,053                                                  | )       | 3,876 |   | 2,823 |   |
| Residential real estate                    |   | (2,604                                                  | )       | 4,779 |   | 2,175 |   |
| Consumer                                   |   | (2,810                                                  | )       | 7,590 |   | 4,780 |   |
| Total loans                                |   | (12,376                                                 | )       | 30,375 |   | 17,999 |   |
| Taxable securities (3)                     |   | (1,931                                                  | )       | 4,934 |   | 3,003 |   |
| Tax-exempt securities (3)                  |   | (626                                                    | )       | 1,305 |   | 679 |   |
| Federal funds sold, et al                  |   | (437                                                    | )       | (111 | ) | (548 | ) |
| Interest-bearing deposits in  other banks  |   | (1                                                      | )       | (2 | ) | (3 | ) |
| Total interest income                      |   | (15,371                                                 | )       | 36,501 |   | 21,130 |   |
|                                       |   |                                                    |    |   |   |   |   |
| Interest paid on:                          |   |                                                    |    |   |   |   |   |
| Savings deposits                           |   | (832                                                    | )       | 446 |   | (386 | ) |
| Checking plus interest deposits            |   | (263                                                    | )       | 166 |   | (97 | ) |
| Money market accounts                      |   | (1,177                                                  | )       | 902 |   | (275 | ) |
| Certificates of deposit  $100,000 and over |   | (2,006                                                  | )       | 417 |   | (1,589 | ) |
| Other time deposits                        |   | (3,941                                                  | )       | 1,926 |   | (2,015 | ) |
| Short-term borrowings                      |   | (404                                                    | )       | 278 |   | (126 | ) |
| Long-term debt                             |   | (302                                                    | )       | 3,196 |   | 2,894 |   |
| Total interest expense                     |   | (8,925                                                  | )       | 7,331 |   | (1,594 | ) |
| Net interest earned                        |   | $                                                       | (24,296 | ) | $ | 43,832 |   | $ | 19,536 |   |

 

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(1)          Interest quarter-to-date tax-equivalent adjustment of $909 thousand and$876 thousand for 2004 and 2003, respectively, are included in the commercialloan rate variances.

(2)          Interest quarter-to-date tax-equivalent adjustment of $237 thousand and$339 thousand for 2004 and 2003, respectively, are included in the constructionloan rate variances.

(3)          Interest quarter-to-date tax-equivalent adjustment of $579 thousand and$333 thousand for 2004 and 2003, respectively, are included in the investmentsecurities rate variances.

(4)          Changes attributable to mix (rate and volume) are included in volumevariance.

 

Net interest income for the quarter ended March 31, 2004 increased 20%to $133.7 million from the first quarter last year primarily as a result of theF&M acquisition.  Net interestincome is affected by both changes in the amount and composition ofinterest-earning assets and interest-bearing liabilities and by changes in thelevel of interest rates. The growth in net interest income was attributable tothe growth in average earning assets, particularly in the loan portfolio (27%)and the investment securities portfolio (20%). This growth is largely as aresult of the F&M acquisition. While the growth in the average loanportfolio shows signs of improvement, management expects loan growth to remainin the mid-single digit range for the next several quarters.

 

Growth in net interest income was partially offset by a 20 basis point(bp) decline in net interest margin from 4.57% for the first quarter of 2003 to4.37% for the current quarter. With slowingdeposit growth, management used excess liquidity, reflected in federal fundssold and maturities in the investment portfolio, to fund loan growth.  End of period loan growth from December 31,2003 to March 31, 2004 was $162.3 million or 2% (7% annualized). Loan growthslowed from the $257.1 million growth in the fourth quarter of 2003. Whileresidential real estate and construction lending each showed double digitannualized growth, annualized commercial and commercial real estate loan growthwas 6.6%, down from 13.3% in the fourth quarter of 2003 and consumer loansdecreased at an annualized 2.5% rate versus a 10.5% positive growth rate in thefourth quarter of 2003. Lower reinvestment yields on maturing investmentsecurities and prepayments of mortgage-related securities reduced yields in theinvestment portfolio. Based on current market conditions, which include arecent slowing of mortgage refinancing activity and a steepening of the yieldcurve, management expects the net interest margin to improve in 2004. Net interest income increased a modest $0.4million from the fourth quarter of 2003. An improvement of 9 bp in the net interest margin, from 4.28% for thefourth quarter of 2003 to 4.37% for the first quarter of 2004, was sufficient tooffset a $48.0 million decline in average earning assets over the same period.The linked quarter improvement in the margin was attributable to a shift inearning assets to loans from investment securities.  Average loans accounted for 74.9% of earning assets this quarteras compared to 72.9%, in the fourth quarter of 2003.

 

19

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Compared to the same quarter last year,average total deposits increased $2.0 billion to $10.1 billion.  Compared to the 2003 fourth quarter’saverage, total deposits declined by $102.1 million.  The slowing of deposit inflows was noted during the fourthquarter of 2003. This deposit flow pattern is more typical of what Bankshareshas historically experienced during the first quarter as compared to theconsistently strong inflows experienced in the first quarter over the pastseveral years.  Based on historicalexperience, management expects deposit inflows to improve in the second quarterof 2004.  At March 31, 2004, totaldeposits were $10.5 billion, representing a $281.0 million increase fromDecember 31, 2003.

 

# **NoninterestIncome**

 
|                                      |   | **For the 3 Months Ended  March 31,** |       | **% Change** |   |
|-------------------------------------------|--------|---------------------------------------|------------|--------------|--------|
| **(Dollars  in thousands)**               |   | **2004**                              |       | **2003**     |   | **2004 / 2003** |   |
| Investment and wealth  management         |   | **$**                                 | **21,983** |         | $      | 17,365 |   | 26.6 | % |
| Service charges on deposit  accounts      |   | **10,119**                            |       | 8,060        |   | 25.5 |   |
| Mortgage banking related fees:            |   |                                  |       |         |   |   |   |
| Commercial                                |   | **1,920**                             |       | 1,626        |   | 18.1 |   |
| Residential                               |   | **1,020**                             |       | 762          |   | 33.9 |   |
| Total mortgage banking related  fees      |   | **2,940**                             |       | 2,388        |   | 23.1 |   |
| Investment securities gains and  (losses) |   | **(55**                               | **)**      | 815          |   | (106.7 | ) |
| Other income:                             |   |                                  |       |         |   |   |   |
| Electronic banking fees                   |   | **4,400**                             |       | 3,453        |   | 27.4 |   |
| Charges and fees on loans                 |   | **2,458**                             |       | 2,449        |   | 0.4 |   |
| Insurance                                 |   | **3,828**                             |       | 158          |   | 2,322.8 |   |
| Bank-owned life insurance                 |   | **794**                               |       | 429          |   | 85.1 |   |
| All other income                          |   | **3,418**                             |       | 2,736        |   | 24.9 |   |
| Total other income                        |   | **14,898**                            |       | 9,225        |   | 61.5 |   |
| Total                                     |   | **$**                                 | **49,885** |         | $      | 37,853 |   | 31.8 | % |

 

Noninterest income for the quarter ended March 31, 2004 increased by$12.0 million, or 32%, to $49.9 million compared to $37.9 million for the sameperiod in 2003. Noninterest income increased 5% from the fourth quarter of2003. The table above shows the major components of noninterest income.  Investment and wealth management (“IWM”)revenue represents the largest source of noninterest income at 44%. Factorshaving a positive impact on IWM revenues were rising equity markets andincreased new sales across both mutual funds and separately managed accounts.The inclusion of Boyd Watterson Asset Management LLC and Peremel & Company,Inc., which were acquired in March and April of 2003, respectively, accountedfor $2.2 million of the increase in IWM revenues over this period.

 

 Service charges on depositaccounts increased in line with the growth in deposit balances. For the firstquarter of 2004 compared to the first quarter of 2003, the $2.1 million, or26%, growth in service charge income was largely attributable to the F&Macquisition. Services charges on deposit accounts declined $0.7 millioncompared to the fourth quarter of 2003 due to lower collected fees onoverdrafts and non-sufficient funds.

 

 Mortgage banking-related fees increased by $0.6 million or 23% inthe first quarter of 2004 compared to the first quarter of 2003 primarily dueto F&M.  Bankshares’ mortgagebanking revenue is comprised of loan activities of Mercantile MortgageCorporation’s commercial mortgage subsidiary, Columbia National Real EstateFinancing LLC, and its residential mortgage joint venture with Wells FargoVentures LLC. Although year-over-year shows a greater increase inresidential-related fees, trends from the fourth quarter of 2003 show a 19%decline in residential-related fees being more than offset by a 23.5% increasein commercial-related fees.

 

Last year, investmentsecurities gains and losses mostly represented sales of equity securities heldin the available-for-sale portfolios. The gain in the first quarter of 2003 was generated as part of arepositioning of the balance sheet for interest rate changes that adjustedportfolio yields and duration.

 

 The year-over-year increases in other incomeincludes several categories. Electronic banking fees, which consisting ofmerchant card processing fees, foreign ATM fees and check card fees, increased$0.9 million. Charges and fees on loans consist of letters of credit fees, latefees and other assessed loan fees. Insurance revenues are derived from feeincome related to the sale and servicing of insurance products. The increase of$3.7 million in insurance income is attributable almost entirely to F&M. Bank-owned life insurance (“BOLI”) income is mostlyderived from Bankshares investment of $50.0 million during the third quarter of 2002. All otherincome consists of revenues from various sources, such as safe deposit boxrent, travelers’ checks, money orders and bill collection fees. Included in allother income in the first quarter of 2004 is $0.5 million in gains from thedisposition of bank-owned buildings, which was excluded from cash operatingearnings. The linked-quarter increase of $2.8 million was attributable largelyto a $1.2 million

 

20

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increasein insurance fees, the $0.5 million gain in the disposition of bank-ownedbuildings and a $0.3 million increase in electronic banking fees.

 

# **NoninterestExpenses**

 
|                                    |   | **For the 3 Months Ended  March 31,** |       | **% Change** |   |
|-----------------------------------------|--------|---------------------------------------|------------|--------------|--------|
| **(Dollars  in thousands)**             |   | **2004**                              |       | **2003**     |   | **2004 / 2003** |   |
| Salaries                                |   | **$**                                 | **44,788** |         | $      | 34,415 |   | 30.1 | % |
| Employee benefits                       |   | **12,513**                            |       | 9,428        |   | 32.7 |   |
| Net occupancy expense of bank  premises |   | **6,060**                             |       | 4,096        |   | 47.9 |   |
| Furniture and equipment expense         |   | **7,364**                             |       | 6,799        |   | 8.3 |   |
| Communication and supplies              |   | **4,304**                             |       | 3,436        |   | 25.3 |   |
| Other expenses:                         |   |                                  |       |         |   |   |   |
| Professional services                   |   | **3,834**                             |       | 2,079        |   | 84.4 |   |
| Advertising and promotional  expense    |   | **1,703**                             |       | 1,465        |   | 16.2 |   |
| Electronic banking expense              |   | **1,929**                             |       | 1,583        |   | 21.8 |   |
| Amortization of intangible  assets      |   | **2,032**                             |       | 560          |   | 262.9 |   |
| Outsourcing expense                     |   | **1,459**                             |       | 949          |   | 53.7 |   |
| All other expenses                      |   | **7,400**                             |       | 4,971        |   | 48.9 |   |
| Total other expense                     |   | **18,357**                            |       | 11,607       |   | 58.2 |   |
| Total                                   |   | **$**                                 | **93,386** |         | $      | 69,781 |   | 33.8 | % |

 

Noninterest expense for the three months ended March 31, 2004 increasedby $23.6 million, or 34%, to $93.4 million compared to $69.8 million for thefirst quarter of 2003.  The table aboveshows the major components of noninterest expenses.  The principal reason for the year-over-year increase in eachnoninterest expense category was the inclusion of the Acquisition. In comparison to the fourth quarter 2003,noninterest expenses decreased $6.0 million from $99.4 million reported forthat quarter. This decline is primarily attributable to a decrease in F&Mmerger-related expenses from $4.7 million last quarter to $0.4 million in thecurrent quarter. Management expects to incur no additional significantmerger-related expenses associated with the F&M acquisition.

 

 As a result of the level ofexpenses, the operating efficiency ratio, a key measure of expense management,increased. The efficiency ratio is computed by dividing noninterest expenses bythe sum of net interest income on a tax-equivalent basis and noninterestincome. Bankshares’ efficiency ratio was 50.40% compared to 46.36% for thethree months ended March 31, 2004 and 2003, respectively. A large portion ofthe increase in the efficiency ratio for 2004 was due to the increased expensesassociated with the inclusion of the Acquisitions.  On a non-GAAP basis, the cash operating efficiency ratio excludesamortization expense for intangibles and nonoperating income and expenses, suchas securities gains and losses and othersignificant gains, losses or expenses (such as those associated withintegrating acquired entities’ operations into Bankshares).  Bankshares’ cash operating efficiency ratiowas 49.24%, compared to 46.25% for the three months ended March 31, 2004 and2003, respectively. For the reconciliation of GAAP to non-GAAP measures, seepages 30 and 31 in this filing.

 

 Employee-related expenses,which include salaries, benefits and incentive compensation, was the largestcomponent at 61% of noninterest expenses. F&M accounted for a substantial portion of the $13.5 millionincrease in employee related expenses for the first quarter of 2004 compared tothe same period in 2003. Salaries expense for the first quarter of 2004compared to the fourth quarter of 2003, declined $0.9 million. Savings from theF&M integration were partially offset by a $0.5 million increase in salescommissions and a $1.0 million increase in salaries expense at Mercantile —Safe Deposit and Trust Company (“MSD&T”), the lead bank, which was largelyattributable to compliance and new business initiatives. The increase inbenefits expense over the prior year and the fourth quarter of 2003 isattributed to increased medical insurancecost, which increased $1.8 million over the quarter ended March 31, 2003 and$1.2 million over the fourth quarter of 2003. The increase is reflective of the increased number of employees andadverse claims experience.  Payrolltaxes also increased $1.1 million over the same quarter last year and $1.5million over the fourth quarter of 2003. These expenses are normally higher in the first quarter than they are inthe remaining quarters of each year.

 

 Net occupancy expense, whichincludes depreciation, rents, maintenance and utilities, increased due to theadditional branch and corporate office locations related to theAcquisitions.  Additionally, generallyhigher rental payments and an increase in expenses associated with improvementsare reflected in the increase in net occupancy expense.

 

 Furniture and equipmentexpenses include premises depreciation, rental and maintenance expenseassociated with the upkeep and improvement of hardware and computer software.

 

21

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 Communications and suppliesincrease in relation to supplies needed for additional branch office locations,including brochures and operational supplies, as well as increased customerinformation mailings and disclosures related to the F&M acquisition.

 

 Other expenses consist ofprofessional services, marketing, electronic banking and several othercategories such as travel and membership, amortization, licensing and insuranceand sundry losses. The year-over-year increases are attributable to theAcquisitions but from the fourth quarter of 2003, other expenses declined of$4.9 million. This decline from the previous quarter is largely due to themerger efficiencies realized and a reduction in merger-related charges.Professional services were favorably affected by a decrease in directors’deferred compensation expense, which declined by $1.4 million from the priorquarter. Marketing expenses also decreased by $1.6 million on a linked-quarterbasis, with $0.8 million of these expenses being merger-related in the fourthquarter of 2003.

 

**Analysis of FinancialCondition**

 

At March 31, 2004 compared to December 31, 2003, total assets increased3% or $446.9 million.  Total loansincreased 2% or $162.3 million. Decreases in commercial and consumer loans,along with the planned run-off in lease receivables, were offset by increasesin commercial real estate, construction and residential real estate loans.Total investment securities decreased 1% or $30.3 million.

 

Total deposits at March 31, 2004, were $10.5 billion, an increase of 3%or $281.0 million over December 31, 2003. Interest-bearing deposits, which represent 74% of total deposits, were$7.8 billion, an increase of 4% or $262.6 million from the end of last year. A 2% decline in other deposits was more thanoffset by increases in all of the other deposit categories.

 

At March 31, 2004, total assets increased 28% or $3.1 billion comparedto one year earlier. Total loans increased 27% or $2.0 billion and totalinvestment securities increased 17% or $446.7 million. These substantial increases are due principally to the acquisition ofF&M, which accounted for approximately 70% of the growth in total assets.

 

At March 31, 2004, total deposits increased 24% or $2.0 billioncompared to one year earlier. A portion of the growth in deposits was due toF&M.  F&M added approximately80% to the total deposit growth.  Theadditional growth in deposits was in core deposits from customers in the localmarkets. The affiliate banking structure positions Bankshares to compete notonly with the large national and regional banking companies in the gathering ofthese funds, but also with local community banks. Management believesBankshares is positioned to retain these deposits in a rising interest ratescenario.  However, should there be anoutflow of deposits, a reversal of recent trends, the investment portfolioshould provide adequate liquidity.

 

Shareholders’ equity at March 31, 2004 was $1.9 billion, an increase of3% from December 31, 2003.  Bankshareshas authorization enabling it to repurchase up to 1.5 million additionalshares.  There were no share repurchasesduring the quarter. Historically, shares have been repurchased in open markettransactions as well as under accelerated programs. In April 2004, managementresumed the repurchase of shares by entering into a privately negotiatedagreement for the accelerated purchase of one million shares. Since the sharerepurchase program began in the mid-1990’s, Management has generally targeted40% of net income for cash dividends to shareholders and 30% of net income forpotential share repurchases.  At March31, 2004 and December 31, 2003, the cash dividend payout ratio was 47.14% and47.78% respectively. For more details, see the Statement of Changes inConsolidated Shareholders’ Equity.

 

RISK MANAGEMENT

# ** **

**Credit Risk Analysis**

 

Bankshares’ loans and commitments are substantially to borrowerslocated in our immediate region. Bankshares has set an internal limit for eachaffiliate bank, that is well below the regulatory limit, on the maximum amountof credit that may be extended to a single borrower. For more information oncredit risk see “Risk Management – Credit Risk Analysis” in the MercantileBankshares Corporation’s Annual Report on Form 10-K

 

**Nonperforming Assets**

 

Nonperforming assets consist of nonaccrual loans, renegotiated loansand other real estate owned (i.e., real estate acquired in foreclosure or inlieu of foreclosure).  With respect tononaccrual loans, Bankshares policy is that, regardless of the value of theunderlying collateral and/or guarantees, no interest is accrued on the entirebalance once either principal or interest payments on any loan become 90 dayspast due at the end of a calendar quarter. All accrued and uncollected interest on such loans is eliminated fromthe income statement and is recognized only as collected. If a loan is impairedand has a specific loss allocation based on an analysis under SFAS No. 114, “**Accounting by Creditors for Impairment of a Loan—anamendment of FASB Statements No. 5 and 15,**” all payments arethen applied against the loan’s principal. A loan may be put on nonaccrualstatus sooner than this standard if, in management’s judgment, such action iswarranted.

 

22

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During the three months ended March 31, 2004, nonperforming assetsdecreased $2.4 million to $48.1 million from $50.5 million at December 31,2003.  Nonaccrual loans were $48.0million at March 31, 2004 and other real estate owned, the other component ofnonperforming assets, was $0.1 million. Nonperforming assets as a percent of period-end loans and other realestate owned was .51% at March 31, 2004 and .55% at December 31, 2003,respectively.  The decrease innonperforming loans was due primarily to continued improvement in creditquality within Bankshares’ Community Banks.

 

At March 31, 2004 and December 31, 2003, monitored loans, or loans withcharacteristics suggesting that they could be classified as nonperforming inthe near future, were $26.6 million and $28.4 million, respectively. Two loansat MSD&T contributed $17.6 million to the current total. These loans aresecured by two commercial aircraft, which are leased to a regional commercialairline. In light of the prevailing conditions in the commercial airlineindustry, management has included these loans in the “monitored” status.

 

The amount of loans past due 30-89 days decreased from $43.6 million atDecember 31, 2003 to $42.9 million at March 31, 2004. In general, creditquality indicators remain stable at the Community Banks with greaterfluctuations occurring at MSD&T.

 

The table below presents a comparison of nonperforming assets at March31, 2004, December 31, 2003 and March 31, 2003.

 
| **(Dollars  in thousands)**                                                        |   | **March 31,  2004** |       | **December 31,  2003** |   | **March 31,  2003** |   |
|------------------------------------------------------------------------------------|--------|---------------------|------------|------------------------|--------|---------------------|--------|
| **Nonaccrual loans*(1)***                                                          |   |                |       |                   |   |                |   |
| Commercial                                                                         |   | **$**               | **41,837** | ** **             | $      | 43,932              |   | $ | 19,993 |   |
| Construction                                                                       |   | **159**             | ** ** | 651                    |   | 1,383               |   |
| Residential real estate                                                            |   | **3,961**           | ** ** | 3,721                  |   | 2,967               |   |
| Consumer                                                                           |   | **1,313**           | ** ** | 1,224                  |   | 234                 |   |
| Lease financing                                                                    |   | **737**             | ** ** | 824                    |   | 2,678               |   |
| Total                                                                              |   | **48,007**          | ** ** | 50,352                 |   | 27,255              |   |
| Renegotiated loans*(1)*                                                            |   | **—**          | ** ** | —                 |   | —              |   |
| Loans contractually past due 90  days or more and still accruing interest          |   | **—**          | ** ** | —                 |   | —              |   |
| Total nonperforming loans                                                          |   | **48,007**          | ** ** | 50,352                 |   | 27,255              |   |
| Other real estate owned                                                            |   | **134**             | ** ** | 191                    |   | 194                 |   |
| Total nonperforming assets                                                         |   | **$**               | **48,141** | ** **             | $      | 50,543              |   | $ | 27,449 |   |
| Nonperforming loans as a  percent of period-end loans                              |   | **0.51**            | **%**      | 0.54                   | %      | 0.37                | %      |
| Nonperforming assets as a  percent of period-end loans and other real estate owned |   | **0.51**            | **%**      | 0.55                   | %      | 0.37                | %      |

 

----

(1)          Aggregate gross interestincome of $811 thousand, $4.1 million and $548 thousand for the first quarter2004, the year 2003 and the first quarter 2003, respectively, on nonaccrual andrenegotiated loans, would have been recorded if these loans had been accruingon their original terms throughout the period or since origination if held forpart of the period.  The amount ofinterest income on the nonaccrual and renegotiated loans that was recordedtotaled $295 thousand, $2.1million and $55 thousand for the first quarter 2004,the year 2003 and the first quarter 2003, respectively

 

**Note:**Bankshareswas monitoring loans estimated to aggregate $26.6 million at March 31, 2004,$28.4 million at December 31, 2003 and $34.9 million at March 31, 2003, notclassified as nonaccrual or renegotiated loans.  These loans had characteristics that indicated they might resultin such classification in the future.

 

**Allowance andProvision for Loan Losses**

 

Each Bankshares affiliate is required to maintain an allowance for loanlosses adequate to absorb losses inherent in the loan portfolio. Eachaffiliate’s reserve is dedicated to that affiliate only and is not available toabsorb losses from another affiliate.  Management at each affiliate, along with Bankshares’ management,conducts a regular review to assure that adequacy.  On a periodic basis, significant credit exposures, nonperformingloans, impaired loans, historical losses by loan type and various statisticalmeasurements of asset quality are examined to assure the adequacy of theallowance for loan losses. Management believes that the allowance for loanlosses is at an adequate level to absorb losses inherent in the portfolio.

 

The allowance for loan losses has been established through provisionsfor loan losses charged against income. Loans deemed uncollectible are chargedagainst the allowance for loan losses and any subsequent recoveries arecredited to the allowance.  Intensivecollection efforts continue after charge-off in order to maximize recoveryamounts.  The provision for loan lossesfor the first quarter of 2004 was $2.4 million, a 20% decrease from the sameperiod last year and from the fourth quarter of 2003. The decline in the 

 

23

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provision reflects a continued improvement in the economy and stablecredit quality within Bankshares’ Community Banks. The Community Banks’ loanportfolios is more heavily weighted toward consumer and residential real estateloans. Potential losses in these portfolios are more predictable andquantifiable, generally resulting in a lower required allowance. Netcharge-offs were $1.1 million for the first quarter of 2004, $3.5 million forthe fourth quarter of 2003 and $1.2 million for the first quarter of 2003. Theallowance for loans as a percent of period-end loans decreased to 1.66% atMarch 31, 2004 from 1.68% at December 31, 2003 and 1.89% at March 31, 2003.

 

The following table presents a summary of the activity in the Allowancefor Loan Losses.

 
|                                                      |   | **For the 3 Months Ended March 31,** |          |
|-----------------------------------------------------------|--------|--------------------------------------|---------------|
| **(Dollars  in thousands)**                               |   | **2004**                             |          | **2003** |   |
| Allowance balance - beginning                             |   | **$**                                | **155,337**   |   | $ | 138,601 |   |
| Charge-offs:                                              |   |                                 |          |   |   |
| Commercial                                                |   | **(718**                             | **)**         | (447 | ) |
| Construction                                              |   | **—**                           | ** **    | — |   |
| Residential real estate                                   |   | **(101**                             | **)**         | — |   |
| Consumer                                                  |   | **(1,117**                           | **)**         | (851 | ) |
| Lease financing                                           |   | **—**                           | ** **    | (641 | ) |
| Total                                                     |   | **(1,936**                           | **)**         | (1,939 | ) |
| Recoveries:                                               |   |                                 | ** **    |   |   |
| Commercial                                                |   | **118**                              | ** **    | 222 |   |
| Construction                                              |   | **4**                                | ** **    | 135 |   |
| Residential real estate                                   |   | **52**                               | ** **    | 4 |   |
| Consumer                                                  |   | **634**                              | ** **    | 388 |   |
| Lease financing                                           |   | **—**                           | ** **    | — |   |
| Total                                                     |   | **808**                              | ** **    | 749 |   |
| Net charge-offs                                           |   | **(1,128**                           | **)**         | (1,190 | ) |
| Provision for loan losses                                 |   | **2,426**                            | ** **    | 3,016 |   |
| Allowance balance - ending                                |   | **$**                                | **156,635**   | ** ** | $ | 140,427 |   |
| Average loans                                             |   | **$**                                | **9,338,433** | ** ** | $ | 7,359,645 |   |
| Percent of net charge-offs  (annualized) to average loans |   | **0.05**                             | **%**         | 0.07 | % |
| Period-end loans                                          |   | **$**                                | **9,434,420** | ** ** | $ | 7,446,553 |   |
| Percent of allowance for loan  losses to period-end loans |   | **1.66**                             | **%**         | 1.89 | % |
|                                                           |        |                                      |               |  |  |  |  |  |

 

**Interest Rate Risk**

 

The objective of interest rate risk management is to contain the risksassociated with interest rate fluctuations. The process involves identificationand management of the sensitivity of net interest income to changing interestrates and other market factors. Interest rate risk, one of the more prominentrisks in terms of potential earnings impact, is an inevitable part of being afinancial intermediary. For more information see “Risk Management – InterestRate Risk” in the Mercantile Bankshares Corporation’s Annual Report on Form10-K

 

EARNINGS SIMULATION MODEL PROJECTIONS

 The following table summarizesthe effect a positive 100 and 200 bp change and a negative 50 bp change ininterest rates would have on Bankshares’ net interest income over the next 12months.

 
|                                         |   | **Calculated increase / (decrease) in  projected net interest income** | ** ** |
|----------------------------------------------|--------|------------------------------------------------------------------------|------------|
| **Change in interest rates  (basis points)** |   | **March 31,  2004**                                                    |       | **December 31,  2003** |   |
| +200                                         |   |                                                                   | **4.5**    | **%** | 4.6 | % |
| +100                                         |   |                                                                   | **2.3**    | **%** | 2.4 | % |
| -50                                          |   |                                                                   | **(2.2**   | **)%** | (2.1 | )% |

 

Bankshares’ interest sensitivity has remained substantially unchangedfrom December 31, 2003. Based on its most recent simulation model, Bankshares’net interest income would increase by $10.9 million and $21.6 million ifinterest rates were to move up 100 bp or 200 bp, respectively. A downwardmovement of 50 bp would reduce net interest income by $10.8 million.

 

24

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##### **Market Risk**

Market risk is defined as the constraint imposed by lower market valuesof assets and liabilities as interest rates and equity markets fluctuate.Changes in market values also impact the fee income earned by IWM, where asignificant portion of the fee schedule is tied to current asset values undermanagement or administration. Bankshares has designated substantially all ofits investment portfolio as available-for-sale and in accordance with financialreporting standards, this portfolio is reported at fair value. Changes in fairvalue, net of tax, are reflected as a component of shareholders’ equity.Bankshares’ maintenance of capital ratios well above regulatory requirements(see Footnote No. 9) provides management with the flexibility to utilize theavailable-for-sale portfolio for liquidity and interest rate risk managementneeds, even during a period when valuations are depressed. Maintaining a fairlyshort duration in the portfolio also mitigates market risk.

 

**Liquidity Risk**

Liquidity risk is the possibility that Bankshares will not be able tofund present and future financial obligations. The objective of liquiditymanagement is to maintain the ability to meet commitments to fund loans,purchase securities and repay deposits and other liabilities in accordance withtheir terms. Core deposits and the available-for-sale investment portfolio arekey elements in meeting this objective. For the three months ended March 31,2004, core deposits (total deposits less certificates of deposit of $100,000and over), averaged $8.8 billion compared to $8.9 billion for the fourthquarter of 2003 and $6.8 billion for the first quarter of 2003. Although not viewedas core deposits, a substantial portion of short-term borrowings comprised ofsecurities sold under agreements to repurchase and commercial paper, originatefrom core deposit relationships tied to the overnight cash management programoffered to customers.

 

By limiting the maturity of securities and maintaining a conservativeinvestment posture, management can rely on the investment portfolio to helpmeet any short-term funding needs. U.S. Treasury and agency securities, whichprovide the greatest liquidity, averaged $1.6 billion in the first quarter of2004, a 19% decrease from the average of $1.9 billion for the same period in2003. In addition to these sources, Bankshares has access to national marketsfor certificates of deposit, commercial paper and debt financing. Should itneed to further supplement its liquidity, Bankshares has $1.8 billion in lineswith the FHLB Atlanta and back-up commercial paper lines of $40 million withcommercial banks. Bankshares is required to obtain approval from holders ofBankshares’ 6.72% and 6.80% unsecured senior notes if it incrementally borrowsin excess of $150 million. For more information see “Risk Management —Liquidity Risk” in the Mercantile Bankshares Corporation’s Annual Report onForm 10-K.

 

In the normal course of business, Banksharesroutinely evaluates alternative sources of funding and liquidity.  With the current strong demand by realestate investors for stable commercial office properties, management is exploringthe merits of a potential sale/leaseback transaction of its headquartersfacility at Two Hopkins Plaza, Baltimore, MD. Such a transaction would enhance Bankshares’ liquidity through the cashgenerated on the sale and a reduced investment in bank premises.  This analysis is still in the preliminarystage and management cannot predict what level of interest outside partiesmight have, the financial value such a transaction will generate, or even if atransaction will be consummated.

 

**Cautionary Statement**

This report contains financial informationdetermined by methods other than in accordance with Generally AcceptedAccounting Principles (“GAAP”). Bankshares’ management uses these non-GAAPmeasures in their analysis of the Company’s performance. In, particular, netinterest income, net interest margin and the cash operating efficiency ratioare calculated on a fully tax-equivalent basis (“FTE”).  The FTE basis is determined by adjusting netinterest income to reflect tax-exempt interest income on a before-taxequivalent basis. These measures typically adjust GAAP performance measures toexclude intangible assets and the amortization of intangible assets related tothe consummation of mergers. These non-GAAP measures may also exclude othersignificant gains, losses or expenses that are unusual in nature. Since theseitems and their impact on Bankshares’ performance are difficult to predict,management believes presentations of financial measures excluding the impact ofthese items provide useful supplemental information that is essential to a properunderstanding of the operating results and financial position of Banksharescore businesses. These disclosures should not be viewed as a substitute forresults determined in accordance with GAAP, nor are they necessarily comparableto non-GAAP performance measures that may be presented by other companies.

 

This report contains forward-looking statements within the meaning ofand pursuant to the safe harbor provisions of the Private Securities LitigationReform Act of 1995.  A forward-lookingstatement encompasses any estimate, prediction, opinion or statement of beliefcontained in this report, and the underlying management assumptions.  Such statements in this report include:identification of trends,;loan growth; comments on adequacy of the allowancefor loan losses; credit quality; changes in leasing activities; effects ofasset sensitivity and interest rate changes; information concerning market riskreferenced in Item 3; expected pro forma assets, loans and deposits of thebanks resulting from the planned reorganization; and the anticipated effect ofthe proposed reorganization on operations, regulatory compliance and service tobanking customers.  Forward-lookingstatements are based on current expectations and assessments of potentialdevelopments affecting market conditions, interest rates and other economicconditions, and results may ultimately vary from the statements made in thisreport.  In addition, the followingfactors, among others, could cause actual results to differ materially from theanticipated results or expectations expressed in the forward-lookingstatements: Regulatory approvals for the transactions occurring in connectionwith the reorganization could be delayed or more burdensome to obtain thancurrently expected resulting in, among other things, an effective date laterthan July 2004; administrative and operational efficiencies may not improve tothe degree projected; and competitive pressures and regulatory complexitiesthat affect our banks may be stronger than expected.

 

25

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**SupplementalInformation by Quarter**

**Select Financial Data**

(in thousands, except per share data)

 
|                                                                                  |   | **1Q 04**      |          | **4Q 03**  |       | **3Q 03**  |       | **2Q 03**  |       | **1Q 03**  |   | **1Q 04  vs  4Q 03** |   | **1Q 04  vs  1Q 03** |      |
|---------------------------------------------------------------------------------------|--------|----------------|---------------|------------|------------|------------|------------|------------|------------|------------|--------|----------------------|--------|----------------------|-----------|
| **OPERATING RESULTS**                                                                 |   |           |          |       |       |       |       |       |       |       |   |                 |   |                 |      |
| Net interest income (1)                                                               |   | **$**          | **133,674**   |       | $          | 133,249    |       | $          | 122,232    |       | $      | 112,723              |   | $                    | 111,126   |   | 0.3 | % | 20.3 | % |
| Net interest income - taxable equivalent (1)                                          |   | **135,399**    |          | 135,130    |       | 123,989    |       | 114,297    |       | 112,674    |   | 0.2                  |   | 20.2                 |      |
| Provision for loan losses                                                             |   | **2,426**      |          | 3,033      |       | 3,005      |       | 3,051      |       | 3,016      |   | (20.0                | )      | (19.6                | )         |
| Net income                                                                            |   | **55,697**     |          | 50,645     |       | 47,173     |       | 50,010     |       | 48,986     |   | 10.0                 |   | 13.7                 |      |
|                                                                                  |   |           |          |       |       |       |       |       |       |       |   |                 |   |                 |      |
| **PER COMMON SHARE DATA**                                                             |   |           |          |       |       |       |       |       |       |       |   |                 |   |                 |      |
| Basic net income                                                                      |   | **$**          | **.70**       |       | $          | .64        |       | $          | .64        |       | $      | .73                  |   | $                    | .71       |   | 9.4 | % | (1.4 | )% |
| Diluted net income                                                                    |   | **.69**        |          | .63        |       | .63        |       | .72        |       | .71        |   | 9.5                  |   | (2.8                 | )         |
| Dividends paid                                                                        |   | **.33**        |          | .33        |       | .33        |       | .33        |       | .30        |   | —               |   | 10.0                 |      |
| Book value at period end                                                              |   | **23.61**      |          | 23.08      |       | 22.89      |       | 19.91      |       | 19.62      |   | 2.3                  |   | 20.3                 |      |
| Market value at period end                                                            |   | **42.93**      |          | 45.58      |       | 40.00      |       | 39.35      |       | 33.94      |   | (5.8                 | )      | 26.5                 |      |
| Market range:                                                                         |   |           |          |       |       |       |       |       |       |       |   |                 |   |                 |      |
| High                                                                                  |   | **46.01**      |          | 45.95      |       | 42.49      |       | 41.30      |       | 40.47      |   | 0.1                  |   | 13.7                 |      |
| Low                                                                                   |   | **41.50**      |          | 39.76      |       | 38.91      |       | 33.90      |       | 30.16      |   | 4.4                  |   | 37.6                 |      |
|                                                                                  |   |           |          |       |       |       |       |       |       |       |   |                 |   |                 |      |
| **AVERAGE  BALANCE  SHEET DATA**                                                 |   |           |          |       |       |       |       |       |       |       |   |                 |   |                 |      |
| Total loans                                                                           |   | **$**          | **9,338,433** |       | $          | 9,129,330  |       | $          | 8,331,265  |       | $      | 7,513,576            |   | $                    | 7,359,645 |   | 2.3 | % | 26.9 | % |
| Total earning assets                                                                  |   | **12,475,851** |          | 12,523,854 |       | 11,750,966 |       | 10,465,457 |       | 9,993,233  |   | (0.4                 | )      | 24.8                 |      |
| Total assets                                                                          |   | **13,618,193** |          | 13,666,099 |       | 12,622,100 |       | 11,033,724 |       | 10,524,209 |   | (0.4                 | )      | 29.4                 |      |
| Total deposits                                                                        |   | **10,066,645** |          | 10,168,699 |       | 9,388,714  |       | 8,313,714  |       | 8,069,338  |   | (1.0                 | )      | 24.8                 |      |
| Shareholders’ equity                                                             |   | **1,848,461**  |          | 1,811,742  |       | 1,550,937  |       | 1,324,293  |       | 1,295,340  |   | 2.0                  |   | 42.7                 |      |
|                                                                                  |   |           |          |       |       |       |       |       |       |       |   |                 |   |                 |      |
| **STATISTICS AND RATIOS   (Net income annualized)**                              |   |           |          |       |       |       |       |       |       |       |   |                 |   |                 |      |
| Return on average assets                                                              |   | **1.64**       | **%**         | 1.47       | %          | 1.48       | %          | 1.82       | %          | 1.89       | %      |                 |   |                 |      |
| Return on average equity (2)                                                          |   | **12.12**      |          | 11.09      |       | 12.07      |       | 15.15      |       | 15.34      |   |                 |   |                 |      |
| Return on average tangible equity (2)                                                 |   | **18.01**      |          | 16.49      |       | 15.70      |       | 17.05      |       | 16.99      |   |                 |   |                 |      |
| Average equity to average assets (2)                                                  |   | **13.57**      |          | 13.26      |       | 12.29      |       | 12.00      |       | 12.31      |   |                 |   |                 |      |
| Average tangible equity to average tangible  assets (2)                               |   | **9.75**       |          | 9.51       |       | 9.91       |       | 10.91      |       | 11.31      |   |                 |   |                 |      |
| Net interest rate spread - taxable equivalent                                         |   | **4.03**       |          | 3.93       |       | 3.81       |       | 3.94       |       | 4.11       |   |                 |   |                 |      |
| Net interest margin on earning assets-taxable  equivalent                             |   | **4.37**       |          | 4.28       |       | 4.19       |       | 4.38       |       | 4.57       |   |                 |   |                 |      |
| Efficiency ratio (1),(3)                                                              |   | **50.40**      |          | 54.47      |       | 53.67      |       | 48.24      |       | 46.36      |   |                 |   |                 |      |
| Operating efficiency ratio (1),(3)                                                    |   | **49.24**      |          | 50.92      |       | 51.14      |       | 49.24      |       | 46.25      |   |                 |   |                 |      |
| Dividend payout ratio                                                                 |   | **47.14**      |          | 51.56      |       | 51.56      |       | 45.21      |       | 42.25      |   |                 |   |                 |      |
| Bank offices                                                                          |   | **229**        |          | 227        |       | 236        |       | 187        |       | 185        |   | 2                    |   | 44                   |      |
| Employees                                                                             |   | **3,575**      |          | 3,565      |       | 3,642      |       | 3,035      |       | 2,939      |   | 10                   |   | 636                  |      |
|                                                                                  |   |           |          |       |       |       |       |       |       |       |   |                 |   |                 |      |
| **CREDIT QUALITY DATA AT PERIOD END**                                                 |   |           |          |       |       |       |       |       |       |       |   |                 |   |                 |      |
| Net charge-offs                                                                       |   | **$**          | **1,128**     |       | $          | 3,450      |       | $          | 2,717      |       | $      | 1,217                |   | $                    | 1,190     |   | (67.3 | )% | (5.2 | )% |
| Nonaccrual loans                                                                      |   | **48,007**     |          | 50,352     |       | 51,001     |       | 37,768     |       | 27,255     |   | (4.7                 | )      | 76.1                 |      |
| Restructured loans                                                                    |   | **—**     |          | —     | ** ** | **—** | ** ** | **—** | ** ** | **—** |   |                 |   |                 |      |
| Total nonperforming loans                                                             |   | **48,007**     |          | 50,352     |       | 51,001     |       | 37,768     |       | 27,255     |   | (4.7                 | )      | 76.1                 |      |
| Other real estate owned, net                                                          |   | **134**        |          | 191        |       | 397        |       | 376        |       | 194        |   | (29.8                | )      | (30.9                | )         |
| Total nonperforming assets                                                            |   | **48,141**     |          | 50,543     |       | 51,398     |       | 38,144     |       | 27,449     |   | (4.8                 | )      | 75.4                 |      |
|                                                                                  |   |           |          |       |       |       |       |       |       |       |   |                 |   |                 |      |
| **CREDIT QUALITY RATIOS**                                                             |   |           |          |       |       |       |       |       |       |       |   |                 |   |                 |      |
| Provision for loan losses (annualized) as a  percent of period-end loans              |   | **.10**        | **%**         | .13        | %          | .13        | %          | .16        | %          | .16        | %      |                 |   |                 |      |
| Net charge-offs (annualized) as a percent of  period-end loans                        |   | **.05**        |          | .15        |       | .12        |       | .06        |       | .06        |   |                 |   |                 |      |
| Nonperforming loans as a percent of period-end  loans                                 |   | **.51**        |          | .54        |       | .57        |       | .50        |       | .37        |   |                 |   |                 |      |
| Allowance for loan losses as a percent of  period-end loans                           |   | **1.66**       |          | 1.68       |       | 1.73       |       | 1.88       |       | 1.89       |   |                 |   |                 |      |
| Allowance for loan losses as a percent of  nonperforming loans                        |   | **326.28**     |          | 308.50     |       | 305.39     |       | 376.67     |       | 515.23     |   |                 |   |                 |      |
| Other real estate owned as a percent of  period-end loans and other real estate owned |   | **—**     |          | —     |       | —     |       | —     |       | —     |   |                 |   |                 |      |
| Nonperforming assets as a percent of period-end  loans and other real estate owned    |   | **.51**        |          | .55        |       | .57        |       | .50        |       | .37        |   |                 |   |                 |      |
| Nonperforming assets as a percent of total  assets                                    |   | **.34**        |          | .37        |       | .37        |       | .33        |       | .25        |   |                 |   |                 |      |

 

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(1),(2),(3) See Reconciliation of Non-GAAP measures on pages 30 and 31 foradditional information.

 

26

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**Statement ofConsolidated Income**

(in thousands, except per share data)

 
|                                                    |   | **1Q 04**   |        | **4Q 03** |   | **3Q 03** |   | **2Q 03** |    | **1Q 03** |   | **1Q 04  vs  4Q 03** |   | **1Q 04  vs  1Q 03** |    |
|---------------------------------------------------------|--------|-------------|-------------|-----------|--------|-----------|--------|-----------|---------|-----------|--------|----------------------|--------|----------------------|---------|
| **INTEREST INCOME**                                     |   |        |        |      |   |      |   |      |    |      |   |                 |   |                 |    |
| Interest and fees on loans                              |   | **$**       | **129,060** |      | $      | 129,288   |   | $         | 120,137 |      | $      | 111,962              |   | $                    | 110,992 |   | (0.2 | )% | 16.3 | % |
| Interest and dividends on investment  securities:       |   |        |        |      |   |      |   |      |    |      |   |                 |   |                 |    |
| Taxable interest income                                 |   | **27,401**  |        | 28,660    |   | 27,285    |   | 26,638    |    | 27,184    |   | (4.4                 | )      | 0.8                  |    |
| Tax-exempt interest income                              |   | **877**     |        | 999       |   | 783       |   | 497       |    | 467       |   | (12.2                | )      | 87.8                 |    |
| Dividends                                               |   | **261**     |        | 114       |   | 212       |   | 199       |    | 229       |   | 128.9                |   | 14.0                 |    |
| Other investment income                                 |   | **3,341**   |        | 2,578     |   | 1,508     |   | 2,318     |    | 564       |   | 29.6                 |   | 492.4                |    |
|                                                    |   | **31,880**  |        | 32,351    |   | 29,788    |   | 29,652    |    | 28,444    |   | (1.5                 | )      | 12.1                 |    |
| Other interest income                                   |   | **175**     |        | 630       |   | 1,291     |   | 1,314     |    | 726       |   | (72.2                | )      | (75.9                | )       |
| Total interest income                                   |   | **161,115** |        | 162,269   |   | 151,216   |   | 142,928   |    | 140,162   |   | (0.7                 | )      | 14.9                 |    |
|                                                    |   |        |        |      |   |      |   |      |    |      |   |                 |   |                 |    |
| **INTEREST EXPENSE**                                    |   |        |        |      |   |      |   |      |    |      |   |                 |   |                 |    |
| Interest on deposits                                    |   | **20,767**  |        | 22,298    |   | 22,313    |   | 23,450    |    | 25,129    |   | (6.9                 | )      | (17.4                | )       |
| Interest on short-term borrowings                       |   | **1,419**   |        | 1,287     |   | 1,303     |   | 1,469     |    | 1,545     |   | 10.3                 |   | (8.2                 | )       |
| Interest on long-term debt                              |   | **5,255**   |        | 5,435     |   | 5,368     |   | 5,286     |    | 2,362     |   | (3.3                 | )      | 122.5                |    |
|                                                    |   |        |        |      |   |      |   |      |    |      |   |                 |   |                 |    |
| Total interest expense                                  |   | **27,441**  |        | 29,020    |   | 28,984    |   | 30,205    |    | 29,036    |   | (5.4                 | )      | (5.5                 | )       |
|                                                    |   |        |        |      |   |      |   |      |    |      |   |                 |   |                 |    |
| **NET INTEREST INCOME**                                 |   | **133,674** |        | 133,249   |   | 122,232   |   | 112,723   |    | 111,126   |   | 0.3                  |   | 20.3                 |    |
| Provision for loan losses                               |   | **2,426**   |        | 3,033     |   | 3,005     |   | 3,051     |    | 3,016     |   | (20.0                | )      | (19.6                | )       |
|                                                    |   |        |        |      |   |      |   |      |    |      |   |                 |   |                 |    |
| **NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES** |   | **131,248** |        | 130,216   |   | 119,227   |   | 109,672   |    | 108,110   |   | 0.8                  |   | 21.4                 |    |
|                                                    |   |        |        |      |   |      |   |      |    |      |   |                 |   |                 |    |
| **NONINTEREST INCOME**                                  |   |        |        |      |   |      |   |      |    |      |   |                 |   |                 |    |
| Investment and wealth management                        |   | **21,983**  |        | 21,483    |   | 20,577    |   | 19,508    |    | 17,365    |   | 2.3                  |   | 26.6                 |    |
| Service charges on deposit accounts                     |   | **10,119**  |        | 10,840    |   | 9,701     |   | 8,311     |    | 8,060     |   | (6.7                 | )      | 25.5                 |    |
| Mortgage banking related fees                           |   | **2,940**   |        | 2,813     |   | 3,403     |   | 2,507     |    | 2,388     |   | 4.5                  |   | 23.1                 |    |
| Investment securities gains and (losses)                |   | **(55**     | **)**       | 122       |   | (336      | )      | 6,536     |    | 815       |   | (145.1               | )      | (106.7               | )       |
| Other income                                            |   | **14,898**  |        | 12,140    |   | 12,558    |   | 8,575     |    | 9,225     |   | 22.7                 |   | 61.5                 |    |
| Total noninterest income                                |   | **49,885**  |        | 47,398    |   | 45,903    |   | 45,437    |    | 37,853    |   | 5.2                  |   | 31.8                 |    |
|                                                    |   |        |        |      |   |      |   |      |    |      |   |                 |   |                 |    |
| **NONINTEREST EXPENSES**                                |   |        |        |      |   |      |   |      |    |      |   |                 |   |                 |    |
| Salaries                                                |   | **44,788**  |        | 45,724    |   | 43,870    |   | 36,317    |    | 34,415    |   | (2.0                 | )      | 30.1                 |    |
| Employee benefits                                       |   | **12,513**  |        | 8,826     |   | 10,144    |   | 9,319     |    | 9,428     |   | 41.8                 |   | 32.7                 |    |
| Net occupancy expense of bank premises                  |   | **6,060**   |        | 7,305     |   | 5,136     |   | 4,219     |    | 4,096     |   | (17.0                | )      | 47.9                 |    |
| Furniture and equipment expenses                        |   | **7,364**   |        | 9,636     |   | 8,432     |   | 6,743     |    | 6,799     |   | (23.6                | )      | 8.3                  |    |
| Communications and supplies                             |   | **4,304**   |        | 4,682     |   | 3,889     |   | 3,181     |    | 3,436     |   | (8.1                 | )      | 25.3                 |    |
| Other expenses                                          |   | **18,357**  |        | 23,255    |   | 19,718    |   | 17,270    |    | 11,607    |   | (21.1                | )      | 58.2                 |    |
| Total noninterest expenses                              |   | **93,386**  |        | 99,428    |   | 91,189    |   | 77,049    |    | 69,781    |   | (6.1                 | )      | 33.8                 |    |
|                                                    |   |        |        |      |   |      |   |      |    |      |   |                 |   |                 |    |
| Income before income taxes                              |   | **87,747**  |        | 78,186    |   | 73,941    |   | 78,060    |    | 76,182    |   | 12.2                 |   | 15.2                 |    |
| Applicable income taxes                                 |   | **32,050**  |        | 27,541    |   | 26,768    |   | 28,050    |    | 27,196    |   | 16.4                 |   | 17.8                 |    |
|                                                    |   |        |        |      |   |      |   |      |    |      |   |                 |   |                 |    |
| **NET INCOME**                                          |   | **$**       | **55,697**  |      | $      | 50,645    |   | $         | 47,173  |      | $      | 50,010               |   | $                    | 48,986  |   | 10.0 |   | 13.7 |   |
|                                                    |   |        |        |      |   |      |   |      |    |      |   |                 |   |                 |    |
| Weighted average shares outstanding                     |   | **79,725**  |        | 79,554    |   | 74,253    |   | 68,860    |    | 68,769    |   | 0.2                  |   | 15.9                 |    |
| Adjusted weighted average shares outstanding            |   | **80,258**  |        | 80,196    |   | 74,840    |   | 69,318    |    | 69,190    |   | 0.1                  |   | 16.0                 |    |
|                                                    |   |        |        |      |   |      |   |      |    |      |   |                 |   |                 |    |
| **NET INCOME PER COMMON SHARE:**                        |   |        |        |      |   |      |   |      |    |      |   |                 |   |                 |    |
| Basic                                                   |   | **$**       | **.70**     |      | $      | .64       |   | $         | .64     |      | $      | .73                  |   | $                    | .71     |   | 9.4 |   | (1.4 | ) |
| Diluted                                                 |   | **$**       | **.69**     |      | $      | .63       |   | $         | .63     |      | $      | .72                  |   | $                    | .71     |   | 9.5 |   | (2.8 | ) |
|                                                         |        |             |             |           |        |           |        |           |         |           |        |                      |        |                      |         |  |  |  |  |  |  |

 

27

----

 

**Statementof Consolidated Noninterest Income and Noninterest Expenses**

(in thousands)

 
| **Noninterest Income**                    |   | **1Q 04**  |       | **4Q 03** |   | **3Q 03** |   | **2Q 03** |   | **1Q 03** |   | **1Q 04  vs  4Q 03** |   | **1Q 04  vs  1Q 03** |   |
|-------------------------------------------|--------|------------|------------|-----------|--------|-----------|--------|-----------|--------|-----------|--------|----------------------|--------|----------------------|--------|
| Investment and wealth  management         |   | **$**      | **21,983** |      | $      | 21,483    |   | $         | 20,577 |      | $      | 19,508               |   | $                    | 17,365 |   | 2.3 | % | 26.6 | % |
| Service charges on deposit  accounts      |   | **10,119** |       | 10,840    |   | 9,701     |   | 8,311     |   | 8,060     |   | (6.7                 | )      | 25.5                 |   |
| Mortgage banking related fees:            |   |       |       |      |   |      |   |      |   |      |   |                 |   |                 |   |
| Commercial                                |   | **1,920**  |       | 1,555     |   | 1,773     |   | 1,693     |   | 1,626     |   | 23.5                 |   | 18.1                 |   |
| Residential                               |   | **1,020**  |       | 1,258     |   | 1,630     |   | 814       |   | 762       |   | (18.9                | )      | 33.9                 |   |
| Total mortgage banking related  fees      |   | **2,940**  |       | 2,813     |   | 3,403     |   | 2,507     |   | 2,388     |   | 4.5                  |   | 23.1                 |   |
| Investment securities gains and  (losses) |   | **(55**    | **)**      | 122       |   | (336      | )      | 6,536     |   | 815       |   | (145.1               | )      | (106.7               | )      |
| Other income:                             |   |       |       |      |   |      |   |      |   |      |   |                 |   |                 |   |
| Electronic banking fees                   |   | **4,400**  |       | 4,083     |   | 5,133     |   | 4,145     |   | 3,453     |   | 7.8                  |   | 27.4                 |   |
| Charges and fees on loans                 |   | **2,458**  |       | 2,602     |   | 2,430     |   | 2,069     |   | 2,449     |   | (5.5                 | )      | 0.4                  |   |
| Insurance                                 |   | **3,828**  |       | 2,670     |   | 1,653     |   | 175       |   | 158       |   | 43.4                 |   | 2,322.8              |   |
| Bank owned life insurance                 |   | **794**    |       | 576       |   | 559       |   | 439       |   | 429       |   | 37.8                 |   | 85.1                 |   |
| All other income                          |   | **3,418**  |       | 2,209     |   | 2,783     |   | 1,747     |   | 2,736     |   | 54.7                 |   | 24.9                 |   |
| Total other income                        |   | **14,898** |       | 12,140    |   | 12,558    |   | 8,575     |   | 9,225     |   | 22.7                 |   | 61.5                 |   |
| Total                                     |   | **$**      | **49,885** |      | $      | 47,398    |   | $         | 45,903 |      | $      | 45,437               |   | $                    | 37,853 |   | 5.2 | % | 31.8 | % |
|                                           |        |            |            |           |        |           |        |           |        |           |        |                      |        |                      |        |  |  |  |  |  |  |

 
| **Noninterest Expenses**                |   | **1Q 04**  |       | **4Q 03** |   | **3Q 03** |   | **2Q 03** |   | **1Q 03** |   | **1Q 04  vs  4Q 03** |   | **1Q 04  vs  1Q 03** |   |
|-----------------------------------------|--------|------------|------------|-----------|--------|-----------|--------|-----------|--------|-----------|--------|----------------------|--------|----------------------|--------|
| Salaries                                |   | **$**      | **44,788** |      | $      | 45,724    |   | $         | 43,870 |      | $      | 36,317               |   | $                    | 34,415 |   | (2.0 | )% | 30.1 | % |
| Employee benefits                       |   | **12,513** |       | 8,826     |   | 10,144    |   | 9,319     |   | 9,428     |   | 41.8                 |   | 32.7                 |   |
| Net occupancy expense of bank  premises |   | **6,060**  |       | 7,305     |   | 5,136     |   | 4,219     |   | 4,096     |   | (17.0                | )      | 47.9                 |   |
| Furniture and equipment expenses        |   | **7,364**  |       | 9,636     |   | 8,432     |   | 6,743     |   | 6,799     |   | (23.6                | )      | 8.3                  |   |
| Communications and supplies             |   | **4,304**  |       | 4,682     |   | 3,889     |   | 3,181     |   | 3,436     |   | (8.1                 | )      | 25.3                 |   |
| Other expenses:                         |   |       |       |      |   |      |   |      |   |      |   |                 |   |                 |   |
| Professional services                   |   | **3,834**  |       | 7,080     |   | 5,380     |   | 4,962     |   | 2,079     |   | (45.8                | )      | 84.4                 |   |
| Advertising and promotional  expenses   |   | **1,703**  |       | 3,275     |   | 2,168     |   | 2,247     |   | 1,465     |   | (48.0                | )      | 16.2                 |   |
| Electronic banking expenses             |   | **1,929**  |       | 1,791     |   | 2,432     |   | 1,851     |   | 1,583     |   | 7.7                  |   | 21.8                 |   |
| Amortization of intangible  assets      |   | **2,032**  |       | 1,847     |   | 1,688     |   | 848       |   | 560       |   | 10.0                 |   | 262.9                |   |
| Outsourcing expenses                    |   | **1,459**  |       | 1,136     |   | 1,049     |   | 1,010     |   | 949       |   | 28.4                 |   | 53.7                 |   |
| All other expenses                      |   | **7,400**  |       | 8,126     |   | 7,001     |   | 6,352     |   | 4,971     |   | (8.9                 | )      | 48.9                 |   |
| Total other expenses                    |   | **18,357** |       | 23,255    |   | 19,718    |   | 17,270    |   | 11,607    |   | (21.1                | )      | 58.2                 |   |
| Total                                   |   | **$**      | **93,386** |      | $      | 99,428    |   | $         | 91,189 |      | $      | 77,049               |   | $                    | 69,781 |   | (6.1 | )% | 33.8 | % |

 

28

----

 

**Consolidated Average Balance Sheets**

(in thousands)

 
|                                              |   |               |           |            |       |               |       |            |       |               |       | **Average Balance**  |       |
|---------------------------------------------------|--------|--------------------|----------------|-----------------|------------|--------------------|------------|-----------------|------------|--------------------|------------|----------------------|------------|
|                                              |   |               |           |            |       |               |       |            |       |               |       | **1Q 04  vs  4Q 03** |       | **1Q 04  vs  1Q 03** |   |
|                                              |   | **1Q04**           |           | **4Q03**        |       | **3Q03**           |       | **2Q03**        |       | **1Q03**           |       |                 |       |   |   |
|                                              |   | **AverageBalance** | ** **     | **Yield*/Rate** | ** ** | **AverageBalance** | ** ** | **Yield*/Rate** | ** ** | **AverageBalance** | ** ** | **Yield*/Rate**      | ** ** | **AverageBalance** | ** ** | **Yield*/Rate** | ** ** | **AverageBalance** | ** ** | **Yield*/Rate** | ** ** |   | ** ** |   | ** ** |
| Earning assets                                    |   |               |           |            |       |               |       |            |       |               |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans: **                                         |   |               |           |            |       |               |       |            |       |               |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial                                        |   | **$**              | **5,401,384**  | ** **      | **5.53**   | **%**              | $          | 5,293,174       |       | 5.57               | %          | $                    | 4,900,613  |   | 5.64 | % | $ | 4,527,486 |   | 5.92 | % | $ | 4,449,636 |   | 6.02 | % | 2.0 | % | 21.4 | % |
| Construction                                      |   | **1,103,901**      | ** **     | **5.18**        | ** ** | 1,053,049          |       | 5.25            |       | 969,251            |       | 5.34                 |       | 870,955 |   | 5.51 |   | 823,547 |   | 5.61 |   | 4.8 |   | 34.0 |   |
| Residential real estate                           |   | **1,358,975**      | ** **     | **6.06**        | ** ** | 1,309,345          |       | 6.13            |       | 1,205,020          |       | 6.28                 |       | 1,089,772 |   | 6.63 |   | 1,077,721 |   | 6.89 |   | 3.8 |   | 26.1 |   |
| Consumer                                          |   | **1,474,173**      | ** **     | **5.79**        | ** ** | 1,473,762          |       | 5.94            |       | 1,256,381          |       | 6.18                 |       | 1,025,363 |   | 6.42 |   | 1,008,741 |   | 6.61 |   | — |   | 46.1 |   |
| Total loans                                       |   | **9,338,433**      | ** **     | **5.61**        | ** ** | 9,129,330          |       | 5.67            |       | 8,331,265          |       | 5.78                 |       | 7,513,576 |   | 6.04 |   | 7,359,645 |   | 6.18 |   | 2.3 |   | 26.9 |   |
| Federal funds sold, et al                         |   | **47,791**         | ** **     | **1.47**        | ** ** | 215,329            |       | 1.15            |       | 413,675            |       | 1.19                 |       | 313,844 |   | 1.68 |   | 56,500 |   | 5.19 |   | (77.8 | ) | (15.4 | ) |
| Securities: ***                                   |   |               | ** **     |            | ** ** |               |       |            |       |               |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Taxable securities                                |   |               | ** **     |            | ** ** |               |       |            |       |               |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury and gov. agencies                   |   | **1,560,700**      | ** **     | **3.89**        | ** ** | 1,629,554          |       | 4.01            |       | 1,629,544          |       | 4.19                 |       | 1,741,380 |   | 4.32 |   | 1,928,045 |   | 4.46 |   | (4.2 | ) | (19.1 | ) |
| Mortgage-backed                                   |   | **1,277,802**      | ** **     | **3.87**        | ** ** | 1,275,875          |       | 3.79            |       | 1,150,073          |       | 3.48                 |       | 760,630 |   | 4.15 |   | 511,513 |   | 4.75 |   | 0.2 |   | 149.8 |   |
| Other stocks and bonds                            |   | **146,592**        | ** **     | **9.90**        | ** ** | 142,405            |       | 7.51            |       | 120,093            |       | 5.70                 |       | 98,277 |   | 10.38 |   | 98,378 |   | 3.38 |   | 2.9 |   | 49.0 |   |
| Tax-exempt securities                             |   |               | ** **     |            | ** ** |               |       |            |       |               |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| States and political subdivisions                 |   | **104,375**        | ** **     | **5.59**        | ** ** | 117,374            |       | 5.59            |       | 84,944             |       | 6.05                 |       | 37,412 |   | 8.82 |   | 38,794 |   | 8.07 |   | (11.1 | ) | 169.0 |   |
| Total securities                                  |   | **3,089,469**      | ** **     | **4.23**        | ** ** | 3,165,208          |       | 4.14            |       | 2,984,654          |       | 4.03                 |       | 2,637,699 |   | 4.56 |   | 2,576,730 |   | 4.53 |   | (2.4 | ) | 19.9 |   |
| Interest-bearing deposits in other banks          |   | **158**            | ** **     | **1.09**        | ** ** | 13,987             |       | .23             |       | 21,372             |       | .85                  |       | 338 |   | 3.50 |   | 358 |   | 3.89 |   | (98.9 | ) | (55.9 | ) |
| Total earning assets                              |   | **12,475,851**     | ** **     | **5.25**        | ** ** | 12,523,854         |       | 5.20            |       | 11,750,966         |       | 5.16                 |       | 10,465,457 |   | 5.54 |   | 9,993,233 |   | 5.75 |   | (0.4 | ) | 24.8 |   |
|                                              |   |               | ** **     |            | ** ** |               |       |            |       |               |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks                           |   | **285,524**        | ** **     |            |       | 298,581            |       |            |       | 295,289            |       |                 |       | 243,728 |   |   |   | 225,975 |   |   |   | (4.4 | ) | 26.4 |   |
| Bank premises and equipment, net                  |   | **141,632**        | ** **     |            |       | 139,022            |       |            |       | 124,275            |       |                 |       | 104,825 |   |   |   | 103,706 |   |   |   | 1.9 |   | 36.6 |   |
| Other assets                                      |   | **871,583**        | ** **     |            |       | 861,348            |       |            |       | 602,614            |       |                 |       | 361,951 |   |   |   | 341,538 |   |   |   | 1.2 |   | 155.2 |   |
| Less: allowance for loan losses                   |   | **(156,397**       | **)**          |            |       | (156,706           | )          |            |       | (151,044           | )          |                 |       | (142,237 | ) |   |   | (140,243 | )  |   |   | (0.2 | ) | 11.5 |   |
| Total assets                                      |   | **$**              | **13,618,193** | ** **      |       |               | $          | 13,666,099      |       |               |       | $                    | 12,622,100 |   |   |   | $ | 11,033,724 |   |   |   | $ | 10,524,209 |   |   |   | (0.4 | ) | 29.4 |   |
|                                              |   |               | ** **     |            | ** ** |               |       |            |       |               |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities                      |   |               | ** **     |            | ** ** |               |       |            |       |               |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                         |   |               | ** **     |            | ** ** |               |       |            |       |               |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings                                           |   | **$**              | **1,364,181**  | ** **      | **.29**    | ** **         | $          | 1,341,697       |       | .30                |       | $                    | 1,218,813  |   | .30 |   | $ | 1,078,760 |   | .51 |   | $ | 1,029,033 |   | .54 |   | 1.7 |   | 32.6 |   |
| Checking plus interest accounts                   |   | **1,236,552**      | ** **     | **.15**         | ** ** | 1,217,573          |       | .16             |       | 1,119,989          |       | .16                  |       | 993,268 |   | .22 |   | 953,243 |   | .24 |   | 1.6 |   | 29.7 |   |
| Money market                                      |   | **1,590,460**      | ** **     | **.60**         | ** ** | 1,606,119          |       | .62             |       | 1,431,262          |       | .61                  |       | 1,201,044 |   | .81 |   | 1,185,071 |   | .90 |   | (1.0 | ) | 34.2 |   |
| Time deposits $100,000 and over                   |   | **1,287,695**      | ** **     | **1.99**        | ** ** | 1,316,951          |       | 2.08            |       | 1,270,016          |       | 2.20                 |       | 1,277,652 |   | 2.37 |   | 1,223,688 |   | 2.64 |   | (2.2 | ) | 5.2 |   |
| Other time deposits                               |   | **1,979,433**      | ** **     | **2.15**        | ** ** | 2,038,739          |       | 2.21            |       | 1,942,113          |       | 2.39                 |       | 1,708,177 |   | 2.72 |   | 1,716,941 |   | 2.98 |   | (2.9 | ) | 15.3 |   |
| Total interest-bearing deposits                   |   | **7,458,321**      | ** **     | **1.12**        | ** ** | 7,521,079          |       | 1.18            |       | 6,982,193          |       | 1.27                 |       | 6,258,901 |   | 1.50 |   | 6,107,976 |   | 1.67 |   | (0.8 | ) | 22.1 |   |
| Short-term borrowings                             |   | **919,388**        | ** **     | **.62**         | ** ** | 907,914            |       | .56             |       | 944,979            |       | .55                  |       | 771,892 |   | .76 |   | 779,200 |   | .80 |   | 1.3 |   | 18.0 |   |
| Long-term debt                                    |   | **649,058**        | ** **     | **3.26**        | ** ** | 649,516            |       | 3.32            |       | 611,801            |       | 3.48                 |       | 527,223 |   | 4.02 |   | 275,838 |   | 3.47 |   | (0.1 | ) | 135.3 |   |
| Total interest-bearing funds                      |   | **9,026,767**      | ** **     | **1.22**        | ** ** | 9,078,509          |       | 1.27            |       | 8,538,973          |       | 1.35                 |       | 7,558,016 |   | 1.60 |   | 7,163,014 |   | 1.64 |   | (0.6 | ) | 26.0 |   |
|                                              |   |               | ** **     |            | ** ** |               |       |            |       |               |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing deposits                      |   | **2,608,324**      | ** **     |            | ** ** | 2,647,620          |       |            |       | 2,406,521          |       |                 |       | 2,054,813 |   |   |   | 1,961,362 |   |   |   | (1.5 | ) | 33.0 |   |
| Other liabilities and accrued expenses            |   | **134,641**        | ** **     |            | ** ** | 128,228            |       |            |       | 125,669            |       |                 |       | 96,602 |   |   |   | 104,493 |   |   |   | 5.0 |   | 28.9 |   |
| Total liabilities                                 |   | **11,769,732**     | ** **     |            | ** ** | 11,854,357         |       |            |       | 11,071,163         |       |                 |       | 9,709,431 |   |   |   | 9,228,869 |   |   |   | (0.7 | ) | 27.5 |   |
| Shareholders’ equity                         |   | **1,848,461**      | ** **     |            | ** ** | 1,811,742          |       |            |       | 1,550,937          |       |                 |       | 1,324,293 |   |   |   | 1,295,340 |   |   |   | 2.0 |   | 42.7 |   |
| Total liabilities & shareholders’ equity |   | **$**              | **13,618,193** | ** **      |       | ** **         | $          | 13,666,099      |       |               |       | $                    | 12,622,100 |   |   |   | $ | 11,033,724 |   |   |   | $ | 10,524,209 |   |   |   | (0.4 | ) | 29.4 |   |
|                                              |   |               | ** **     |            | ** ** |               |       |            |       |               |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest rate spread                          |   |               |           | **4.03**        | **%**      |               |       | 3.93            | %          |               |       | 3.81                 | %          |   |   | 3.94 | % |   |   | 4.11 | % |   |   |   |   |
| Effect of noninterest-bearing funds               |   |               |           | **.34**         | ** ** |               |       | .35             |       |               |       | .38                  |       |   |   | .44 |   |   |   | .46 |   |   |   |   |   |
| Net interest margin on earning assets             |   |               |           | **4.37**        | **%**      |               |       | 4.28            | %          |               |       | 4.19                 | %          |   |   | 4.38 | % |   |   | 4.57 | % |   |   |   |   |
|                                                   |        |                    |                |                 |            |                    |            |                 |            |                    |            |                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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* Presented on a tax-equivalent basis using the statutory federalcorporate income tax rate of 35% (see reconciliation of non-GAAP measures onpages 30 and 31)

** Nonaccrual loans are included in average loans

*** Balances reported at amortized cost; excludes pretax unrealizedgains (losses) on securities available-for-sale

 

29

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**Reconciliation ofNon-GAAP Measures (unaudited)**

*(Dollars inthousands, except per share data)*

 
|   |   | **1 Q 04** |   | **4 Q 03** |   | **3 Q 03** |   | **2 Q 03** |   | **1 Q 03** |   |
|--------|--------|------------|--------|------------|--------|------------|--------|------------|--------|------------|--------|

 

(1)          The net interest marginand efficiency ratios are presented on a fully tax-equivalent (“FTE”) andannualized basis. The FTE basis adjustments are for the tax-favored status ofincome from certain loans and investments. Management believes this measure to be the preferred industrymeasurement of the net interest income and provides a relevant comparison betweentaxable and non-taxable investments.

 
| Net interest income (GAAP basis)         |   | **$**     | **133,674** |   | $      | **133,249** |   | $     | **122,232** |   | $      | **112,723** |   | $ | **111,126** |   |
|------------------------------------------|--------|-----------|-------------|--------|--------|-------------|--------|-------|-------------|--------|--------|-------------|--------|---|-------------|--------|
| Taxable-equivalent adjustment            |   | **1,725** |        | 1,881  |   | 1,757       |   | 1,574 |        | 1,548  |   |
| Net interest income - taxable equivalent |   | **$**     | **135,399** |   | $      | **135,130** |   | $     | **123,989** |   | $      | **114,297** |   | $ | **112,674** |   |

 

(2)          Management excludes thebalance of intangible assets and their amortization expense from itscalculation of return on average tangible assets, return on average tangibleequity and average tangible equity to average tangible assets. This adjustmentallows management to review the core operating results and core capitalposition of the Company. This is consistent with the treatment by bankregulatory agencies which exclude goodwill and other intangible assets fromtheir calculation of risk-based capital ratios.

 
| Return on average assets (GAAP  basis)                          |   | **1.64**  | **%**      | 1.47   | %      | 1.48   | %      | 1.82   | %      | 1.89   | %      |
|-----------------------------------------------------------------|--------|-----------|------------|--------|--------|--------|--------|--------|--------|--------|--------|
| Impact of excluding average  intangible assets and amortization |   | **0.12**  | ** ** | 0.10   |   | 0.08   |   | 0.04   |   | 0.03   |   |
| Return on average tangible  assets                              |   | **1.76**  | **%**      | 1.57   | %      | 1.56   | %      | 1.86   | %      | 1.92   | %      |
|                                                            |   |      | ** ** |   |   |   |   |   |   |   |   |
| Return on average equity (GAAP  basis)                          |   | **12.12** | **%**      | 11.09  | %      | 12.07  | %      | 15.15  | %      | 15.34  | %      |
| Impact of excluding average  intangible assets and amortization |   | **5.89**  | ** ** | 5.40   |   | 3.63   |   | 1.90   |   | 1.65   |   |
| Return on average tangible  equity                              |   | **18.01** | **%**      | 16.49  | %      | 15.70  | %      | 17.05  | %      | 16.99  | %      |
|                                                            |   |      | ** ** |   |   |   |   |   |   |   |   |
| Average equity to average  assets (GAAP basis)                  |   | **13.57** | **%**      | 13.26  | %      | 12.29  | %      | 12.00  | %      | 12.31  | %      |
| Impact of excluding average  intangible assets and amortization |   | **(3.82** | **)**      | (3.75  | )      | (2.38  | )      | (1.09  | )      | (1.00  | )      |
| Average tangible equity to average  tangible assets             |   | **9.75**  | **%**      | 9.51   | %      | 9.91   | %      | 10.91  | %      | 11.31  | %      |

 

When computing the cash operating efficiency ratio and cash operatingearnings, management excludes the amortization of intangible assets,merger-related expenses, gains on building sales and gains and losses fromsales of investment securities in order to assess the core operating results ofthe Company and because of the uncertainty as to timing and amount of gain orlosses to be recognized.

 

(3)          The efficiency ratio ismeasured by dividing noninterest expenses by the sum of net interest income ona FTE basis and noninterest income.

 
| Efficiency ratio                |                                 | **50.40** | **%**     | 54.47      | %      | 53.67  | %      | 48.24  | %     | 46.36  | %     |
|---------------------------------|--------------------------------------|-----------|-----------|------------|--------|--------|--------|--------|-------|--------|-------|
| Impact of excluding:            | Securities gains and (losses)        |      | **(0.01** | **)**      | 0.04   |   | (0.10  | )      | 2.05  |   | 0.25  |   |
|                            | Gains on building sales              |      | **0.17**  | ** ** | — |   | — |   | 0.02  |   | 0.05  |   |
|                            | Amortization of deposit  intangibles |      | **(0.74** | **)**      | (0.60  | )      | (0.69  | )      | (0.23 | )      | (0.24 | ) |
|                            | Amortization of other  intangibles   |      | **(0.36** | **)**      | (0.40  | )      | (0.30  | )      | (0.32 | )      | (0.13 | ) |
|                            | Merger-related expenses              |      | **(0.22** | **)**      | (2.59  | )      | (1.44  | )      | (0.52 | )      | (0.04 | ) |
| Cash operating efficiency ratio |                                 | **49.24** | **%**     | 50.92      | %      | 51.14  | %      | 49.24  | %     | 46.25  | %     |

 

30

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|   |   | **1 Q 04** |   | **4 Q 03** |   | **3 Q 03** |   | **2 Q 03** |   | **1 Q 03** |   |
|--------|--------|------------|--------|------------|--------|------------|--------|------------|--------|------------|--------|

 

(4)          Bankshares presents cashoperating earnings and diluted cash operating earnings per share in order toassess the core operating results of the Company.

 
| Net income (GAAP basis)                                |   | **$**      | **55,697** | ** ** | $      | 50,645 |   | $      | 47,173 |   | $      | 50,010 |   | $ | 48,986 |   |
|--------------------------------------------------------|--------|------------|------------|------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|---|--------|--------|
| Less: Securities (gains) and  losses, net of tax       |   | **33**     | ** ** | (74        | )      | 203    |   | (3,951 | )      | (493   | )      |
| Gains on building sales, net of  tax                   |   | **(394**   | **)**      | —     |   | — |   | (52    | )      | (86    | )      |
| Plus: Amortization of deposit intangibles,  net of tax |   | **826**    | ** ** | 670        |   | 708    |   | 221    |   | 221    |   |
| Amortization of other  intangibles, net of tax         |   | **402**    | ** ** | 446        |   | 311    |   | 292    |   | 117    |   |
| Merger-related expenses, net of  tax                   |   | **248**    | ** ** | 2,847      |   | 1,481  |   | 487    |   | 30     |   |
| Cash operating earnings                                |   | **$**      | **56,812** | ** ** | $      | 54,534 |   | $      | 49,876 |   | $      | 47,007 |   | $ | 48,775 |   |
|                                                   |   |       |       |       |   |   |   |   |   |   |   |
| Diluted net income per share  (GAAP basis)             |   | **$**      | **0.69**   | ** ** | $      | 0.63   |   | $      | 0.63   |   | $      | 0.72   |   | $ | 0.71   |   |
| Less: Securities (gains) and  losses, net of tax       |   | **—** | ** ** | —     |   | — |   | (0.06  | )      | (0.01  | )      |
| Gains on building sales, net of  tax                   |   | **—** | ** ** | —     |   | — |   | — |   | — |   |
| Plus: Amortization of deposit intangibles,  net of tax |   | **0.01**   | ** ** | 0.01       |   | 0.01   |   | — |   | — |   |
| Amortization of other  intangibles, net of tax         |   | **0.01**   | ** ** | 0.01       |   | 0.01   |   | 0.01   |   | — |   |
| Merger-related expenses, net of  tax                   |   | **—** | ** ** | 0.04       |   | 0.02   |   | 0.01   |   | — |   |
| Diluted cash operating earnings  per share             |   | **$**      | **0.71**   | ** ** | $      | 0.69   |   | $      | 0.67   |   | $      | 0.68   |   | $ | 0.70   |   |

 

# **ITEM3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

Information responsive to this item as of December 31, 2003 appearsunder the captions “*Risk Management”, “Interest Rate Sensitivity Analysis(Static Gap)”* and*“Earnings Simulation Model Projections”*of the registrant’s Form 10-K for the year ended December 31, 2003. There wasno material change in such information as of March 31, 2004.

 

# **ITEM4. CONTROLS AND PROCEDURES**

 

As of March 31, 2004, Bankshares’ management, under the supervision andwith the participation of the Company’s principal executive officer andprincipal financial officer, evaluated the effectiveness of the design andoperation of the Company’s disclosure controls and procedures, as that term isdefined in Rule 13a-15(e) under the Securities and Exchange Act of 1934, asamended. Based on the evaluation, the principal executive officer and principalfinancial officer concluded that the Company’s disclosure controls andprocedures are effective. There were no significant changes in the Company’sinternal controls during the last fiscal quarter.

 

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# **PARTII – OTHER INFORMATION**

 

**Item5.        Other Information**

The 2004Annual Meeting of stockholders of the registrant is expected to be held on May11, 2004.

 

**Item6.        Exhibits and Reports on Form 8-K**

 

(a)                                  Exhibits

 

31.1 Section 302 Certification of Chief Executive Officer. Filed as anexhibit hereto and incorporated herein by reference

 

31.2 Section 302 Certification of Chief Financial Officer. Filed as anexhibit hereto and incorporated herein by reference

 

32.1 Section 906 Certification of Chief Executive Officer. Filed as anexhibit hereto and incorporated herein by reference

 

32.2 Section 906 Certification of Chief Financial Officer. Filed as anexhibit hereto and incorporated herein by reference

 

(b)                                 Reports on Form 8-K

 

Form 8-K filed, dated February 2, 2004, Item 7 and 9

Form 8-K filed, dated March 10, 2004, Item 5 and 7

Form 8-K filed, dated March 10, 2004, Item 6 and 7

Form 8-K filed, dated March 18, 2004, Item 5 and 7

 

**Signatures**

 

Pursuant to the requirements of the Securities Exchange Act of 1934 theregistrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
|                    |   |   |                        | **BANKSHARES**              |
|-------------------------|--------|--------|-----------------------------|-----------------------------|
|                    |   |   |                        | (Registrant)                |
|                    |   |   |                        |                        |
|   May 4, 2004 |   |   | /s/ Edward J. Kelly, III    |
|                    | Date   |   |                        | By: Edward J. Kelly, III    |
|                    |   |   |                        | Chairman of the Board,      |
|                    |   |   |                        | President and               |
|                    |   |   |                        | Chief Executive Officer     |
|                    |   |   |                        |                        |
|  May 4, 2004       |   |   | /s/ Terry L. Troupe         |
|                    | Date   |   |                        | By: Terry L. Troupe         |
|                    |   |   |                        | Chief Financial Officer     |
|                    |   |   |                        |                        |
|  May 4, 2004       |   |   | /s/ William T. Skinner, Jr. |
|                    | Date   |   |                        | By: William T. Skinner, Jr. |
|                    |   |   |                        | Controller                  |
|                         |        |        |                             |                             |  |

 

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