**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

** **

** **

**FORM 10-Q**

(Mark One)

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

 

**For the quarterly periodended**June 30, 2006

** **

**OR**

** **

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

**For the transition period from                      to                     **

** **

** **

**Commission file number**:  **0-5127**

 

**MERCANTILE BANKSHARES CORPORATION**

(Exact name of registrant as specified in its charter)

 

 

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

** **

**2 Hopkins Plaza**

**Baltimore, Maryland 21201**

(Address of principal executive offices) (Zip Code)

 

 

**(410) 237-5900**

(Registrant’s telephone number, including area code)

 

 

**NONE**

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

 

Indicate by check mark whether the registrant (1)has filed all reports required to be filed by Section 13 or 15(d) of 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 x    No o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” inRule 12b-2 of the Exchange Act.  (Check one).

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

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

As of July 31, 2006, therewere 125,362,712 shares of registrant’s Common Stock, $2 par value per share,outstanding.

 

 

----

 

**MERCANTILEBANKSHARES CORPORATIONQuarterly Report on Form 10-QJune 30, 2006**

**Table of Contents**
| **Part I - Financial  Information** |
|-------------------------------------|
| ** **                          |
|                                | Item 1. | Financial Statements (Unaudited) |
|                                |   | Consolidated Balance Sheets |
|                                |   | Statements of Consolidated Income |
|                                |   | Statements of Changes in Consolidated Shareholders’  Equity |
|                                |   | Statements of Consolidated Cash Flows |
|                                |   | Notes to Consolidated Financial Statements |
|                                |   |   |
|                                | Item 2. | Management’s Discussion and Analysis of Financial  Condition and Results of Operations |
|                                |   |   |
| .                                   | Item 3. | Quantitative and Qualitative Disclosures about Market  Risk |
|                                |   |   |
|                                | Item 4. | Controls and Procedures |
|                                |   |   |
| **Part  II - Other Information**    |
| ** **                          |
|                                | Item  1. | Legal  Proceedings |
|                                |   |   |
|                                | Item 1A. | Risk Factors |
|                                |   |   |
|                                | Item 4. | Submission of Matters to a Vote of Security Holders |
|                                |   |   |
|                                | Item 6. | Exhibits |
|                                |   |   |
| ** Signatures**                |   |

 

2

----

**PARTI — FINANCIAL INFORMATION**

**Item 1. Financial Statements (Unaudited)**

**MERCANTILEBANKSHARES CORPORATIONCONSOLIDATED BALANCE SHEETS**
| **(Dollars in thousands, except per share data)**                                                                               | ** ** | **June 30,  2006** | ** **     | **December 31,  2005** | ** ** | **June 30,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|----------------|-----------------------------|------------|-------------------------|------------|
| **ASSETS**                                                                                                                                                    | ** ** | ** **              | ** **     | ** **                  | ** ** | ** **              | ** ** |
| Cash and due  from banks                                                                                                                                      | ** ** | **$**                   | **380,476**    |                        | $          | 369,536                 |       | $ | 382,695 |   |
| Interest-bearing  deposits in other banks                                                                                                                     | ** ** | **200**                 |           | 200                         |       | 200                     |       |
| Federal funds  sold                                                                                                                                           | ** ** | **19,106**              |           | 25,104                      |       | 95,102                  |       |
| Total cash and cash equivalents                                                                                                                               | ** ** | **399,782**             |           | 394,840                     |       | 477,997                 |       |
| Investment  securities available-for-sale (Note 4)                                                                                                            | ** ** | **3,109,708**           |           | 3,089,628                   |       | 2,960,275               |       |
| Investment  securities held-to-maturity (Note 4) - fair value of $15,871 (June 2006),  $17,181 (December 2005) and $18,788 (June 2005)                        | ** ** | **15,532**              |           | 16,659                      |       | 18,056                  |       |
| Total investment securities                                                                                                                                   | ** ** | **3,125,240**           |           | 3,106,287                   |       | 2,978,331               |       |
| Loans  held-for-sale                                                                                                                                          | ** ** | **61,721**              |           | 26,263                      |       | 16,754                  |       |
| Loans:                                                                                                                                                        |       |                    |           |                        |       |                    |       |
| Commercial                                                                                                                                                    | ** ** | **2,935,369**           |           | 2,957,301                   |       | 2,923,419               |       |
| Commercial real estate                                                                                                                                        | ** ** | **3,826,335**           |           | 3,703,297                   |       | 3,585,592               |       |
| Construction                                                                                                                                                  | ** ** | **1,855,110**           |           | 1,607,095                   |       | 1,560,149               |       |
| Residential real estate                                                                                                                                       | ** ** | **1,905,032**           |           | 1,802,373                   |       | 1,776,959               |       |
| Home equity lines                                                                                                                                             | ** ** | **479,011**             |           | 505,508                     |       | 517,342                 |       |
| Consumer                                                                                                                                                      | ** ** | **1,049,323**           |           | 1,032,271                   |       | 1,000,845               |       |
| Total loans                                                                                                                                                   | ** ** | **12,050,180**          |           | 11,607,845                  |       | 11,364,306              |       |
| Less: allowance  for loan losses                                                                                                                              | ** ** | **(142,860**            | **)**          | (156,673                    | )          | (157,101                | )          |
| Loans, net                                                                                                                                                    | ** ** | **11,907,320**          |           | 11,451,172                  |       | 11,207,205              |       |
| Bank premises  and equipment, less accumulated depreciation of $147,264 (June 2006),  $146,585 (December 2005) and $151,132 (June 2005)                       | ** ** | **139,007**             |           | 137,419                     |       | 147,774                 |       |
| Other real  estate owned, net                                                                                                                                 | ** ** | **49**                  |           | 667                         |       | 777                     |       |
| Goodwill, net                                                                                                                                                 | ** ** | **679,710**             |           | 670,028                     |       | 667,465                 |       |
| Other intangible  assets, net (Note 8)                                                                                                                        | ** ** | **42,403**              |           | 46,653                      |       | 49,830                  |       |
| Other assets                                                                                                                                                  | ** ** | **647,482**             |           | 588,400                     |       | 546,861                 |       |
| Total assets                                                                                                                                                  | ** ** | **$**                   | **17,002,714** |                        | $          | 16,421,729              |       | $ | 16,092,994 |   |
| ** **                                                                                                                                                    |       |                    |           |                        |       |                    |       |
| **COMMITMENTS and CONTINGENCIES**(Note  7)                                                                                                                    |       |                    |           |                        |       |                    |       |
| ** **                                                                                                                                                    | ** ** | ** **              | ** **     | ** **                  | ** ** | ** **              | ** ** |
| **LIABILITIES**                                                                                                                                               | ** ** | ** **              | ** **     | ** **                  | ** ** | ** **              | ** ** |
| Deposits:                                                                                                                                                     |       |                    |           |                        |       |                    |       |
| Noninterest-bearing deposits                                                                                                                                  | ** ** | **$**                   | **3,392,286**  |                        | $          | 3,324,650               |       | $ | 3,293,344 |   |
| Interest-bearing deposits                                                                                                                                     | ** ** | **9,051,736**           |           | 8,752,700                   |       | 8,537,407               |       |
| Total deposits                                                                                                                                                | ** ** | **12,444,022**          |           | 12,077,350                  |       | 11,830,751              |       |
| Short-term borrowings                                                                                                                                         | ** ** | **1,432,119**           |           | 1,237,714                   |       | 1,192,782               |       |
| Accrued expenses  and other liabilities                                                                                                                       | ** ** | **210,699**             |           | 169,780                     |       | 140,390                 |       |
| Long-term debt                                                                                                                                                | ** ** | **650,829**             |           | 742,163                     |       | 807,954                 |       |
| Total liabilities                                                                                                                                             | ** ** | **14,737,669**          |           | 14,227,007                  |       | 13,971,877              |       |
| ** **                                                                                                                                                    | ** ** | ** **              | ** **     | ** **                  | ** ** | ** **              | ** ** |
| **SHAREHOLDERS’ EQUITY**                                                                                                                                 | ** ** | ** **              | ** **     | ** **                  | ** ** | ** **              | ** ** |
| Preferred stock, no par  value; authorized 2,000,000 shares; issued and outstanding - None                                                                    |       |                    |           |                        |       |                    |       |
| Common stock, $2  par value; authorized 200,000,000 shares; issued shares - 123,523,069 (June  2006), 123,248,121 (December 2005) and 122,973,563 (June 2005) | ** ** | **247,046**             |           | 164,331                     |       | 163,965                 |       |
| Capital surplus                                                                                                                                               | ** ** | **600,349**             |           | 676,830                     |       | 665,006                 |       |
| Retained  earnings                                                                                                                                            | ** ** | **1,466,852**           |           | 1,386,405                   |       | 1,302,869               |       |
| Accumulated  other comprehensive income (loss)                                                                                                                | ** ** | **(49,202**             | **)**          | (32,844                     | )          | (10,723                 | )          |
| Total shareholders’ equity                                                                                                                               | ** ** | **2,265,045**           |           | 2,194,722                   |       | 2,121,117               |       |
| Total  liabilities and shareholders’ equity                                                                                                              | ** ** | **$**                   | **17,002,714** |                        | $          | 16,421,729              |       | $ | 16,092,994 |   |

 

See Notes to ConsolidatedFinancial Statements.

3

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**MERCANTILEBANKSHARES CORPORATIONSTATEMENTS OF CONSOLIDATED INCOME**
| ** **                                                                      | ** ** | **For the 6 months ended  June 30,** | ** **  | **For the 3 months ended  June 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|---------------------------------------------------------------|-------------|---------------------------------------------------------------|------------|
| **(Dollars in thousands, except per share data)** | ** ** | **2006**                                                      | ** **  | **2005**                                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| **INTEREST INCOME**                                                             | ** ** | ** **                                                    | ** **  | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest and  fees on loans                                                     | ** ** | **$**                                                         | **404,151** |                                                          | $          | 322,421 | ** ** | **$** | **208,096** |   | $ | 169,877 |   |
| Interest and dividends  on investment securities:                               |       |                                                          |        |                                                          |       |   |   |   |   |
| Taxable interest income                                                         | ** ** | **60,930**                                                    |        | 50,366                                                        | ** ** | **31,135** |   | 25,374 |   |
| Tax-exempt interest income                                                      | ** ** | **1,543**                                                     |        | 1,509                                                         | ** ** | **765** |   | 788 |   |
| Other investment income                                                         | ** ** | **1,326**                                                     |        | 1,227                                                         | ** ** | **699** |   | 583 |   |
| Total interest and dividends on investment  securities                          | ** ** | **63,799**                                                    |        | 53,102                                                        | ** ** | **32,599** |   | 26,745 |   |
| Other interest  income                                                          | ** ** | **1,756**                                                     |        | 786                                                           | ** ** | **1,098** |   | 442 |   |
| Total interest income                                                           | ** ** | **469,706**                                                   |        | 376,309                                                       | ** ** | **241,793** |   | 197,064 |   |
| ** **                                                                      | ** ** | ** **                                                    | ** **  | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| **INTEREST EXPENSE**                                                            | ** ** | ** **                                                    | ** **  | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest on  deposits                                                           | ** ** | **106,846**                                                   |        | 56,689                                                        | ** ** | **57,603** |   | 31,384 |   |
| Interest on  short-term borrowings                                              | ** ** | **24,523**                                                    |        | 9,526                                                         | ** ** | **13,500** |   | 5,484 |   |
| Interest on  long-term debt                                                     | ** ** | **18,614**                                                    |        | 14,644                                                        | ** ** | **9,280** |   | 7,829 |   |
| Total interest expense                                                          | ** ** | **149,983**                                                   |        | 80,859                                                        | ** ** | **80,383** |   | 44,697 |   |
| **NET  INTEREST INCOME**                                                        | ** ** | **319,723**                                                   |        | 295,450                                                       | ** ** | **161,410** |   | 152,367 |   |
| Provision for  credit losses                                                    | ** ** | **—**                                                    |        | 756                                                           | ** ** | **—** |   | — |   |
| **NET  INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES**                      | ** ** | **319,723**                                                   |        | 294,694                                                       | ** ** | **161,410** |   | 152,367 |   |
| ** **                                                                      | ** ** | ** **                                                    | ** **  | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| **NONINTEREST INCOME**                                                          | ** ** | ** **                                                    | ** **  | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Investment and  wealth management                                               | ** ** | **54,986**                                                    |        | 47,837                                                        | ** ** | **28,865** |   | 23,780 |   |
| Service charges  on deposit accounts                                            | ** ** | **21,160**                                                    |        | 21,514                                                        | ** ** | **10,868** |   | 11,088 |   |
| Mortgage  banking-related fees                                                  | ** ** | **4,545**                                                     |        | 5,178                                                         | ** ** | **2,335** |   | 2,895 |   |
| Investment  securities (losses) gains                                           | ** ** | **(13**                                                       | **)**       | 490                                                           | ** ** | **—** |   | 76 |   |
| Nonmarketable  investments                                                      | ** ** | **12,233**                                                    |        | 9,493                                                         | ** ** | **5,964** |   | 4,222 |   |
| Other income                                                                    | ** ** | **32,163**                                                    |        | 33,423                                                        | ** ** | **16,436** |   | 18,005 |   |
| Total noninterest income                                                        | ** ** | **125,074**                                                   |        | 117,935                                                       | ** ** | **64,468** |   | 60,066 |   |
| ** **                                                                      | ** ** | ** **                                                    | ** **  | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| **NONINTEREST EXPENSES**                                                        | ** ** | ** **                                                    | ** **  | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Salaries                                                                        | ** ** | **96,331**                                                    |        | 96,734                                                        | ** ** | **47,232** |   | 50,180 |   |
| Employee  benefits                                                              | ** ** | **29,027**                                                    |        | 23,853                                                        | ** ** | **14,292** |   | 11,956 |   |
| Net occupancy  expense of bank premises                                         | ** ** | **15,702**                                                    |        | 13,779                                                        | ** ** | **7,931** |   | 6,857 |   |
| Furniture and equipment  expenses                                               | ** ** | **16,399**                                                    |        | 15,203                                                        | ** ** | **8,094** |   | 7,924 |   |
| Communications  and supplies                                                    | ** ** | **8,287**                                                     |        | 8,059                                                         | ** ** | **4,469** |   | 4,019 |   |
| Other expenses                                                                  | ** ** | **50,391**                                                    |        | 46,438                                                        | ** ** | **27,404** |   | 22,977 |   |
| Total noninterest expenses                                                      | ** ** | **216,137**                                                   |        | 204,066                                                       | ** ** | **109,422** |   | 103,913 |   |
| Income before  income taxes                                                     | ** ** | **228,660**                                                   |        | 208,563                                                       | ** ** | **116,456** |   | 108,520 |   |
| Applicable  income taxes                                                        | ** ** | **84,809**                                                    |        | 78,063                                                        | ** ** | **43,364** |   | 40,647 |   |
| **NET  INCOME**                                                                 | ** ** | **$**                                                         | **143,851** |                                                          | $          | 130,500 | ** ** | **$** | **73,092** |   | $ | 67,873 |   |
| ** **                                                                      | ** ** | ** **                                                    | ** **  | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| **NET INCOME PER SHARE OF COMMON  STOCK (Note 3):**                             | ** ** | ** **                                                    | ** **  | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic                                                                           | ** ** | **$**                                                         | **1.17**    |                                                          | $          | 1.09 | ** ** | **$** | **0.59** |   | $ | 0.56 |   |
| Diluted                                                                         | ** ** | **$**                                                         | **1.16**    |                                                          | $          | 1.08 | ** ** | **$** | **0.59** |   | $ | 0.56 |   |
| **DIVIDENDS PAID PER COMMON SHARE**                                             | ** ** | **$**                                                         | **0.54**    |                                                          | $          | 0.49 | ** ** | **$** | **0.28** |   | $ | 0.25 |   |

 

See Notes to ConsolidatedFinancial Statements.

4

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**MERCANTILEBANKSHARES CORPORATIONSTATEMENTS OF CHANGES IN CONSOLIDATED SHAREHOLDERS’ EQUITY**
| **For the 6 months ended June 30, 2006 and 2005  (Dollars in thousands, except per share data)** | ** ** | **Total** | ** **    | **Common  Stock** | ** ** | **Capital  Surplus** | ** ** | **Retained  Earnings** | ** **  | **Accumulated  Other  Comprehensive  Loss** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------|---------------|-------------------|------------|----------------------|------------|------------------------|-------------|---------------------------------------------|------------|
| BALANCE,  DECEMBER 31, 2004                                                                                                                                                 |       | $         | 1,917,683     |              | $          | 158,601              |       | $                      | 530,705     |                                        | $          | 1,231,102 |   | $ | (2,725 | ) |
| Net income                                                                                                                                                                  |       | 130,500   |          |              |       |                 |       | 130,500                |        |                                        |       |
| Unrealized gains  (losses) on securities available-for-sale, net of reclassification  adjustment, net of taxes                                                              |       | (7,998    | )             |              |       |                 |       |                   |        | (7,998                                      | )          |
| Comprehensive  income                                                                                                                                                       |       | 122,502   |          |              |       |                 |       |                   |        |                                        |       |
| Cash dividends paid:                                                                                                                                                        |       |      |          |              |       |                 |       |                   |        |                                        |       |
| Common stock ($0.49 per share)                                                                                                                                              |       | (57,897   | )             |              |       |                 |       | (57,897                | )           |                                        |       |
| Issuance of  2,444,408 shares for bank acquisition                                                                                                                          |       | 124,335   |          | 4,889             |       | 119,446              |       |                   |        |                                        |       |
| Fair value of  138,764 converted options related to employee stock option plan of acquired  bank                                                                            |       | 5,182     |          |              |       | 5,182                |       |                   |        |                                        |       |
| Issuance of  54,750 shares for dividend reinvestment and stock purchase plan                                                                                                |       | 2,677     |          | 110               |       | 2,567                |       |                   |        |                                        |       |
| Issuance of  11,740 shares for employee stock purchase dividend reinvestment plan                                                                                           |       | 592       |          | 23                |       | 569                  |       |                   |        |                                        |       |
| Issuance of  132,034 shares for employee stock option plan                                                                                                                  |       | 1,957     |          | 265               |       | 1,692                |       |                   |        |                                        |       |
| Directors’ deferred  compensation plan:                                                                                                                                |       |      |          |              |       |                 |       |                   |        |                                        |       |
| Issuance of 1,599 shares                                                                                                                                                    |       | —    |          | 2                 |       | (2                   | )          |                   |        |                                        |       |
| Contribution                                                                                                                                                                |       | 370       |          |              |       | 370                  |       |                   |        |                                        |       |
| Dividend                                                                                                                                                                    |       | —    |          |              |       | 127                  |       | (127                   | )           |                                        |       |
| Nonvested stock awards                                                                                                                                                      |       |      |          |              |       |                 |       |                   |        |                                        |       |
| Issuance of 37,338 shares                                                                                                                                                   |       | 1,906     |          | 75                |       | 1,831                |       |                   |        |                                        |       |
| Deferred compensation                                                                                                                                                       |       | (2,000    | )             |              |       |                 |       | (2,000                 | )           |                                        |       |
| Expense                                                                                                                                                                     |       | 1,291     |          |              |       |                 |       | 1,291                  |        |                                        |       |
| Vested stock  options                                                                                                                                                       |       | 2,519     |          |              |       | 2,519                |       |                   |        |                                        |       |
| BALANCE, JUNE  30, 2005                                                                                                                                                     |       | $         | 2,121,117     |              | $          | 163,965              |       | $                      | 665,006     |                                        | $          | 1,302,869 |   | $ | (10,723 | ) |
|                                                                                                                                                                        |       |      |          |              |       |                 |       |                   |        |                                        |       |
| BALANCE,  DECEMBER 31, 2005                                                                                                                                                 |       | $         | 2,194,722     |              | $          | 164,331              |       | $                      | 676,830     |                                        | $          | 1,386,405 |   | $ | (32,844 | ) |
| Net income                                                                                                                                                                  |       | 143,851   |          |              |       |                 |       | 143,851                |        |                                        |       |
| Unrealized gains  (losses) on securities available-for-sale, net of reclassification  adjustment, net of taxes                                                              |       | (16,358   | )             |              |       |                 |       |                   |        | (16,358                                     | )          |
| Comprehensive  income                                                                                                                                                       |       | 127,493   |          |              |       |                 |       |                   |        |                                        |       |
| Cash dividends paid:                                                                                                                                                        |       |      |          |              |       |                 |       |                   |        |                                        |       |
| Common stock ($0.54 per share)                                                                                                                                              |       | (66,508   | )             |              |       |                 |       | (66,508                | )           |                                        |       |
| Issuance of  89,574 shares for dividend reinvestment and stock purchase plan                                                                                                |       | 3,162     |          | 179               |       | 2,983                |       |                   |        |                                        |       |
| Issuance of  16,685 shares for employee stock purchase dividend reinvestment plan                                                                                           |       | 643       |          | 33                |       | 610                  |       |                   |        |                                        |       |
| Issuance of  50,606 shares for employee stock option plan                                                                                                                   |       | 1,083     |          | 101               |       | 982                  |       |                   |        |                                        |       |
| Directors’ deferred  compensation plan:                                                                                                                                |       |      |          |              |       |                 |       |                   |        |                                        |       |
| Issuance of 4,575 shares                                                                                                                                                    |       | 143       |          | 9                 |       | 134                  |       |                   |        |                                        |       |
| Contribution                                                                                                                                                                |       | 690       |          |              |       | 690                  |       |                   |        |                                        |       |
| Dividend                                                                                                                                                                    |       | —    |          |              |       | 102                  |       | (102                   | )           |                                        |       |
| Nonvested stock awards  and units                                                                                                                                           |       |      |          |              |       |                 |       |                   |        |                                        |       |
| Issuance of 148,641 shares                                                                                                                                                  |       | 375       |          | 297               |       | 78                   |       |                   |        |                                        |       |
| Repurchase of 37,252 shares for tax settlement                                                                                                                              |       | (1,431    | )             | (74               | )          | (1,357               | )          |                   |        |                                        |       |
| Expense                                                                                                                                                                     |       | 3,333     |          |              |       | 3,333                |       |                   |        |                                        |       |
| Vested stock  options                                                                                                                                                       |       | 1,422     |          |              |       | 1,422                |       |                   |        |                                        |       |
| Adjustment for  adoption of SFAS No. 123R                                                                                                                                   |       | —    |          |              |       | (3,206               | )          | 3,206                  |        |                                        |       |
| Issuance of  41,084,826 shares for the 3 for 2 stock split                                                                                                                  |       | (82       | )             | 82,170            |       | (82,252              | )          |                   |        |                                        |       |
| **BALANCE, JUNE 30, 2006**                                                                                                                                                  | ** ** | **$**     | **2,265,045** | ** **        | **$**      | **247,046**          | ** ** | **$**                  | **600,349** | ** **                                  | **$**      | **1,466,852** | ** ** | **$** | **(49,202** | **)** |

 

See Notes to ConsolidatedFinancial Statements.

5

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**MERCANTILEBANKSHARES CORPORATIONSTATEMENTS OF CONSOLIDATED CASH FLOWS**
| **Increase (decrease) in cash and cash equivalents** | ** ** | **For the 6 months ended June 30,** | ** **  |
|------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|-------------|
| **(Dollars in thousands)**                                               | ** ** | **2006**                                                          | ** **  | **2005** | ** ** |
| **CASH FLOWS FROM OPERATING  ACTIVITIES:**                                         | ** ** | ** **                                                        | ** **  | ** ** | ** ** |
| Net income                                                                         | ** ** | **$**                                                             | **143,851** |   | $ | 130,500 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                                              |        |   |   |
| Provision for credit losses                                                        | ** ** | **—**                                                        |        | 756 |   |
| Depreciation                                                                       | ** ** | **7,822**                                                         |        | 7,560 |   |
| Amortization of other intangible assets                                            | ** ** | **4,542**                                                         |        | 4,251 |   |
| Tax benefit from the issuance of stock-based  compensation                         | ** ** | **99**                                                            |        | — |   |
| Write-downs of other real estate owned                                             | ** ** | **—**                                                        |        | 1 |   |
| Gains on sales of other real estate owned                                          | ** ** | **(7**                                                            | **)**       | (153 | ) |
| Loss (gains) on sales of investments securities                                    | ** ** | **13**                                                            |        | (490 | ) |
| Gains on sales of premises                                                         | ** ** | **(103**                                                          | **)**       | (4,541 | ) |
| Net increase in loans held-for-sale                                                | ** ** | **(36,292**                                                       | **)**       | (5,754 | ) |
| Net increase in  assets:                                                           |       |                                                              |        |   |   |
| Interest receivable                                                                | ** ** | **(3,754**                                                        | **)**       | (444 | ) |
| Nonmarketable investments                                                          | ** ** | **(9,829**                                                        | **)**       | (6,683 | ) |
| Other assets                                                                       | ** ** | **(10,503**                                                       | **)**       | (4,472 | ) |
| Net increase  (decrease) in liabilities:                                           |       |                                                              |        |   |   |
| Interest payable                                                                   | ** ** | **6,774**                                                         |        | 3,591 |   |
| Other liabilities                                                                  | ** ** | **(11,797**                                                       | **)**       | (27,356 | ) |
| Net cash provided by operating activities                                          | ** ** | **90,816**                                                        |        | 96,766 |   |
|                                                                               | ** ** | ** **                                                        |        |   |   |
| **CASH FLOWS FROM INVESTING  ACTIVITIES:**                                         | ** ** | ** **                                                        | ** **  | ** ** | ** ** |
| Proceeds from  maturities of investment securities held-to-maturity                | ** ** | **1,127**                                                         |        | 2,120 |   |
| Proceeds from  maturities of investment securities available-for-sale              | ** ** | **492,581**                                                       |        | 425,262 |   |
| Proceeds from  sales of investment securities available-for-sale                   | ** ** | **1,791**                                                         |        | 89,878 |   |
| Purchases of  investment securities held-to-maturity                               | ** ** | **—**                                                        |        | (408,727 | ) |
| Purchases of  investment securities available-for-sale                             | ** ** | **(540,550**                                                      | **)**       | — |   |
| Net increase in  loans                                                             | ** ** | **(440,535**                                                      | **)**       | (465,812 | ) |
| Proceeds from  sales of other real estate owned                                    | ** ** | **2,241**                                                         |        | 273 |   |
| Capital  expenditures                                                              | ** ** | **(10,426**                                                       | **)**       | (10,189 | ) |
| Proceeds from  sales of premises                                                   | ** ** | **536**                                                           |        | 5,893 |   |
| Business  acquisitions (net of cash received)                                      | ** ** | **—**                                                        |        | (78,655 | ) |
| Business  acquisitions contingent consideration                                    | ** ** | **(8,806**                                                        | **)**       | — |   |
| Purchases of  nonmarketable investments                                            | ** ** | **(5,866**                                                        | **)**       | (3,926 | ) |
| Net cash used in investing activities                                              | ** ** | **(507,907**                                                      | **)**       | (443,883 | ) |
|                                                                               | ** ** | ** **                                                        | ** **  |   |   |
| **CASH FLOWS FROM FINANCING  ACTIVITIES:**                                         | ** ** | ** **                                                        | ** **  | ** ** | ** ** |
| Net increase in  noninterest-bearing deposits                                      | ** ** | **67,636**                                                        |        | 136,463 |   |
| Net increase in  interest-bearing deposits                                         | ** ** | **299,421**                                                       |        | 268,181 |   |
| Net increase in  short-term borrowings                                             | ** ** | **194,405**                                                       |        | 295,219 |   |
| Repayment of  long-term debt                                                       | ** ** | **(77,545**                                                       | **)**       | (67,212 | ) |
| Tax benefit from  the issuance of stock-based compensation                         | ** ** | **983**                                                           |        | — |   |
| Excess tax  benefit related to stock-based compensation                            | ** ** | **327**                                                           |        | — |   |
| Proceeds from  issuance of shares                                                  | ** ** | **4,745**                                                         |        | 5,226 |   |
| Repurchase of  common shares                                                       | ** ** | **(1,431**                                                        | **)**       | — |   |
| Dividends paid                                                                     | ** ** | **(66,508**                                                       | **)**       | (57,897 | ) |
| Net cash provided by financing activities                                          | ** ** | **422,033**                                                       |        | 579,980 |   |
| Net increase in  cash and cash equivalents                                         | ** ** | **4,942**                                                         |        | 232,863 |   |
| Cash and cash  equivalents at beginning of period                                  | ** ** | **394,840**                                                       |        | 245,134 |   |
| Cash and cash  equivalents at end of period                                        | ** ** | **$**                                                             | **399,782** |   | $ | 477,997 |   |
|                                                                               | ** ** | ** **                                                        |        |   |   |
| **SUPPLEMENTAL INFORMATION**                                                       | ** ** | ** **                                                        | ** **  | ** ** | ** ** |
| Cash payments  for interest                                                        | ** ** | **$**                                                             | **143,209** |   | $ | 75,916 |   |
| Cash payments for  income taxes                                                    | ** ** | **87,998**                                                        |        | 91,109 |   |

 

See Notes to ConsolidatedFinancial Statements.

6

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**MERCANTILEBANKSHARES CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

1.  Basis of Presentation

Theconsolidated financial statements, which include the accounts of MercantileBankshares Corporation (“Bankshares”) (Nasdaq: MRBK) and all of its affiliates,are prepared in conformity with accounting principles generally accepted in theUnited States of America and follow general practice within the bankingindustry.  In the opinion of management,the consolidated financial statements include all adjustments necessary for afair presentation of the interim period. These adjustments are of a normal nature and include adjustments toeliminate all significant intercompany transactions.  In view of the changing conditions in thenational economy, the effect of actions taken by regulatory authorities andnormal seasonal factors, the results for the interim period are not necessarilyindicative of annual performance.  Forpurposes of comparability, certain prior period amounts have been reclassifiedto conform to current period presentation.

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and contingent assets and liabilities in the financial statements,and the disclosure of revenue and expenses during the reporting period.  These assumptions are based on informationavailable as of the date of the financial statements and could differ fromactual results.  See Bankshares’ AnnualReport on Form 10-K for more detail.

OnJanuary 10, 2006, Bankshares announced a three-for-two stock split on itscommon stock payable in the form of a stock dividend on January 27, 2006 to stockholdersof record as of the close of business on January 20, 2006.  For comparative purposes, certain share,average share and per share amounts have been restated.

2.  Business Combinations / Restructuring

Thefollowing provides information concerning acquisitions and restructurings.  Acquisitions were accounted for as purchaseswith the results of their operations subsequent to the acquisition dateincluded in Bankshares’ Statements of Consolidated Income.

OnMarch 27, 2006, Bankshares signed a definitive merger agreement with JamesMonroe Bancorp, Inc. (“James Monroe”). The acquisition of this Arlington, Virginia-based commercial bank wascompleted on July 17, 2006, and it was merged into Mercantile-Safe Deposit& Trust Company (“MSD&T”).  Underthe terms of the agreement, shareholders of James Monroe were entitled to electto receive either cash in the amount of $23.50 for each share, or .6033 sharesof Bankshares common stock for each share of James Monroe common stock theyheld.  The total consideration paid toJames Monroe shareholders in connection with the acquisition was $71.4 millionand 1.8 million shares of Bankshares’ common stock.  Bankshares’ acquisition of James Monroe, asof July 17, 2006, will add approximately $552 million in total assets, $414million in gross loans, $434 million in total deposits, and six full-servicebranches and a loan production office located in Northern Virginia and suburbanWashington, D.C.  For additionalinformation, see the Form 8-K filed in connection with the merger on March 27,2006.

OnMay 18, 2005, Bankshares completed its acquisition of Community Bank ofNorthern Virginia (“CBNV”), a bank headquartered in Sterling, Virginia, whichwas merged into MSD&T.  The totalconsideration paid to CBNV shareholders in connection with the acquisition was$82.9 million in cash and 3.7 million shares of Bankshares’ common stock.  The transaction resulted in total assetsacquired as of May 18, 2005 of $888.2 million, including $671.0 million ofloans and leases; liabilities assumed were $842.3 million, including $626.9million of deposits.  Additionally,Bankshares recorded $162.9 million of goodwill and $4.6 million of core depositintangibles.  Bankshares expensed nomerger-related costs for the six-month period ended June 30, 2006 and hasexpensed $1.3 million since the inception of the merger. 

7

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3.  Earnings per Share

Basicearnings per share (“EPS”) are computed by dividing income available to commonshareholders by weighted average common shares outstanding.  Diluted EPS are computed using the samecomponents as basic EPS with the denominator adjusted for the dilutive effectof stock options, restricted stock awards, restricted stock units and vesteddirectors’ deferred compensation plan shares. The following tables provide reconciliations between the computation ofbasic EPS and diluted EPS for the six and three months ended June 30, 2006 and2005, respectively.

 
| ** **                                                         | ** ** | **For the 6 months ended June 30,** | ** **  |
|--------------------------------------------------------------------|------------|-------------------------------------------------------------------|-------------|
| ** **                                                         | ** ** | **2006**                                                          | ** **  | **2005** | ** ** |
| **(In thousands, except per share data)** | ** ** | **Net  Income**                                                   | ** **  | **Weighted  Average  Common  Shares** | ** ** | **EPS** | ** ** | **Net  Income** | ** ** | **Weighted  Average  Common  Shares** | ** ** | **EPS** | ** ** |
| Basic EPS                                                          | ** ** | **$**                                                             | **143,851** | ** ** | **123,133** | ** ** | **$** | **1.17** |   | $ | 130,500 |   | 119,812 |   | $ | 1.09 |   |
| Dilutive effect of :                                               |       |                                                              |        |   |   |   |   |   |   |   |   |   |   |
| Stock options                                                      | ** ** | ** **                                                        |        | **768** |   |   |   |   |   | 603 |   |   |   |
| Restricted stock awards and units                                  | ** ** | ** **                                                        |        | **112** |   |   |   |   |   | 112 |   |   |   |
| Vested directors’ deferred compensation plan shares           |       |                                                              | ** **  | **292** |   |   |   |   |   | 255 |   |   |   |
| Diluted EPS                                                        | ** ** | **$**                                                             | **143,851** | ** ** | **124,305** | ** ** | **$** | **1.16** |   | $ | 130,500 |   | 120,782 |   | $ | 1.08 |   |

 

 
| ** **                                                         | ** ** | **For the 3 months ended June 30,** | ** ** |
|--------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                         | ** ** | **2006**                                                          | ** ** | **2005** | ** ** |
| **(In thousands, except per share data)** | ** ** | **Net  Income**                                                   | ** ** | **Weighted  Average  Common  Shares** | ** ** | **EPS** | ** ** | **Net  Income** | ** ** | **Weighted  Average  Common  Shares** | ** ** | **EPS** | ** ** |
| Basic EPS                                                          | ** ** | **$**                                                             | **73,092** | ** ** | **123,222** | ** ** | **$** | **0.59** |   | $ | 67,873 |   | 120,772 |   | $ | 0.56 |   |
| Dilutive effect  of :                                              |       |                                                              |       |   |   |   |   |   |   |   |   |   |   |
| Stock options                                                      | ** ** | ** **                                                        |       | **743** |   |   |   |   |   | 601 |   |   |   |
| Restricted stock awards and units                                  | ** ** | ** **                                                        |       | **65** |   |   |   |   |   | 110 |   |   |   |
| Vested directors’ deferred compensation plan shares           |       |                                                              |       | **294** |   |   |   |   |   | 258 |   |   |   |
| Diluted EPS                                                        | ** ** | **$**                                                             | **73,092** | ** ** | **124,324** | ** ** | **$** | **0.59** |   | $ | 67,873 |   | 121,741 |   | $ | 0.56 |   |

 

Antidilutiveoptions, awards and units excluded from the computation of diluted earnings pershare were 311,207 and 314,961 for the six months ended June 30, 2006 and 2005,respectively and 581,790 and 468,483 for the second quarter of 2006 and 2005,respectively.

8

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4.  Investment Securities

AtJune 30, 2006 and December 31, 2005, securities with an amortized cost of $1.4billion and $1.3 billion, respectively, were pledged as collateral forrepurchase transactions and certain deposits as required by regulatoryguidelines.  The following table showsthe amortized cost and fair value of investment securities at June 30, 2006 andDecember 31, 2005.

 
| ** **                                | ** ** | **June 30, 2006** | ** **    | **December 31, 2005** | ** ** |
|-------------------------------------------|------------|-----------------------------|---------------|---------------------------------|------------|
| **(Dollars in thousands)**      | ** ** | **Amortized  Cost**         | ** **    | **Gross  Unrealized  Gains**    | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
| Investment securities  held-to-maturity   |       |                        |          |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| States and political subdivisions         | ** ** | **$**                       | **15,532**    | ** **                      | **$**      | **366** | ** ** | **$** | **27** | ** ** | **$** | **15,871** |   | $ | 16,659 |   | $ | 541 |   | $ | 19 |   | $ | 17,181 |   |
| * *                                  | * *   | * *                    | * *      | * *                        | * *   | * * | * * | * * | * * | * * | * * | * * | * * | * * | * * | * * | * * |
| Investment securities  available-for-sale |       |                        |          |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury                             | ** ** | **$**                       | **439,856**   | ** **                      | **$**      | **—** | ** ** | **$** | **4,923** | ** ** | **$** | **434,933** |   | $ | 434,893 |   | $ | 223 |   | $ | 3,080 |   | $ | 432,036 |   |
| U.S. Government agencies                  | ** ** | **995,392**                 | ** **    | **—**                      | ** ** | **14,670** | ** ** | **980,722** |   | 992,040 |   | 29 |   | 12,761 |   | 979,308 |   |
| Mortgage-backed securities                | ** ** | **1,623,647**               | ** **    | **346**                         | ** ** | **58,014** | ** ** | **1,565,979** |   | 1,581,845 |   | 685 |   | 38,269 |   | 1,544,261 |   |
| States and political subdivisions         | ** ** | **63,670**                  | ** **    | **45**                          | ** ** | **472** | ** ** | **63,243** |   | 70,017 |   | 306 |   | 188 |   | 70,135 |   |
| Other bonds, notes and debentures         | ** ** | **16,137**                  | ** **    | **—**                      | ** ** | **263** | ** ** | **15,874** |   | 19,083 |   | — |   | 215 |   | 18,868 |   |
| Total bonds                               | ** ** | **3,138,702**               | ** **    | **391**                         | ** ** | **78,342** | ** ** | **3,060,751** |   | 3,097,878 |   | 1,243 |   | 54,513 |   | 3,044,608 |   |
| Other  investments                        | ** ** | **49,321**                  | ** **    | **1,076**                       | ** ** | **1,440** | ** ** | **48,957** |   | 43,980 |   | 1,236 |   | 196 |   | 45,020 |   |
| Total                                     | ** ** | **$**                       | **3,188,023** | ** **                      | **$**      | **1,467** | ** ** | **$** | **79,782** | ** ** | **$** | **3,109,708** |   | $ | 3,141,858 |   | $ | 2,479 |   | $ | 54,709 |   | $ | 3,089,628 |   |

 

The following table shows the unrealized gross losses and fair value ofsecurities in the securities available-for-sale portfolio at June 30, 2006, bylength of time that individual securities in each category have been in acontinuous loss position.
| ** **                           | ** ** | **Less than 12 Months** | ** ** | **12 months or more** | ** ** | **Total**                     | ** ** |
|--------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|-------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **Gross  Unrealized  Losses**          | ** ** | **Fair  Value**                      | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
| U.S. Treasury                        |       | $                                      | 2,715      |                                 | $          | 321,877                       |       | $ | 2,208 |   | $ | 113,056 |   | $ | 4,923 |   | $ | 434,933 |   |
| U.S. Government  agencies            |       | 5,086                                  |       | 473,034                              |       | 9,584                         |       | 507,688 |   | 14,670 |   | 980,722 |   |
| Mortgage-backed  securities          |       | 17,330                                 |       | 798,954                              |       | 40,684                        |       | 767,025 |   | 58,014 |   | 1,565,979 |   |
| States and  political subdivisions   |       | 431                                    |       | 59,197                               |       | 41                            |       | 4,046 |   | 472 |   | 63,243 |   |
| Other bonds,  notes and debentures   |       | 87                                     |       | 6,751                                |       | 176                           |       | 9,123 |   | 263 |   | 15,874 |   |
| Total bonds                          |       | 25,649                                 |       | 1,659,813                            |       | 52,693                        |       | 1,400,938 |   | 78,342 |   | 3,060,751 |   |
| Other  investments                   |       | 1,440                                  |       | 48,957                               |       | —                        |       | — |   | 1,440 |   | 48,957 |   |
| Total                                |       | $                                      | 27,089     |                                 | $          | 1,708,770                     |       | $ | 52,693 |   | $ | 1,400,938 |   | $ | 79,782 |   | $ | 3,109,708 |   |

 

AtJune 30, 2006, there were $1.4 billion of individual securities that hadunrealized losses for a period greater than 12 months.  At June 30, 2006, these securities had anunrealized loss of $52.7 million of which 54.7% were mortgage-backedsecurities. Management has assessed the impairment of these securities anddetermined that the impairment is temporary. All principal and interest payments on available-for-sale debtsecurities in an unrealized loss position for greater than 12 months areexpected to be collected given the high credit quality of the U.S. governmentagency debt securities and Bankshares’ ability and intent to hold thesecurities until the value recovers or they mature.

9

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# 5.  Allowance for Loan Losses and Reserve forUnfunded Commitments

Duringthe first quarter of 2006, Bankshares refined the model used for determiningcertain components of the allowance for loan losses. The model refinement didnot have a material impact on Bankshares’ recorded allowance for loan losses.Additionally, Bankshares reclassified a portion of the allowance for loanlosses to a reserve for unfunded lending commitments reflected in otherliabilities in the consolidated balance sheet.** **As a result of the refinement ofthe modeling process for the allowance for loan losses, Bankshares was ablespecifically to identify risk inherent in unfunded commitments and make thereclassification noted above.  As nomodel data existed for previous years, prior period data has not beenreclassified for comparability.

# The allowance for loanlosses and reserve for unfunded commitments is presented below.

| ** **                                    | ** ** | **For the 6 months ended June 30,** | ** **  | **For the 3 months ended June 30,** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------------------------|-------------|-------------------------------------------------------------------|------------|
| **(Dollars in thousands)**          | ** ** | **2006**                                                          | ** **  | **2005**                                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Allowance for Loan Losses**                 | ** ** | ** **                                                        | ** **  | ** **                                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance,  beginning of period                 | ** ** | **$**                                                             | **156,673** |                                                              | $          | 149,002 | ** ** | **$** | **141,874** |   | $ | 149,017 |   |
| Allowance of  acquired bank                   | ** ** | **—**                                                        |        | 7,086                                                             | ** ** | **—** |   | 7,086 |   |
| Provision for  credit losses                  | ** ** | **(990**                                                          | **)**       | 756                                                               | ** ** | **—** |   | — |   |
| Transfer to  reserve for unfunded commitments | ** ** | **(13,968**                                                       | **)**       | —                                                            | ** ** | **—** |   | — |   |
| Total                                         | ** ** | **141,715**                                                       |        | 156,844                                                           | ** ** | **141,874** |   | 156,103 |   |
| Charge-offs                                   | ** ** | **(2,228**                                                        | **)**       | (3,115                                                            | )          | **(850** | **)** | (1,173 | ) |
| Recoveries                                    | ** ** | **3,373**                                                         |        | 3,372                                                             | ** ** | **1,836** |   | 2,171 |   |
| Net recoveries (charge-offs)                  | ** ** | **1,145**                                                         |        | 257                                                               | ** ** | **986** |   | 998 |   |
| Balance, end of  period                       | ** ** | **$**                                                             | **142,860** |                                                              | $          | 157,101 | ** ** | **$** | **142,860** |   | $ | 157,101 |   |
|                                          |       |                                                              |        |                                                              |       |   |   |   |   |
| **Reserve for Unfunded  Commitments**         | ** ** | ** **                                                        | ** **  | ** **                                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance,  beginning of period                 | ** ** | **$**                                                             | **—**  |                                                              | $          | — | ** ** | **$** | **14,958** |   | $ | — |   |
| Provision for  credit losses                  | ** ** | **990**                                                           |        | —                                                            | ** ** | **—** |   | — |   |
| Transfer from  allowance for loan losses      | ** ** | **13,968**                                                        |        | —                                                            | ** ** | **—** |   | — |   |
| Balance, end of period                        | ** ** | **$**                                                             | **14,958**  |                                                              | $          | — | ** ** | **$** | **14,958** |   | $ | — |   |

#  

# 6.  Impaired Loans

When scheduled principal or interest payments are pastdue 90 days or more at quarter-end on any loan, the accrual of interest incomeis discontinued and subsequent receipts on these loans are recorded as areduction of principal, and interest income is recorded only once principalrecovery is reasonably assured. Previously accrued but uncollected interest on these loans is chargedagainst interest income.  Generally, aloan may be restored to accruing status when all past due principal, interestand late charges have been paid and the bank expects repayment of the remainingcontractual principal and interest on a timely basis.

Under Statements of Financial Accounting Standards(SFAS) Nos. 114 and 118, “Accounting by Creditors for Impairment of a Loan-anamendment of FASB Statements Nos. 5 and 15,” a loan is considered impaired,based on current information and events, if it is probable that Bankshares willnot collect all principal and interest payments according to the contractualterms of the loan agreement.  Theimpairment of a loan is measured based on the present value of expected futurecash flows discounted at the loan’s effective interest rate, or the fair valueof the collateral if the repayment is expected to be provided predominantly bythe underlying collateral.  Information with respect to impaired loansand the related valuation allowance (if the measure of the impaired loan isless than the recorded investment) at June 30, 2006, December 31, 2005 and June30, 2005 is shown below.  See Bankshares’Annual Report on Form 10-K for more detail.

10

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| **(Dollars in thousands)**                                             | ** ** | **June 30,  2006** | ** **  | **December 31,  2005** | ** ** | **June 30,  2005** | ** ** |
|----------------------------------------------------------------------------------|------------|-------------------------|-------------|-----------------------------|------------|-------------------------|------------|
| Impaired loans  with a specific valuation allowance                              | ** ** | **$**                   | **2,474**   |                        | $          | 11,512                  |       | $ | 16,460 |   |
| All other  impaired loans                                                        | ** ** | **25,030**              |        | 9,086                       |       | 8,746                   |       |
| Total impaired loans                                                             | ** ** | **$**                   | **27,504**  |                        | $          | 20,598                  |       | $ | 25,206 |   |
|                                                                             |       |                    |        |                        |       |                    |       |
| Specific  allowance for loan losses applicable to impaired loans                 | ** ** | **$**                   | **2,054**   |                        | $          | 4,150                   |       | $ | 10,225 |   |
| General  allowance for loan losses applicable to other than impaired loans       | ** ** | **140,806**             |        | 152,523                     |       | 146,876                 |       |
| Total allowance for loan losses                                                  | ** ** | **$**                   | **142,860** |                        | $          | 156,673                 |       | $ | 157,101 |   |
|                                                                             |       |                    |        |                        |       |                    |       |
| Year-to-date  interest income on impaired loans recorded on the cash basis       | ** ** | **$**                   | **76**      |                        | $          | 128                     |       | $ | 53 |   |
| Year-to-date  average recorded investment in impaired loans during the period    | ** ** | **$**                   | **22,448**  |                        | $          | 26,703                  |       | $ | 27,887 |   |
| Quarter-to-date  interest income on impaired loans recorded on the cash basis    | ** ** | **$**                   | **41**      |                        | $          | 14                      |       | $ | 30 |   |
| Quarter-to-date average  recorded investment in impaired loans during the period | ** ** | **$**                   | **24,133**  |                        | $          | 24,817                  |       | $ | 26,993 |   |

 

Impairedloans do not include large groups of smaller balance homogeneous loans that areevaluated collectively for impairment (e.g., residential mortgages and consumerinstallment loans).  The allowance forloan losses related to these loans is included in the general allowance forloan losses applicable to other than impaired loans.

OnMay 18, 2005, Bankshares acquired, as part of the CBNV acquisition, twocommercial real estate loans totaling $4.9 million that were within the scopeof American Institute of Certified Public Accountants issued Statement ofPosition (“SOP”) 03-3, “Accounting for Certain Loans or Debt SecuritiesAcquired in a Transfer.”  One of theloans was subsequently paid in full and the remaining loan is deemed to beimmaterial for purposes of the required disclosures.

7.  Commitments and Contingencies 

Banksharesis a party to financial instruments that are not reflected in the balancesheet, which include commitments to extend credit and standby letters ofcredit.  Various commitments to extendcredit (lines of credit) are made in the normal course of bankingbusiness.  Letters of credit are issuedfor the benefit of customers by affiliated banks.  These commitments are subject to loanunderwriting standards and geographic boundaries consistent with Bankshares’loans outstanding. Bankshares’ lending activities are concentrated in Maryland,Delaware and Virginia.

Commitmentsto extend credit are agreements to lend to a customer as long as there is noviolation of any condition established in the contract.  Commitments generally have fixed expirationdates or other termination clauses and 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 extend credit were $4.9 billion at June 30, 2006,$4.8 billion at December 31, 2005, and $4.7 billion at June 30, 2005.

Lettersof credit are commitments issued to guarantee the performance of a customer toa third party.  Outstanding letters ofcredit were $564.3 million at June 30, 2006, $540.6 million at December 31,2005 and $438.3 million at June 30, 2005. Fees received for issuing letters of credit are deferred and amortizedover the life of the commitment.  Theunamortized fees on letters of credit at June 30, 2006, December 31, 2005, andJune 30, 2005 had a carrying value of $2.9 million, $2.7 million and $2.3million, respectively.

Oneof Bankshares’ mortgage-banking subsidiaries 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 $268.5million, $249.8 million and $225.8 million at June 30, 2006, December 31, 2005and June 30, 2005, respectively.  Theloss reserve for potential losses on loans originated and sold in the secondarymarket was $84.0 thousand at June 30, 2006 and $60.7 thousand at December 31,2005.  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 $1.0 million at June 30,2006 and $1.3 million at both December 31, 2005 and June 30, 2005.  These mortgages are generally in goodstanding and are well collateralized; no loss has ensued and no future loss isexpected.

11

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Bankshareshas committed to invest funds in third-party private equity investments.  At June 30, 2006, December 31, 2005 and June30, 2005, $25.6 million, $26.6 million and $30.0 million, respectively,remained unfunded.

Inthe ordinary course of business, Bankshares and its subsidiaries are involvedin a number of pending and threatened legal actions and proceedings.  In certain of these actions and proceedings,claims for substantial monetary damages are asserted against Bankshares and itssubsidiaries.  In view of the inherentdifficulty of predicting the outcome of such matters, Bankshares cannot statewhat the eventual outcome of pending matters will be.  However, based on current knowledge, managementdoes not believe that liabilities, if any, arising from pending litigationmatters, will have a material adverse effect on the consolidated financialposition, earnings or liquidity of Bankshares. If payment associated with a claim becomes probable and the cost can bereasonably estimated, a contingent liability would be established based oninformation currently available, advice of counsel and available insurancecoverage.

8.  Goodwill and Other Intangible Assets

Goodwill,net, totaled $679.7 million at June 30, 2006 and $670.0 million at December 31,2005.  In 2005, Bankshares recorded$162.9 million in goodwill in connection with the CBNV acquisition.  In the first quarter of 2006, there was anincrease in goodwill of $8.8 million related to a payment made in contingentconsideration to the management of Boyd Watterson Asset Management as they metthe performance conditions outlined in the merger agreement.

Thefollowing table discloses the gross carrying amount and accumulatedamortization of intangible assets subject to amortization at June 30, 2006 andDecember 31, 2005.

 
| ** **                           | ** ** | **June 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|--------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **Gross  carrying  amount** | ** ** | **Accumulated  amortization**   | ** ** | **Net  amount** | ** ** | **Gross  carrying  amount** | ** ** | **Accumulated  amortization** | ** ** | **Net  amount** | ** ** |
| Core deposits                        | ** ** | **$**                       | **54,509** | ** **                      | **$**      | **(23,765** | **)** | **$** | **30,744** |   | $ | 54,509 |   | $ | (20,790 | ) | $ | 33,719 |   |
| Mortgage  servicing                  | ** ** | **3,116**                   | ** ** | **(1,258**                      | **)**      | **1,858** |   | 2,902 |   | (1,145 | ) | 1,757 |   |
| Customer lists  and other            | ** ** | **17,845**                  | ** ** | **(8,044**                      | **)**      | **9,801** |   | 17,845 |   | (6,668 | ) | 11,177 |   |
| Total                                | ** ** | **$**                       | **75,470** | ** **                      | **$**      | **(33,067** | **)** | **$** | **42,403** |   | $ | 75,256 |   | $ | (28,603 | ) | $ | 46,653 |   |

 

Inconnection with the CBNV acquisition, Bankshares recorded $4.6 million in coredeposit intangibles.  The core depositintangible from CBNV is amortized over a weighted average remaining useful lifeof nine years on a straight-line basis.

Identifiableintangible assets are amortized based on estimated lives of up to 15years.  Management reviews otherintangible assets for impairment yearly or whenever events or changes incircumstances indicate that their carrying amounts may not be recoverable.  For those intangible assets subject toamortization, impairment is indicated if the sum of undiscounted estimatedfuture net cash flows is less than the carrying amount of the asset. Impairmentis recognized by writing down the carrying value or adjusting the estimatedlife of the asset.  Any impairmentrecognized in a valuation account is reflected in the income statement in thecorresponding period.

12

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Thefollowing table shows the current period and estimated future amortizationexpense for amortized intangible assets. The projections of amortization expense shown for mortgage servicingrights are based on asset balances and the interest rate environment as of June30, 2006.  Future amortization expensemay be significantly different depending upon changes in the mortgage-servicingportfolio, mortgage interest rates and market conditions.

 
| **(Dollars in thousands)**               | ** ** | ** ** | ** ** | **Core  Deposits** | ** ** | **Mortgage  Servicing** | ** ** | **Customer Lists  and Other** | ** ** | **Total** | ** ** |
|----------------------------------------------------|------------|------------|------------|--------------------|------------|-------------------------|------------|-----------------------------------------|------------|-----------|------------|
| Six months ended  June 30, 2006 (actual)           | ** ** | ** ** | ** ** | **$**              | **2,975**  | ** **              | **$**      | **180**                                 | ** ** | **$**     | **1,387**  | ** ** | **$** | **4,542** | ** ** |
| Six months ended  December 31, 2006 (estimated)    |       |       |       | 2,975              |       | 140                     |       | 1,231                                   |       | 4,346     |       |
| Twelve months  ended December 31, 2006 (estimated) |       |       |       | $                  | 5,950      |                    | $          | 320                                     |       | $         | 2,618      |   | $ | 8,888 |   |
|                                               |       |       |       |               |       |                    |       |                                    |       |      |       |
| Estimate for  years ended December 31,             |       |       |       |               |       |                    |       |                                    |       |      |       |
|                                               |       | 2007       |       | $                  | 5,747      |                    | $          | 274                                     |       | $         | 2,533      |   | $ | 8,554 |   |
|                                               |       | 2008       |       | 4,653              |       | 257                     |       | 1,637                                   |       | 6,547     |       |
|                                               |       | 2009       |       | 4,502              |       | 257                     |       | 641                                     |       | 5,400     |       |
|                                               |       | 2010       |       | 4,502              |       | 236                     |       | 505                                     |       | 5,243     |       |

 

9.  Comprehensive Income

Thefollowing table summarizes the market value change and related tax effect ofunrealized gains (losses) on securities available-for-sale for the six monthsand three months ended June 30, 2006 and 2005, respectively.  Total comprehensive income is included in theStatements of Changes in Consolidated Shareholders’ Equity.
| ** **                                                             | ** ** | **For the 6 months ended June 30,** | ** ** |
|------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                             | ** ** | **2006**                                                          | ** ** | **2005** | ** ** |
| **(Dollars in  thousands)**                                            | ** ** | **Pretax  Amount**                                                | ** ** | **Tax  (Expense)  Benefit** | ** ** | **Net   Amount** | ** ** | **Pretax  Amount** | ** ** | **Tax  (Expense)  Benefit** | ** ** | **Net  Amount** | ** ** |
| Net Income                                                             | ** ** | ** **                                                        |       |   |   | **$** | **143,851** |   |   |   |   |   | $ | 130,500 |   |
| Other comprehensive income                                             |       |                                                              |       |   |   |   |   |   |   |   |   |   |   |
| Unrealized holding gains (losses) arising during the  period           |       | **(26,097**                                                       | **)**      | **9,731** |   | **(16,366** | **)** | (12,477 | ) | 4,775 |   | (7,702 | ) |
| Reclassification adjustment for (gains) losses  included in net income |       | **13**                                                            |       | **(5** | **)** | **8** |   | (490 | ) | 194 |   | (296 | ) |
| Total other comprehensive income                                       | ** ** | **(26,084**                                                       | **)**      | **9,726** | ** ** | **(16,358** | **)** | (12,967 | ) | 4,969 |   | (7,998 | ) |
| Total comprehensive  income                                            | ** ** | ** **                                                        |       |   |   | **$** | **127,493** |   |   |   |   |   | $ | 122,502 |   |

 

 
| ** **                                                             | ** ** | **For the 3 months ended June 30,** | ** ** |
|------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                             | ** ** | **2006**                                                          | ** ** | **2005** | ** ** |
| **(Dollars in  thousands)**                                            | ** ** | **Pretax  Amount**                                                | ** ** | **Tax  (Expense)  Benefit** | ** ** | **Net   Amount** | ** ** | **Pretax  Amount** | ** ** | **Tax  (Expense)  Benefit** | ** ** | **Net  Amount** | ** ** |
| Net Income                                                             | ** ** | ** **                                                        |       |   |   | **$** | **73,092** |   |   |   |   |   | $ | 67,873 |   |
| Other comprehensive  income                                            |       |                                                              |       |   |   |   |   |   |   |   |   |   |   |
| Unrealized holding gains (losses) arising during the  period           |       | **(11,265**                                                       | **)**      | **4,192** |   | **(7,073** | **)** | (19,744 | ) | (7,256 | ) | 12,488 |   |
| Reclassification adjustment for (gains) losses  included in net income |       | **—**                                                        |       | **—** |   | **—** |   | (76 | ) | 30 |   | (46 | ) |
| Total other comprehensive income                                       | ** ** | **(11,265**                                                       | **)**      | **4,192** | ** ** | **(7,073** | **)** | (19,668 | ) | (7,226 | ) | 12,442 |   |
| Total comprehensive  income                                            | ** ** | ** **                                                        |       |   |   | **$** | **66,019** |   |   |   |   |   | $ | 80,315 |   |

 

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10.  Capital Adequacy

Banksharesand its bank affiliates are subject to various regulatory capital adequacyrequirements administered by federal and state banking agencies.  These requirements include maintainingcertain capital ratios above minimum levels. These capital ratios include Tier I Capital and Total Risk-Based Capitalas percentages of net risk-weighted assets and Tier I Capital as a percentageof 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 mustmaintain minimum ratios of 6.00%, 10.00% and 5.00%, for its Tier I Capital,Total Capital and Leverage Ratios, respectively.  As of June 30, 2006, Bankshares and each ofits bank affiliates exceeded all capital adequacy requirements to be consideredwell capitalized.

Actualcapital amounts and ratios are presented in the following table for Banksharesand its affiliates.

 
| **June 30, 2006  (Dollars in thousands)** | ** ** | **Tier I  Capital** | ** **    | **Total  Risk-Based  Capital** | ** ** | **Net  Risk-Weighted  Assets** | ** ** | **Adjusted  Average  Total Assets** | ** **     | **Tier I  Capital  Ratio** | ** ** | **Total  Capital  Ratio** | ** ** | **Leverage  Ratio** | ** ** |
|---------------------------------------------------------------|------------|--------------------------|---------------|--------------------------------|------------|--------------------------------|------------|------------------------------------------|----------------|---------------------------------|------------|---------------------------|------------|---------------------|------------|
| **Bankshares**                                                | ** ** | **$**                    | **1,597,978** | ** **                     | **$**      | **2,049,782**                  | ** ** | **$**                                    | **13,346,820** | ** **                      | **$**      | **16,000,332**            | ** ** | **11.97**           | **%**      | **15.36** | **%** | **9.99** | **%** |
| Annapolis Banking &  Trust                                |       | 43,962                   |          | 51,224                         |       | 340,939                        |       | 478,732                                  |           | 12.89                           |       | 15.02                     |       | 9.18                |       |
| Citizens National Bank                                        |       | 107,036                  |          | 154,814                        |       | 1,176,819                      |       | 1,324,604                                |           | 9.10                            |       | 13.16                     |       | 8.08                |       |
| Farmers & Mechanics  Bank                                 |       | 166,507                  |          | 227,647                        |       | 1,356,200                      |       | 1,695,357                                |           | 12.28                           |       | 16.79                     |       | 9.82                |       |
| Marshall National Bank  & Trust                           |       | 13,587                   |          | 20,021                         |       | 138,278                        |       | 181,032                                  |           | 9.83                            |       | 14.48                     |       | 7.51                |       |
| Mercantile County Bank                                        |       | 81,471                   |          | 118,289                        |       | 732,072                        |       | 941,815                                  |           | 11.13                           |       | 16.16                     |       | 8.65                |       |
| Mercantile Eastern Shore  Bank                                |       | 54,074                   |          | 85,376                         |       | 471,352                        |       | 602,238                                  |           | 11.47                           |       | 18.11                     |       | 8.98                |       |
| Mercantile Peninsula Bank                                     |       | 148,022                  |          | 219,360                        |       | 1,396,872                      |       | 1,763,519                                |           | 10.60                           |       | 15.70                     |       | 8.39                |       |
| Mercantile-Safe Deposit  & Trust Company                  |       | 542,958                  |          | 661,045                        |       | 6,053,819                      |       | 7,167,270                                |           | 8.97                            |       | 10.92                     |       | 7.58                |       |
| Mercantile Southern  Maryland Bank                            |       | 95,251                   |          | 132,077                        |       | 679,647                        |       | 980,757                                  |           | 14.01                           |       | 19.43                     |       | 9.71                |       |
| National Bank of  Fredericksburg                              |       | 38,737                   |          | 49,492                         |       | 384,705                        |       | 473,753                                  |           | 10.07                           |       | 12.86                     |       | 8.18                |       |
| Westminster Union Bank                                        |       | 69,578                   |          | 100,048                        |       | 520,477                        |       | 820,147                                  |           | 13.37                           |       | 19.22                     |       | 8.48                |       |
|                                                               |            |                          |               |                                |            |                                |            |                                          |                |                                 |            |                           |            |                     |            |  |  |  |  |

 
| **December 31, 2005  (Dollars in thousands)** | ** ** | **Tier I  Capital** | ** ** | **Total  Risk-Based  Capital** | ** ** | **Net  Risk-Weighted  Assets** | ** ** | **Adjusted  Average  Total Assets** | ** ** | **Tier I  Capital  Ratio** | ** ** | **Total  Capital  Ratio** | ** ** | **Leverage  Ratio** | ** ** |
|-------------------------------------------------------------------|------------|--------------------------|------------|--------------------------------|------------|--------------------------------|------------|------------------------------------------|------------|---------------------------------|------------|---------------------------|------------|---------------------|------------|
| Bankshares                                                        |       | $                        | 1,518,454  |                           | $          | 1,975,313                      |       | $                                        | 12,848,926 |                            | $          | 15,471,385                |       | 11.82               | %          | 15.37 | % | 9.81 | % |
| Annapolis Banking &  Trust                                    |       | 43,148                   |       | 50,382                         |       | 331,167                        |       | 484,567                                  |       | 13.03                           |       | 15.21                     |       | 8.90                |       |
| Citizens National Bank                                            |       | 103,600                  |       | 151,903                        |       | 1,139,217                      |       | 1,281,737                                |       | 9.09                            |       | 13.33                     |       | 8.08                |       |
| Farmers & Mechanics  Bank                                     |       | 164,489                  |       | 225,553                        |       | 1,341,615                      |       | 1,700,721                                |       | 12.26                           |       | 16.81                     |       | 9.67                |       |
| Marshall National Bank  & Trust                               |       | 12,661                   |       | 19,235                         |       | 132,110                        |       | 164,212                                  |       | 9.58                            |       | 14.56                     |       | 7.71                |       |
| Mercantile County Bank                                            |       | 77,489                   |       | 116,005                        |       | 728,884                        |       | 916,864                                  |       | 10.63                           |       | 15.92                     |       | 8.45                |       |
| Mercantile Eastern Shore  Bank                                    |       | 52,538                   |       | 83,614                         |       | 451,831                        |       | 575,426                                  |       | 11.63                           |       | 18.51                     |       | 9.13                |       |
| Mercantile Peninsula Bank                                         |       | 141,149                  |       | 214,251                        |       | 1,336,315                      |       | 1,677,958                                |       | 10.56                           |       | 16.03                     |       | 8.41                |       |
| Mercantile-Safe Deposit  & Trust Company                      |       | 509,252                  |       | 624,036                        |       | 5,795,437                      |       | 6,721,535                                |       | 8.79                            |       | 10.77                     |       | 7.58                |       |
| Mercantile Southern  Maryland Bank                                |       | 94,717                   |       | 131,461                        |       | 620,898                        |       | 954,636                                  |       | 15.25                           |       | 21.17                     |       | 9.92                |       |
| National Bank of  Fredericksburg                                  |       | 37,081                   |       | 48,169                         |       | 353,718                        |       | 455,590                                  |       | 10.48                           |       | 13.62                     |       | 8.14                |       |
| Westminster Union Bank                                            |       | 66,961                   |       | 98,053                         |       | 509,424                        |       | 810,677                                  |       | 13.14                           |       | 19.25                     |       | 8.26                |       |
|                                                                   |            |                          |            |                                |            |                                |            |                                          |            |                                 |            |                           |            |                     |            |  |  |  |  |

 

Bankshareshas an ongoing share repurchase program. Purchases may be made from time to time, subject to regulatoryrequirements, in open market or in privately negotiated transactions.  Purchased shares are retired.  During the six months ended June 30, 2006,Bankshares purchased 37,252 shares in net settlement of the minimum taxliability for vested restricted stock. On June 13, 2006, Bankshares’ Board of Directors authorized therepurchase of an additional 2,000,000 shares to the 677,000 shares remaining froma previously announced program.  At June30, 2006, there were approximately 2.68 million shares remaining available forrepurchase under the program.

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11.  Segment Reporting

Operatingsegments as defined by SFAS No. 131, “Disclosures about Segments of anEnterprise and Related Information,” are components of an enterprise withseparate financial information.  Thecomponent engages in business activities from which it derives revenues andincurs expenses and the operating results of which management relies on fordecision-making and performance assessment. Bankshares has two reportablesegments — Banking and Investment and Wealth Management (“IWM”).  The Banking segment is comprised of 11affiliate banks.  During 2005, thePrivate Bank Group of Mercantile-Safe Deposit and Trust Company wasconsolidated into the Private Banking Group of IWM.  The segment results havebeen reclassified to conform to current presentation for comparability.  Additionally, as loans and deposits are nowbeing reflected in the IWM segment, a funds transfer-pricing model was utilizedto match the duration of the funding and investment of the IWM segment assetsand liabilities.

Thetables below present selected segment information for the six and three monthsended June 30, 2006 and 2005.  Thecomponents in the “Other” column consist of amounts for the nonbank affiliates,unallocated corporate expenses, including income taxes, and intercompanyeliminations.  Certain expense amountssuch as operations overhead were reclassified from internal financial reportingin order to provide for full cost absorption. These reclassifications are shown in the “Adjustments” line.

 
| ** **                         | ** ** | **For the 6 months ended June 30, 2006** | ** **     | **For the 6 months ended June 30, 2005** | ** ** |
|------------------------------------|------------|-----------------------------------------------------------------------------|----------------|-----------------------------------------------------------------------------|------------|
| **(Dollars in thousands)**    | ** ** | **Banking**                                                                 | ** **     | **IWM**                                                                     | ** ** | **Other** | ** ** | **Total** | ** ** | **Banking** | ** ** | **IWM** | ** ** | **Other** | ** ** | **Total** | ** ** |
| Net interest income                | ** ** | **$**                                                                       | **313,993**    | ** **                                                                  | **$**      | **5,942** | ** ** | **$** | **(212** | **)** | **$** | **319,723** |   | $ | 291,444 |   | $ | 4,222 |   | $ | (216 | ) | $ | 295,450 |   |
| Provision for credit losses        | ** ** | **—**                                                                  | ** **     | **—**                                                                  | ** ** | **—** | ** ** | **—** |   | (756 | ) | — |   | — |   | (756 | ) |
| Noninterest income                 | ** ** | **60,857**                                                                  | ** **     | **55,200**                                                                  | ** ** | **9,017** | ** ** | **125,074** |   | 62,479 |   | 47,841 |   | 7,615 |   | 117,935 |   |
| Noninterest expenses               | ** ** | **(171,169**                                                                | **)**          | **(43,564**                                                                 | **)**      | **(1,404** | **)** | **(216,137** | **)** | (164,104 | ) | (35,823 | ) | (4,139 | ) | (204,066 | ) |
| Adjustments                        | ** ** | **10,916**                                                                  | ** **     | **(421**                                                                    | **)**      | **(10,495** | **)** | **—** |   | 7,965 |   | (2,411 | ) | (5,554 | ) | — |   |
| Income (loss) before income  taxes | ** ** | **214,597**                                                                 | ** **     | **17,157**                                                                  | ** ** | **(3,094** | **)** | **228,660** |   | 197,028 |   | 13,829 |   | (2,294 | ) | 208,563 |   |
| Income tax expense                 | ** ** | **(75,713**                                                                 | **)**          | **(6,863**                                                                  | **)**      | **(2,233** | **)** | **(84,809** | **)** | (68,820 | ) | (5,532 | ) | (3,711 | ) | (78,063 | ) |
| Net income (loss)                  | ** ** | **$**                                                                       | **138,884**    | ** **                                                                  | **$**      | **10,294** | ** ** | **$** | **(5,327** | **)** | **$** | **143,851** |   | $ | 128,208 |   | $ | 8,297 |   | $ | (6,005 | ) | $ | 130,500 |   |
|                               | ** ** | ** **                                                                  | ** **     | ** **                                                                  | ** ** | ** ** | ** ** | ** ** |   |   |   |   |   |   |   |   |   |
| Average loans                      | ** ** | **$**                                                                       | **11,605,636** | ** **                                                                  | **$**      | **179,004** | ** ** | **$** | **341** | ** ** | **$** | **11,784,981** |   | $ | 10,463,869 |   | $ | 144,160 |   | $ | 399 |   | $ | 10,608,428 |   |
| Average earning assets             | ** ** | **14,917,768**                                                              | ** **     | **179,004**                                                                 | ** ** | **(57,014** | **)** | **15,039,758** |   | 13,372,528 |   | 144,160 |   | 16,125 |   | 13,532,813 |   |
| Average assets                     | ** ** | **16,365,303**                                                              | ** **     | **179,558**                                                                 | ** ** | **73,609** | ** ** | **16,618,470** |   | 14,573,533 |   | 144,476 |   | 154,924 |   | 14,872,933 |   |
| Average deposits                   | ** ** | **12,097,362**                                                              | ** **     | **293,583**                                                                 | ** ** | **(324,681** | **)** | **12,066,264** |   | 10,997,963 |   | 190,503 |   | (190,934 | ) | 10,997,532 |   |
| Average equity                     | ** ** | **2,019,791**                                                               | ** **     | **37,321**                                                                  | ** ** | **228,417** | ** ** | **2,285,529** |   | 1,818,552 |   | 33,504 |   | 144,388 |   | 1,996,444 |   |

 
| ** **                           | ** ** | **For the 3 months ended June 30, 2006** | ** **     | **For the 3 months ended June 30, 2005** | ** ** |
|--------------------------------------|------------|-----------------------------------------------------------------------------|----------------|-----------------------------------------------------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **Banking**                                                                 | ** **     | **IWM**                                                                     | ** ** | **Other** | ** ** | **Total** | ** ** | **Banking** | ** ** | **IWM** | ** ** | **Other** | ** ** | **Total** | ** ** |
| Net interest income                  | ** ** | **$**                                                                       | **158,099**    | ** **                                                                  | **$**      | **3,370** | ** ** | **$** | **(59** | **)** | **$** | **161,410** |   | $ | 150,336 |   | $ | 2,236 |   | $ | (205 | ) | $ | 152,367 |   |
| Provision for credit losses          | ** ** | **—**                                                                  | ** **     | **—**                                                                  | ** ** | **—** | ** ** | **—** |   | — |   | — |   | — |   | — |   |
| Noninterest income                   | ** ** | **30,791**                                                                  | ** **     | **29,006**                                                                  | ** ** | **4,671** | ** ** | **64,468** |   | 32,988 |   | 23,528 |   | 3,550 |   | 60,066 |   |
| Noninterest expenses                 | ** ** | **(85,897**                                                                 | **)**          | **(22,045**                                                                 | **)**      | **(1,480** | **)** | **(109,422** | **)** | (83,653 | ) | (18,977 | ) | (1,283 | ) | (103,913 | ) |
| Adjustments                          | ** ** | **5,810**                                                                   | ** **     | **(164**                                                                    | **)**      | **(5,646** | **)** | **—** |   | 4,429 |   | (742 | ) | (3,687 | ) | — |   |
| Income (loss) before income  taxes   | ** ** | **108,803**                                                                 | ** **     | **10,167**                                                                  | ** ** | **(2,514** | **)** | **116,456** |   | 104,100 |   | 6,045 |   | (1,625 | ) | 108,520 |   |
| Income tax expense                   | ** ** | **(38,598**                                                                 | **)**          | **(4,067**                                                                  | **)**      | **(699** | **)** | **(43,364** | **)** | (36,532 | ) | (2,419 | ) | (1,696 | ) | (40,647 | ) |
| Net income (loss)                    | ** ** | **$**                                                                       | **70,205**     | ** **                                                                  | **$**      | **6,100** | ** ** | **$** | **(3,213** | **)** | **$** | **73,092** |   | $ | 67,568 |   | $ | 3,626 |   | $ | (3,321 | ) | $ | 67,873 |   |
|                                 | ** ** | ** **                                                                  | ** **     | ** **                                                                  | ** ** | ** ** | ** ** | ** ** |   |   |   |   |   |   |   |   |   |
| Average loans                        | ** ** | **$**                                                                       | **11,739,031** | ** **                                                                  | **$**      | **182,202** | ** ** | **$** | **307** | ** ** | **$** | **11,921,540** |   | $ | 10,751,944 |   | $ | 146,944 |   | $ | 375 |   | $ | 10,899,263 |   |
| Average earning assets               | ** ** | **15,085,461**                                                              | ** **     | **182,202**                                                                 | ** ** | **(70,667** | **)** | **15,196,996** |   | 13,683,513 |   | 146,944 |   | 10,534 |   | 13,840,991 |   |
| Average assets                       | ** ** | **16,556,117**                                                              | ** **     | **182,808**                                                                 | ** ** | **60,047** | ** ** | **16,798,972** |   | 14,936,074 |   | 147,288 |   | 150,209 |   | 15,233,571 |   |
| Average deposits                     | ** ** | **12,209,522**                                                              | ** **     | **316,777**                                                                 | ** ** | **(336,106** | **)** | **12,190,193** |   | 11,280,789 |   | 189,692 |   | (197,261 | ) | 11,273,220 |   |
| Average equity                       | ** ** | **2,034,960**                                                               | ** **     | **37,877**                                                                  | ** ** | **236,312** | ** ** | **2,309,149** |   | 1,864,138 |   | 33,875 |   | 144,091 |   | 2,042,104 |   |

 

15

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12.  Derivative Instruments and Hedging Activities

SFASNo. 133, “Accounting for Derivative Instruments and Hedging Activitie*s*”,**SFAS No. 138, “Accountingfor Certain Derivative Instruments and Certain Hedging Activities — anamendment to FASB Statement No. 133,”**and SFAS No.149, “Amendment of Statement No. 133 on Derivative Instruments and HedgingActivities”*(*collectively referred to as “derivatives”),establish accounting and reporting standards for derivative instruments and forhedging activities.  Bankshares maintainsan overall interest rate risk management strategy that incorporates the use ofderivative instruments to minimize significant unplanned fluctuations inearnings that are caused by interest rate volatility.  Currently, derivative instruments that areused as part of the interest rate risk management strategy have been restrictedto interest rate swaps.  Interest rateswaps generally involve the exchange of fixed-rate and variable-rate interestpayments between two parties, based on a common notional principal amount andmaturity date.  At June 30, 2006,Bankshares had interest rate swaps to convert a portion of its nonprepayablefixed-rate debt to floating-rate debt. Bankshares also arranges interest rate swaps, caps and swaptions forcommercial loan customers through its Capital Markets Group.  Derivative transactions executed with loancustomers are hedged by means of an offsetting derivative trade with a thirdparty.  In this way, Bankshares managesthe market risk arising from capital markets-related derivative activity.

Thefair value of derivative instruments is based on swap and optionvaluations.  The swap value is estimatedby using pricing models that incorporate quoted market prices for swap rates andfutures contracts and assumes all counterparties have the same creditrating.  The option valuation isestimated by using standard market models (such as the modified Black-Scholesmodel on interest rate options), incorporating quoted market prices andvolatilities.  The fair value ofderivative instruments related to customer accommodations recorded in otherassets was $12.1 million (notional $398.4 million) and $5.3 million (notional$345.5 million) at June 30, 2006 and December 31, 2005, respectively.  The fair value of derivative instrumentsrelating to hedges and customer accommodations recorded in other liabilitieswas $30.9 million (notional $690.8 million) and $12.3 million (notional $609.1million) at June 30, 2006 and December 31, 2005, respectively.

Changesin the fair value of a derivative that is designated and qualifies as a fairvalue hedge, along with the gain or loss on the hedged asset or liability thatis attributable to the hedged risk are recorded as other noninterest income inthe results of operations.  For all hedgerelationships, ineffectiveness resulting from differences between the changesin fair values or cash flows of the hedged item and changes in fair value ofthe derivative are recognized as other noninterest income in the results ofoperations.  The net interest settlementon derivatives designated as fair value or cash flow hedges is treated as anadjustment of the interest income or interest expense of the hedged assets orliabilities.  The fair-value hedges ofnonprepayable fixed-rate debt were effective for the reported periods andqualified for short-cut hedge accounting treatment.  The impact of the hedges increased interestexpense $441 thousand in the first six months of 2006 as compared with adecrease of $2.8 million for the same period in 2005.

Thefollowing tables summarize the gross position of derivatives relating tohedging activities at June 30, 2006 and December 31, 2005.
| ** **                           | ** ** | **June 30, 2006**                    | ** **  | **December 31, 2005**   | ** ** |
|--------------------------------------|------------|-------------------------------------------|-------------|-----------------------------------|------------|
| **(Dollars in  thousands)**          | ** ** | **Notional or  Contractual  Amount** | ** **  | **Credit  Risk  Amount (1)** | ** ** | **Estimated  Net  Fair Value** | ** ** | **Notional or  Contractual  Amount** | ** ** | **Credit  Risk  Amount (1)** | ** ** | **Estimated  Net  Fair Value** | ** ** |
| *Asset/Liability  Management Hedges* |       |                                      |        |                              |       |   |   |   |   |   |   |   |   |
| Interest Rate  Contracts:            |       |                                      |        |                              |       |   |   |   |   |   |   |   |   |
| Swaps                                | ** ** | **$**                                     | **350,000** | ** **                        | **$**      | **—** | ** ** | **$** | **(23,573** | **)** | $ | 350,000 |   | $ | — |   | $ | (10,349 | ) |
|                                 |       |                                      |        |                              |       |   |   |   |   |   |   |   |   |
| *Customer  Accommodations*           | * *   | * *                                  | * *    | * *                          | * *   | * * | * * | * * | * * | * * | * * | * * | * * |
| Interest Rate  Contracts:            |       |                                      |        |                              |       |   |   |   |   |   |   |   |   |
| Swaps                                | ** ** | **$**                                     | **727,602** | ** **                        | **$**      | **12,136** | ** ** | **$** | **4,400** |   | $ | 592,934 |   | $ | 5,327 |   | $ | 3,462 |   |
| Swaptions/Caps Purchased             | ** ** | **5,787**                                 | ** **  | **62**                            | ** ** | **62** |   | 5,850 |   | 57 |   | 57 |   |
| Swaptions/Caps  Sold                 | ** ** | **5,787**                                 | ** **  | **—**                        | ** ** | **(62** | **)** | 5,850 |   | — |   | (57 | ) |

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(1)             Creditrisk amounts reflect the replacement cost for those contracts in a gainposition in the event of nonperformance by all counterparties.

16

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Mortgageloans held-for-sale have inherent forward contract (agreements to sell orpurchase loans at a specific rate or yield) characteristics.  Risk may arise from the corresponding parties’inability to meet the terms of their contracts and from movements in interestrates.  Bankshares has forward commitmentsto sell individual fixed-rate and variable-rate mortgage loans that are on itsbalance sheet at fair value or are approved, but not yet funded.  The fair value of the forward contracts was$6.4 million at June 30, 2006 and $0.2 million at December 31, 2005.

13.  Stock-based Compensation Expense

Banksharesadopted SFAS No. 123(R), “Share-Based Payment,” effective January 1, 2006 underthe modified version of prospective application.  The following disclosures are providedpursuant to the requirements of SFAS 123(R).

UnderSFAS 123(R), awards granted to retirement eligible employees are expensedimmediately.  Under Bankshares’ OmnibusStock Plan, retirement eligible is defined as employees reaching normalretirement at age 65.  As a practice,Bankshares has not granted awards to retirement eligible employees.  As of June 30, 2006, there were no retirementeligible employees with outstanding awards that had not been fullyexpensed.  Prior to implementing SFAS123(R), Bankshares accrued compensation cost for share-based compensation basedon total awards granted, pursuant to SFAS 123. Any subsequent forfeitures were reversed from compensation expense whenthe performance or service requirement was not achieved.  Upon implementation of SFAS 123(R), Banksharesis estimating forfeitures upon the grant of awards and reducing the amount tobe charged to expense by this estimate.

Wesponsor several share-based plans, which are described below.  The compensation cost expensed for thoseplans was $3.3 million and $1.3 million for the quarters ended June 30, 2006and 2005, respectively, and $5.0 million and $2.7 million for the six monthsended June 30, 2006 and 2005, respectively. The total income tax benefit recognized in the income statement forshare-based compensation arrangements was $889 thousand and $178 thousand forthe quarters ended June 30, 2006 and 2005, respectively, and $1.3 million and$357 thousand for the six months ended June 30, 2006 and 2005,respectively.  At June 30, 2006,unrecognized compensation cost related to nonvested stock options, restrictedstock awards and restricted stock units (“RSUs”) totaled $22.8 million.  The cost of these nonvested awards isexpected to be recognized over a weighted average period of 2.61 years.

The1999 Omnibus Stock Plan permitted the grant of stock options and other stockincentives, including restricted stock awards and restricted stock units, tokey employees of Bankshares and its affiliates. The 1999 Plan provided for the issuance of up to 4,500,000 shares (asadjusted for the stock split) of Bankshares authorized but unissued commonstock.  The number of shares of commonstock that remained available for future grants under the Plan at June30, 2006 was 933,983 shares. Options issued as a result of mergers or acquisitions are not consideredto be part of the 1999 Omnibus Stock Plan. Options outstanding were granted at market value and included bothperformance-based and nonperformance-based options.  Options became exercisable ratably over threeor four years.  All options terminate 10years from date of grant if not exercised. The estimated forfeiture rate used to calculate the current quarter andyear-to-date compensation cost was 2.0%. Because of the historically low forfeiture rate, the impact to compensationexpense was immaterial as compared with the same periods of 2005.

On March 29, 2006, theCompensation Committee authorized the issuance of up to 317,802 performancebased restricted stock units (“Performance RSUs”) pursuant to the 2006 PerformanceStock Program.  The vesting of thePerformance RSUs will be determined based upon the percentage improvement inBankshares’ pre-tax operating income (“PTOI”) over a three-year performanceperiod (the “Performance Period”) ending December 31, 2008 (with noadjustments for acquisitions or other extraordinary events).  In addition to the performance period, theawards earned are subject to an additional one-year service requirement.  Depending on actual performance, thePerformance RSUs will vest at levels from 0% to 100%.  The estimated forfeiture rate used tocalculate the current quarter and year-to-date compensation for RSUs was33.3%.  On the same date, the Committeealso awarded 104,630 RSUs to Bankshares’ chief executive officer.  The award will vest ratably over fouryears.  The RSUs do not convert intocommon stock and will not be available for sale until the employment of thechief executive officer terminates.

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Thetable below summarizes activity related to stock options during the six monthsended June 30, 2006.

 
| ** **                  | ** ** | **Options issued  and outstanding** | ** ** | **Weighted average  exercise price** | ** ** | **Options  exercisable** | ** **    | **Weighted average  exercise price** | ** ** |
|-----------------------------|------------|-----------------------------------------------|------------|------------------------------------------------|------------|--------------------------|---------------|------------------------------------------------|------------|
| Balance,  December 31, 2005 |       | 2,659,240                                     |       | $                                              | 25.01      |                     | 1,489,397     |                                           | $          | 20.80 |   |
| Granted                     |       | 524,000                                       |       | 38.03                                          |       |                     |          |                                           |       |
| Expired/Forfeited           |       | (519                                          | )          | 13.45                                          |       |                     |          |                                           |       |
| Exercised                   |       | (60,215                                       | )          | 20.16                                          |       |                     |          |                                           |       |
| **Balance, June 30, 2006**  | ** ** | **3,122,506**                                 | ** ** | **$**                                          | **27.28**  | ** **               | **2,045,469** | ** **                                     | **$**      | **23.15** | ** ** |

 

Thetotal intrinsic value of stock options exercised during the six months endedJune 30, 2006 and 2005 was $1.1 million and $4.7 million, respectively.  Cash received from options exercised underall share-based payment arrangements for the six months ended June 30, 2006 and2005 was $0.9 million and $2.0 million, respectively.  The actual tax return benefit associated withthe tax deductions recognized in the income statement from the option exerciseof the share-based payment arrangements totaled $1.0 million for the six monthsended June 30, 2006; there was no actual tax return benefit for the six monthsended June 30, 2005.

Thefollowing table provides selected information on nonvested stock options as ofJune 30, 2006, and changes during the six months ended June 30, 2006.
| ** **                  | ** ** | **Nonvested  stock options** | ** ** | **Weighted average  grant-date   fair value** | ** ** |
|-----------------------------|------------|-----------------------------------|------------|--------------------------------------------------------------|------------|
| Balance,  December 31, 2005 |       | 1,164,825                         |       | $                                                            | 30.36      |   |
| Granted                     |       | 524,000                           |       | 38.03                                                        |       |
| Vested                      |       | (611,788                          | )          | 28.52                                                        |       |
| Forfeited                   |       | —                            |       |                                                         |       |
| **Balance, June 30, 2006**  | ** ** | **1,077,037**                     | ** ** | **$**                                                        | **35.14**  | ** ** |

 

Thefollowing table provides selected information on stock options outstanding andexercisable at June 30, 2006.
| ** **                                                                      | ** ** | **June 30, 2006** | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------------|------------|
| **(Dollars in thousands, except per share data)** | ** ** | **Outstanding**             | ** ** | **Exercisable** | ** ** |
| Number of  options                                                              | ** ** | **3,122,506**               | ** ** | **2,045,469** | ** ** |
| Weighted-average  exercise price                                                | ** ** | **$**                       | **27.28**  | ** ** | **$** | **23.15** | ** ** |
| Aggregate  intrinsic value                                                      | ** ** | **$**                       | **27,426** | ** ** | **$** | **25,614** | ** ** |
| Weighted-average  remaining contractual term, in years                          | ** ** | **7.30**                    | ** ** | **6.42** | ** ** |

 

Theweighted average grant-date fair value of options granted during the six monthsended June 30, 2006 and 2005 was $7.15 and $10.15, respectively.  The total fair value of shares vested duringthe six months ended June 30, 2006 and 2005 was $22.2 million and $16.0million, respectively.

Theweighted average fair value of options granted is estimated as of the grantdate using the Black-Scholes option-pricing model.

Thefollowing weighted average assumptions were used as inputs to the Black-Scholesmodel for grants in the six months ended June 30, 2006 and 2005, respectively:

·                  Dividendyields of 2.75% and 2.53%

·                  Volatilitiesof 20.62% and 17.24%

·                  Risk-freeinterest rates of 4.67% and 4.88%

·                  Expectedterms of 4.73 and 4.57 years

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The expected volatilityassumptions were derived by analyzing the historical price volatility of ourstock over the past five years.  Theexpected terms of options were determined by reviewing historically the  time within which a minimum of 50% of sharesgranted to an employee were exercised over the past 6 years.

Restrictedstock awards outstanding were granted at market value and vest ratably overthree years or in total at the end of a specified three-year period.  The number of restricted stock awards grantedin the six months ended June 30, 2006 and 2005 was 148,641 and 54,386,respectively.  Compensation expense isrecognized on a straight-line basis over the vesting period.  Relative to awards granted in the six monthsended June 30, 2006, 85,309 shares are subject to a one-year vesting, and54,015 vest over three years. Additionally, 9,317 shares, representing dividend equivalent sharesrelated to previous awards that vested during the current period, were awardedand vested immediately.

Thefollowing table provides selected information related to restricted stockawards and restricted stock units as of June 30, 2006, and changes during thesix months ended June 30, 2006.

 
| ** **                        | ** ** | **Restricted  Stock Awards** | ** ** | **Restricted   Stock Units** | ** ** |
|-----------------------------------|------------|-----------------------------------|------------|----------------------------------------|------------|
| Outstanding at  December 31, 2005 |       | 249,090                           |       | —                                 |       |
| Granted                           |       | 148,641                           |       | 422,432                                |       |
| Vested                            |       | (147,584                          | )          | —                                 |       |
| **Outstanding at June 30, 2006**  | ** ** | **250,147**                       | ** ** | **422,432**                            | ** ** |

 

Anotherform of stock-based compensation is phantom stock, which is used for a portionof Bankshares’ directors’ deferred compensation plan.  This plan provides for the issuance of up to667,500 shares of Bankshares’ authorized but unissued common stock.  The Plan requires all deferred fees to besettled in Bankshares’ stock.

14.  Pension & Other Postretirement BenefitPlans

Banksharessponsors qualified and nonqualified pension plans and other postretirementbenefit plans for its employees.  Thefollowing table summarizes the components of the net periodic benefit cost forthe pension plans for the six and three months ended June 30, 2006 and 2005,respectively.

 
| ** **                           | ** ** | **For the 6 months ended June 30, 2006** | ** ** | **For the 6 months ended June 30, 2005** | ** ** |
|--------------------------------------|------------|-----------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **Qualified**                                                               | ** ** | **Nonqualified**                                                            | ** ** | **Total** | ** ** | **Qualified** | ** ** | **Nonqualified** | ** ** | **Total** | ** ** |
| Service cost                         | ** ** | **$**                                                                       | **3,799**  | ** **                                                                  | **$**      | **428** | ** ** | **$** | **4,227** |   | $ | 3,660 |   | $ | 304 |   | $ | 3,964 |   |
| Interest cost                        | ** ** | **5,977**                                                                   | ** ** | **215**                                                                     | ** ** | **6,192** |   | 5,638 |   | 80 |   | 5,718 |   |
| Expected return on plan assets       | ** ** | **(8,780**                                                                  | **)**      | **—**                                                                  | ** ** | **(8,780** | **)** | (8,287 | ) | — |   | (8,287 | ) |
| Amortization of prior service cost   | ** ** | **592**                                                                     | ** ** | **15**                                                                      | ** ** | **607** |   | 585 |   | 12 |   | 597 |   |
| Recognized net actuarial loss (gain) | ** ** | **1,075**                                                                   | ** ** | **40**                                                                      | ** ** | **1,115** |   | 731 |   | (93 | ) | 638 |   |
| Amortization of transition asset     | ** ** | **—**                                                                  | ** ** | **—**                                                                  | ** ** | **—** |   | — |   | — |   | — |   |
| Net  periodic benefit cost           | ** ** | **$**                                                                       | **2,663**  | ** **                                                                  | **$**      | **698** | ** ** | **$** | **3,361** |   | $ | 2,327 |   | $ | 303 |   | $ | 2,630 |   |

 
| ** **                           | ** ** | **For the 3 months ended June 30, 2006** | ** ** | **For the 3 months ended June 30, 2005** | ** ** |
|--------------------------------------|------------|-----------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **Qualified**                                                               | ** ** | **Nonqualified**                                                            | ** ** | **Total** | ** ** | **Qualified** | ** ** | **Nonqualified** | ** ** | **Total** | ** ** |
| Service cost                         | ** ** | **$**                                                                       | **1,904**  | ** **                                                                  | **$**      | **255** | ** ** | **$** | **2,159** |   | $ | 1,882 |   | $ | 139 |   | $ | 2,021 |   |
| Interest cost                        | ** ** | **3,069**                                                                   | ** ** | **172**                                                                     | ** ** | **3,241** |   | 2,825 |   | 45 |   | 2,870 |   |
| Expected return on plan assets       | ** ** | **(4,291**                                                                  | **)**      | **—**                                                                  | ** ** | **(4,291** | **)** | (4,149 | ) | — |   | (4,149 | ) |
| Amortization of prior service cost   | ** ** | **292**                                                                     | ** ** | **15**                                                                      | ** ** | **307** |   | 285 |   | 12 |   | 297 |   |
| Recognized net actuarial loss (gain) | ** ** | **701**                                                                     | ** ** | **86**                                                                      | ** ** | **787** |   | 381 |   | (93 | ) | 288 |   |
| Amortization of transition asset     | ** ** | **—**                                                                  | ** ** | **—**                                                                  | ** ** | **—** |   | — |   | — |   | — |   |
| Net  periodic benefit cost           | ** ** | **$**                                                                       | **1,675**  | ** **                                                                  | **$**      | **528** | ** ** | **$** | **2,203** |   | $ | 1,224 |   | $ | 103 |   | $ | 1,327 |   |

 

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Thefollowing table summarizes the components of the net periodic benefit cost forthe other postretirement benefit plans for the six and three months ended June30, 2006 and 2005, respectively.

 
| ** **                           | ** ** | **For the 6 months ended June 30,** | ** ** | **For the 3 months ended June 30,** | ** ** |
|--------------------------------------|------------|-------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **2006**                                                          | ** ** | **2005**                                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Service cost                         | ** ** | **$**                                                             | **215**    |                                                              | $          | 267 | ** ** | **$** | **108** |   | $ | 134 |   |
| Interest cost                        | ** ** | **496**                                                           |       | 498                                                               | ** ** | **248** |   | 249 |   |
| Expected return on plan assets       | ** ** | **—**                                                        |       | —                                                            | ** ** | **—** |   | — |   |
| Amortization of prior service cost   | ** ** | **—**                                                        |       | —                                                            | ** ** | **—** |   | — |   |
| Recognized net actuarial loss        | ** ** | **152**                                                           |       | 176                                                               | ** ** | **76** |   | 88 |   |
| Amortization of transition asset     | ** ** | **—**                                                        |       | —                                                            | ** ** | **—** |   | — |   |
| Net  periodic benefit cost           | ** ** | **$**                                                             | **863**    |                                                              | $          | 941 | ** ** | **$** | **432** |   | $ | 471 |   |

 

Aspreviously disclosed in its financial statements for the year ended December31, 2005, Bankshares generally makes cash contributions to the pension plan inamounts up to that permitted by guidelines established under employee benefitand tax laws.  Bankshares estimates thatit could be able to contribute up to approximately $19 million to the pensionplan for 2006.  Cash contributions arenormally made after valuations have been finalized for the plan year and priorto the tax return filing date.  As ofJune 30, 2006, total contributions of $15 million had been made in 2006.  No further contributions are expected to be madein the current year.

15.  Recent Accounting Standards

OnFebruary 16, 2006, the Financial Accounting Standards Board (“FASB”) issuedStatement No. 155, “Accounting forCertain Hybrid Instruments.”  Thisstandard amends the guidance in FASB Statements (“SFAS”) No. 133, “Accounting for Derivative Instruments andHedging Activities,” and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets andExtinguishments of Liabilities.” SFAS No. 155 allows financial instruments that have embedded derivativesto be accounted for as a whole (eliminating the need to bifurcate thederivative from its host) if the holder elects to account for the wholeinstrument on a fair value basis.  SFASNo. 155 is effective for all financial instruments acquired or issued after thebeginning of an entity’s first fiscal year that begins after September 15,2006.  Bankshares does not anticipatethis statement will have a material effect on its results of operations orfinancial condition.

InMarch 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets-An Amendment of FASBStatement No. 140.”  This standardamends the guidance in SFAS No.140, “Accountingfor Transfers and Servicing of Financial Assets and Extinguishments ofLiabilities.”  Among otherrequirements, SFAS No. 156 requires an entity to recognize a servicing asset orservicing liability each time it undertakes an obligation to service afinancial asset by entering into a servicing contract.  Thestandard requires initial measurement of all newly purchased or issuedseparately recognized servicing assets and servicing liabilities at fair value,if practicable.  Subsequent measurementsmay be made using either the fair value or amortization method.  SFAS No. 156 is effectiveas of the beginning of an entity’s first fiscal year that begins afterSeptember 15, 2006 with early adoption permitted in the quarter-ended March 31,2006.  Bankshares does not anticipatethis statement will have a material effect on its results of operations orfinancial condition.

# On July 13, 2006, the FASBissued FASB Interpretation No. 48 (“FIN 48”).  FIN 48 clarifies theaccounting for uncertainty in income taxes recognized in an enterprise’sfinancial statements in accordance with SFAS No. 109, “Accounting for IncomeTaxes.” FIN 48 prescribes a recognition threshold and measurement attribute forthe financial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interestand penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. An enterprise shall disclose the cumulative effect of the change on retainedearnings in the statement of financial position as of the date of adoption andsuch disclosure is required only in the year of adoption.  Bankshares isin the process of analyzing the implications of FIN 48.

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**Item 2.  Management’s Discussion and Analysis of Financial Condition and Resultsof Operations**

**MERCANTILEBANKSHARES CORPORATION**

**HIGHLIGHTS**

**ConsolidatedFinancial Results**

OnJanuary 10, 2006, Bankshares announced a three-for-two split on its commonstock payable in the form of a stock dividend on January 27, 2006 tostockholders of record as of the close of business on January 20, 2006.  For comparative purposes, certain share,average share and per share amounts have been restated.

Netincome for the quarter ended June 30, 2006 was $73.1 million, a 7.7% increasefrom net income of $67.9 million for the same period in 2005 and a 3.3%increase from the $70.8 million reported for the first quarter of 2006.  For the quarter ended June 30, 2006, dilutednet income per share was $0.59, an increase of 5.4% from the $0.56 reported forthe same period last year and an increase of 3.5% from the $0.57 reported forthe first quarter of 2006.  Adjustedweighted average shares outstanding increased from 121.7 million for thequarter ended June 30, 2005 to 124.3 million for the quarter ended June 30,2006.

Netinterest income, on a taxable equivalent basis, for the quarter ended June 30,2006 increased 6.0% to $163.3 million from $154.0 million for the secondquarter of last year.  Compared with thefirst quarter of 2006, net interest income increased 1.9% over the $160.1million reported for that period.  Asnoted in prior quarters, the competitive pressures on the lending and thefunding fronts have not subsided.  Theresult is that the net interest margin continues to be under pressure.  The net interest margin for the currentquarter was 4.31% as compared with 4.36% for the first quarter of 2006.  The net interest margin for the secondquarter of 2005 was 4.46%.

AtJune 30, 2006, nonperforming assets amounted to $29.3 million, or 0.24%, ofperiod-end loans and other real estate owned, an increase of $1.6 million fromthe $27.7 million at June 30, 2005. Nonperforming assets were $23.6 million at March 31, 2006.  The comparable nonperforming asset ratioswere 0.24% and 0.20% at June 30, 2005 and March 31, 2006, respectively.  The level of “monitored” loans, or loans withcharacteristics suggesting that they could be classified as nonperforming inthe near future, amounted to $13.5 million at June 30, 2006.  Monitored loans were $0.5 million at June 30,2005 and $13.9 million at March 31, 2006. The increase in nonperforming loans over the prior year is largelyattributable to one relationship at the lead bank.  The allowance for possible loan losses was1.19% of loans outstanding at June 30, 2006.

Noninterestincome, which includes investment and wealth management fees, service chargeson deposit accounts, mortgage banking-related fees, securities gains andlosses, nonmarketable investments income and other income, increased 7.3% to$64.5 million for the second quarter of 2006 from $60.1 million for the secondquarter of 2005.

Noninterest income increased$3.9 million, or 6.4%, in the second quarter of 2006 from the first quarter of2006. The increase was primarily due to the $2.7 million increase in IWMrevenues, higher electronic banking fees and service charges on deposits.  These increases were offset partially byseasonally lower insurance revenues.

Duringthe quarter, Bankshares reached an agreement to sell its ownership interest inColumbia National Real Estate Finance, LLC (“CNREF”) to the minority partners.The transaction is not expected to have a material impact on future operatingresults.  Bankshares will continue tooperate in this business through its other subsidiary, HarborPoint Capital,which is a licensed Fannie Mae DUSTM lender. For the first six months of 2006, CNREF accounted for $1.6 million innet interest income, $3.5 million in noninterest income, and $3.6 million innoninterest expense.  The sale isexpected to close on July 31, 2006.

Bankshares’IWM unit restructured its Real Estate Advisory Unit and a major advisoryrelationship within the unit.   As aresult of the changes, pretax income of $1.4 million was recognized thisquarter.

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Noninterestexpenses, which include salaries, employee benefits, net occupancy expense ofbank premises, furniture and equipment expenses, communications and suppliesand other expenses, increased by 5.3% for the quarter ended June 30, 2006 to$109.4 million from $103.9 million for the second quarter of 2005.

Noninterest expense increased$2.7 million from the first quarter of 2006 primarily due to professionalservices and a licensing fee related to the restructured real estate pensionadvisory relationship.

Bankshares also reports cash operating earnings, definedas “GAAP”(Generally Accepted Accounting Principles) earnings excluding the amortizationof intangible assets associated with purchase accounting for businesscombinations; securities gains and losses; and other significant gains, lossesor expenses (such as those associated with integrating acquired entities’operations into Bankshares) unrelated toBankshares’ core operations.  We believe these non-GAAP measuresprovide information useful to investors in understanding our ongoing corebusiness and operational performance trends. These measures should not be viewed as a substitute for GAAP.  Management believes presentations of financialmeasures excluding the impact of certain items provide useful supplementalinformation and better reflect core operating activities.  In order to arrive at core business operatingresults, the effects of certain non-core business transactions such as gainsand losses on the sale of securities, amortization of intangibles, restructuringcharges and merger-related expenses, have been excluded.  Management reviews these same measuresinternally.  For instance, the cashoperating efficiency ratio, rather than the GAAP basis efficiency ratio, isused to measure management’s success at controlling ongoing, core operatingexpenses.  We believe these measures areconsistent with how investors and analysts typically evaluate our industry, andby providing these measures, we facilitate their analysis.  Cashoperating earnings totaled $74.4 million for the second quarter of 2006, anincrease of 10.8% over $67.2 million for the same period in 2005.

Additionally,management believes that reporting several key measures based on tangibleassets (total assets less intangible assets) and tangible equity (total equityless intangible assets) is important, as this more closely approximates thebasis for measuring the adequacy of capital for regulatory purposes.  The ratio of average tangible equity to averagetangible assets was 9.88% for the quarter ended June 30, 2006 compared with9.67% for the same period in 2005.  See *Reconciliation of Non-GAAP Measures* for the reconciliationof GAAP measures to non-GAAP measures found at the end of this management’sdiscussion.

Forthe first six months of 2006, net income was $143.9 million, an increase of10.2% over the $130.5 million reported for the same period in 2005.  Diluted net income per share was $1.16, anincrease of 7.4% from the $1.08 reported for the same period last year.  For the six months ended June 30, 2006, cashoperating earnings were $146.5 million compared with $130.2 million for thesame period last year.  Average tangibleequity to average tangible assets for the year-to-date 2006 and 2005 were 9.85%and 9.83%, respectively.

CRITICALACCOUNTING POLICIES AND RELATED ESTIMATES

Inorder to understand Bankshares’ financial position and results of operations,it is important to understand Bankshares’ significant accounting policies andthe extent to which judgment and estimates are used in applying those policies.Bankshares’ accounting and reporting policies are in accordance with accountingprinciples generally accepted in the United States (GAAP), and they conform togeneral practices within the applicable industries. Management uses asignificant amount of judgment and estimates based on assumptions for which theactual results are uncertain when the estimate is made. Bankshares hasidentified five policies as being particularly sensitive in terms of judgmentsand the extent to which estimates are used: allowance for loan losses and thereserve for unfunded commitments; loans in nonaccrual status or deemed to beimpaired; investment securities; income taxes; and valuation of goodwill andintangible assets. An update of our accounting policy for the allowance forloan losses and the reserve for unfunded commitments is provided below. Formore information on our critical accounting policies, please refer to our 2005Annual Report on Form 10-K.

 

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**Allowancefor Loan Losses and Reserve for Unfunded Commitments**

Arrivingat an appropriate level of allowance for loan losses involves a high degree ofjudgment. Bankshares’ allowance for loan losses provides for probable lossesbased on evaluations of known and inherent risks in the loan portfolio.  The allowance for loan losses is maintainedat a level considered by management to be adequate to absorb losses inherent inthe loan portfolio as of the date of the consolidated financialstatements.  We have developedappropriate policies and procedures for assessing the adequacy of the allowancefor loan losses that reflect management’s careful evaluation of credit riskconsidering all available information. Management uses historical quantitativeinformation to assess the adequacy of the allowance for loan losses as well asqualitative information about the prevailing economic and business environment,among other things. In developing this assessment, management must rely onestimates and exercise judgment in assigning credit risk.  Depending on changing circumstances, futureassessments of credit risk may yield materially different results from theestimates, which may require an increase or decrease in the allowance for loanlosses.

Weemploy a variety of modeling and estimation tools in developing the appropriateallowance.  Bankshares’ allowanceconsists of formula-based components for business and retail loans, anallowance for impaired loans and an unallocated component.  The following provides a description of eachof these components of the allowance, the techniques used and the estimates andjudgments inherent in each.  In the firstquarter of 2006, management refined the methodologies for the formula-basedcomponents to align more appropriately the allowance methodology with ourcurrent framework for analyzing credit losses. Formula-based allowance calculations for business and retail componentspermit us to address specifically the current trends and events affecting thecredit risk in the loan portfolio.

Businessloans are comprised of commercial, commercial real estate and constructionloans, which are evaluated separately for impairment.  For business loans, the formula-basedcomponent of the allowance for loan losses is based on statistical migrationestimates of the average losses observed for business loans classified bycredit grade. Average losses for each credit grade are computed using theannualized historical rate at which loans in each credit grade have defaulted(probability of default rates or “PD”) and the historical average lossesrealized for defaulted loans (loss-given-default or “LGD”).  We have developed default rates by analyzingfour years of our default experience and more than 14 years of comparableexternal data.  Default rates, which arevalidated annually, are estimates derived from long-term averages and are notbased on short-term economic or environmental factors.  LGD rates have been developed using industrybenchmarks.

Retailloans are comprised of consumer installment and residential mortgage loans. Forretail loans, the formula-based component of the allowance for loan losses isprimarily based on the probability of default rates and LGD rates for specificgroups of similar loans by product category. The probability of default rates are based on four years of our defaultexperience and between 14 and 19 years of comparable industry data.  LGD rates were developed using industrybenchmarks.

Forboth business and retail loans, the formula-based components include additionalqualitative amounts to establish reasonable ranges that consider observedhistorical variability in losses. Factors we may consider in setting these amounts include, but are notlimited to, industry-specific data, portfolio-specific risks or concentrations,and macroeconomic conditions. Including these variability components in themodel enables us to capture probable incurred losses that are not yet evidentin current default rates, delinquencies and other credit-risk measurementtools.

Thespecific allowance allocation is based on an analysis of the loan portfolio.Each loan with an outstanding balance in excess of a specified threshold thatis either in nonaccrual status or on the “Watchlist” is evaluated. TheWatchlist includes loans identified and closely followed by management. Theseloans possess certain qualities or characteristics that may lead to collectionand loss issues. The identified loans are evaluated for potential loss byanalyzing current collateral values or present value of cash flows, as well asthe capacity of the guarantor, as applicable. This is in accordance with SFAS No. 114, “Accounting for Creditorsfor Impairment of a Loan,” and SFAS No. 118, “Accounting for Creditors forImpairment of a Loan — Income Recognition and Disclosure.”

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Theallowance for loan losses also contains an unallocated component.  The unallocated allowance recognizes theimprecision inherent in estimating and measuring inherent loss when allocatingthe allowance to individual, or pools of, loans.  It also takes into consideration theallowance level deemed appropriate by each affiliate based on its localknowledge and input from bank regulators and their view from the standpoint ofsafety and soundness, among other factors. The amount of this component and its relationship to the total allowancefor loan losses may change from one period to another.

Infirst quarter of 2006, we reclassified a portion of the allowance for loanlosses to a reserve for unfunded commitments, which is included in the otherliabilities section of the consolidated balance sheet.  The modeling process used in the firstquarter of 2006 for the determination of the reserve for unfunded lendingcommitments is consistent with the process described above for theformula-based component of the allowance for loan losses, also including as akey factor a benchmark average rate at which unfunded exposures have beenfunded at the time of default.  Thedevelopment of this modeling in 2006 enabled Bankshares to evaluatespecifically the risk inherent in unfunded commitments and make thereclassification discussed above.  As nomodel data existed in previous years, prior period data has not beenreclassified for comparability.

SEGMENTREPORTING

Asnoted in Note No. 11 — Segment Reporting, Bankshares reports two businesssegments — (1) Banking and (2) Investment and Wealth Management (“IWM”) — forwhich financial information is segregated for use in assessing performance andallocating resources when reporting to the Board of Directors.  Segment financial information is subjectiveand, unlike financial accounting, is not necessarily based on GAAP. As aresult, the financial information of the reporting segments is not necessarilycomparable with similar information reported by others and may not be comparablewith Bankshares’ consolidated results. Certain expense amounts, such as operations overhead, have beenreclassified for internal financial reporting purposes in order to provide forproper allocation of costs in the reported data.

Aschedule disclosing the details of these operating segments can be found inNote No. 11 — Segment Reporting.

**Banking**

TheBanking segment consists of 11 affiliate banks. Mortgage banking activities are not viewed as a separate business linedue to their insignificant impact on the core business of Bankshares and,accordingly, are included in the Banking segment.

Netincome for the six months ended June 30, 2006 increased 8.3%, to $138.9million, from the $128.2 million earned during the same period last year.  Net interest income for Banking increased7.7% to $314.0 million for the six months ended June 30, 2006.  The growth in net interest income reflectedan 11.6% increase in average earning assets, offset by an 11 basis point declinein the net interest margin from 4.45% at June 30, 2005 to 4.34% at June 30,2006.  Average loan balances increased10.9% year-over-year.   Commercial realestate loan balances increased 14.6%, residential real estate loan balancesincreased 6.8% and construction loan balances increased 25.9%.  Average deposits included growth in moneymarket accounts, time deposits greater than $100,000 and noninterest-bearingchecking, offset by a reduction in balances associated with savings accountsand checking plus interest accounts in the first half of 2006, compared withthe first half of 2005.  The decline inthe net interest margin was primarily attributable to the impact of growth inpremium money market accounts and certificates of deposit as customers shiftedto these higher rate products, and yields on loans and investments lagging theincrease in funding costs.

Asa reflection of the favorable credit quality within the loan portfolio, Bankingrecorded no provision for credit losses for the first half of 2006 as comparedwith a $756 thousand provision for the same period of 2005.  During the first quarter of 2006, Bankingestablished a reserve for unfunded commitments of $15 million by areclassification of $14 million from the allowance for loan losses and therecording of a $1.0 million provision related to increased unfunded commitmentsduring the quarter.  No provision forunfunded commitments was deemed necessary in the second quarter of 2006.  The allowance for loan losses as a percent ofloans was 1.19% at June 30, 2006 compared with 1.35% at December 31, 2005 and1.38% at June 30, 2005.

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Noninterestexpenses were $171.2 million for the first half of 2006 compared with $164.1million for the same period of 2005, an increase of $7.1 million, or 4.3%.  Noninterest expenses net of adjustments were$160.3 million for the first half of 2006, a $4.1 million increase, or 2.6%,over $156.1 million for the same period of 2005.  The increase in noninterest expenses wasprimarily related to the CBNV acquisition as well as normal merit and salaryincreases, higher benefit costs, higher professional fees and the addition ofnew branches.  These increases werepartially offset by an increase in the amount of deferred loan originationcosts and a decrease in incentive compensation accruals based on lower growthin net income.

**Investment& Wealth Management**

Investment and Wealth Management (“IWM”) includes Asset Management,Private Banking, Trust Services, Retail Brokerage Services and CustodyServices.  IWM provides a full line ofinvestment products and retirement, tax and estate planning services. IWMproducts include:

·                  RetailBrokerage Services:  Stocks, bonds,proprietary and nonproprietary mutual funds, fixed and variable annuities.

·                  AssetManagement Services:  Proprietary andnonproprietary mutual funds, proprietary and nonproprietary separate accountmanagement, customized wealth advisory services, defined benefit and definedcontribution retirement services, family office services, individual andinstitutional trust services and custody services.

·                  PrivateBanking Services:  Deposits, loans, andmortgages.

Net income for the first half of 2006 increased 24.1%, or $2.0 million,to $10.3 million over the $8.3 million in the first half of 2005.  Pretax profit margins, prior to corporate overheadallocations, were 28.1% and 26.6% for the first half of 2006 and 2005,respectively.  During the second quarterof 2006, Bankshares’ IWM Real Estate Advisory Unit restructured a majoradvisory relationship.  As a result, pretax income of $1.4million was recognized during the second quarter of 2006.  For more information on corporate overheadsee “Other” in Segment Reporting below.

Whilethe equity markets rose during the past twelve months, this positive momentumreversed somewhat in the second quarter of 2006.  The S&P 500 Index ended June 30, 2006 at1,270, up 6.6% from 1,191 at the end of June 2005, but down 1.9% from the firstquarter of this year.  Between June 30,2005 and June 30, 2006, the Dow Jones Industrial Average increased 8.5% to11,150 and the Nasdaq rose 5.6 % to 2,172. The fixed income markets, as measured by the Lehman Brothers USAggregate Bond Index, were down 5.8% for the twelve-month period ended June 30,2006.  Bankshares’ investment asset baseis relatively balanced between equities (including real estate) and fixedincome, cash and other securities.  As ofJune 30, 2006, 48.5% of IWM managed assets were invested in equities, includingreal estate.  Approximately 30.2% wereinvested in fixed income securities and 21.2% were invested in cash and other.

** **
| ** **                               | ** ** | **As of June 30,** | ** ** |
|------------------------------------------|------------|--------------------|------------|
| **Market  Indices**                      | ** ** | **2006**           | ** ** | **2005** | ** ** |
| Dow Jones  Industrial Average            | ** ** | **11,150**         |       | 10,275 |   |
| Year-over-Year %  Change                 | ** ** | **8.5%**           |       | -1.5% |   |
| S&P 500  Index-period-end            | ** ** | **1,270**          |       | 1,191 |   |
| Year-over-Year %  Change                 | ** ** | **6.6%**           |       | 4.4% |   |
| Nasdaq                                   | ** ** | **2,172**          |       | 2,057 |   |
| Year-over-Year %  Change                 | ** ** | **5.6%**           |       | 0.4% |   |
| Lehman Brothers  US Aggregate Bond Index | ** ** | **98.5**           |       | 104.6 |   |
| Year-over-Year % Change                  | ** ** | **-5.8%**          |       | 1.6% |   |

 

Revenues in the first half of 2006 increased $9.1 million, or 17.4%, to$61.1 million from $52.1 million in the same period last year.  Solid revenue growth was realized inInstitutional Management, Mercantile Funds, and Private Banking.  Solid growth was also realized in PrivateWealth Management and Brokerage.

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PrivateWealth Management benefited from the rise in equity markets during the pastyear, the addition of net new assets and a fee increase on some accounts at thebeginning of 2006. Personal Assets under Administration at June 30, 2006,increased $0.8 billion, or 6.7%, to $12.8 billion from June 30, 2005.  At June 30, 2006 as compared with June 30,2005, Personal Assets with Investment Responsibility increased $0.7 billion, or8.5%, to $8.9 billion and Assets with No Investment Responsibility increased$0.1 billion, or 2.6%, to $3.9 billion.

InstitutionalInvestment Management benefited principally from the restructuring of a majorreal estate pension advisory relationship. The impact of this change was to increase revenues $3.5 million and to increaseexpenses $2.1 million.  OtherInstitutional Management revenues were essentially unchanged.  Revenue declined in our Boyd Watterson AssetManagement subsidiary due to lower assets under management.  Additionally, higher terminations in ourinstitutional business last year continued to impede institutional revenuegrowth in the first half of 2006. At June 30, 2006 as compared with June 30,2005, Total Institutional Assets under Administration (including Boyd Watterson)declined $2.0 billion, or 5.5%, to $34.1 billion; Institutional Assets withInvestment Responsibility declined $1.1 billion, or 8.8%, to $11.4 billion; andAssets under Administration with No Investment Responsibility declined $0.9billion, or 3.8%, to $22.7 billion.

TheMercantile Funds benefited from higher asset flows into the funds, improvedequity markets, and strong performance in the hedge funds of funds.  Mercantile Fund assets increased $336million, or 8.9 %, to $4.1 billion, driven by a 20% increase in personal trustassets, at June 30, 2006 compared with June 30, 2005.

Brokeragecommissions and income benefited from growth in the number of accounts andassets held in accounts. Brokerage assets increased $185 million, or 20%, to$1.1 billion, at June 30, 2006 compared with June 30, 2005.

PrivateBanking revenues benefited from $34.8 million and $103.1 million in loan anddeposit growth during the past year.

 
| **IWM Asset Data (Dollars in billions)** | ** ** | **For the period ended June 30,** | ** ** |
|-------------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| ** **                                                        | ** ** | **2006**                                                   | ** ** | **2005** | ** ** |
| *Personal*                                                        | * *   | * *                                                   | * *   | * * | * * |
| Assets with  Investment Responsibility                            | ** ** | **$**                                                      | **8.9**    |   | $ | 8.2 |   |
| Assets with No  Investment Responsibility                         | ** ** | **3.9**                                                    |       | 3.8 |   |
| Total Personal                                                    |       | **12.8**                                                   | ** ** | 12.0 |   |
|                                                              |       |                                                       |       |   |   |
| *Institutional*                                                   | * *   | * *                                                   | * *   | * * | * * |
| Assets with  Investment Responsibility                            | ** ** | **11.4**                                                   |       | 12.5 |   |
| Assets with No  Investment Responsibility                         | ** ** | **22.7**                                                   |       | 23.6 |   |
| Total Institutional                                               |       | **34.1**                                                   | ** ** | 36.1 |   |
|                                                              |       |                                                       |       |   |   |
| *Mutual  Funds Not Included Above*                                | ** ** | **0.3**                                                    |       | 0.2 |   |
|                                                              |       |                                                       |       |   |   |
| *Total*                                                           | * *   | * *                                                   | * *   | * * | * * |
| Assets with  Investment Responsibility                            | ** ** | **20.6**                                                   |       | 20.9 |   |
| Assets with No  Investment Responsibility                         | ** ** | **26.6**                                                   |       | 27.4 |   |
| Total Assets  under Administration                                |       | **$**                                                      | **47.2**   | ** ** | $ | 48.3 |   |

 

AtJune 30, 2006, Assets under Administration by IWM were $47.2 billion, adecrease of $1.1 billion, or 2.3%, from the prior year.  Bankshares had investment responsibility for$20.6 billion, a decline of $0.3 billion, or 1.4%, compared with last year.

Additionalrevenue growth will depend on continued new sales and increased distribution,equity and bond market conditions and acquisitions, if any.

Inthe first half of 2006, expenses increased 21.6%, or $7.7 million, to $43.6million, compared with $35.8 million in the first half of last year.  Increases occurred in employee-related,technology, marketing, professional services, general operating and occupancyexpenses, which were only partially offset by a modest decrease incommunications and supplies expenses. The real estate advisory businessrestructuring-related expenses including marketing, incentive compensation,recruiting, and license fees totaled $2.1 million.

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**BANKSHARESEARNINGS PERFORMANCEAnalysis of Interest Rates and Interest Differentials**

Thefollowing table presents the distribution of the average consolidated balancesheet, interest income/expense and annualized yields earned and rates paid forthe six months ended June 30, 2006 and 2005.
| ** **                                                     | ** ** | **2006**                      | ** **     | **2005**                            | ** **  |
|----------------------------------------------------------------|------------|-------------------------------|----------------|-------------------------------------|-------------|
| **(Dollars in thousands)**                           | ** ** | **Average  Balance (2)** | ** **     | **Income (1)  / Expense** | ** **  | **Yield (1)  / Rate** | ** ** | **Average  Balance (2)** | ** ** | **Income (1)  / Expense** | ** ** | **Yield (1)  / Rate** | ** ** |
| Earning assets                                                 |       |                          |           |                                |        |   |   |   |   |   |   |   |   |
| Loans:                                                         |       |                          |           |                                |        |   |   |   |   |   |   |   |   |
| Commercial                                                     | ** ** | **$**                         | **2,944,881**  | ** **                          | **$**       | **105,274** | ** ** | **7.21** | **%** | $ | 2,887,558 |   | $ | 87,488 |   | 6.11 | % |
| Commercial real estate                                         | ** ** | **3,711,298**                 | ** **     | **128,031**                         | ** **  | **6.96** |   | 3,249,322 |   | 103,143 |   | 6.40 |   |
| Construction                                                   | ** ** | **1,745,346**                 | ** **     | **69,072**                          | ** **  | **7.98** |   | 1,385,942 |   | 44,403 |   | 6.46 |   |
| Residential real estate                                        | ** ** | **1,854,029**                 | ** **     | **56,640**                          | ** **  | **6.16** |   | 1,736,644 |   | 51,096 |   | 5.93 |   |
| Home equity lines                                              | ** ** | **490,428**                   | ** **     | **18,120**                          | ** **  | **7.45** |   | 499,446 |   | 13,890 |   | 5.61 |   |
| Consumer                                                       | ** ** | **1,038,999**                 | ** **     | **29,670**                          | ** **  | **5.76** |   | 849,516 |   | 24,638 |   | 5.85 |   |
| Total loans                                                    | ** ** | **11,784,981**                | ** **     | **406,807**                         | ** **  | **6.96** |   | 10,608,428 |   | 324,658 |   | 6.17 |   |
| Federal funds sold, et  al                                     | ** ** | **64,422**                    | ** **     | **1,755**                           | ** **  | **5.49** |   | 36,404 |   | 785 |   | 4.35 |   |
|                                                           | ** ** | ** **                    | ** **     | ** **                          | ** **  | ** ** |   |   |   |   |   |   |   |
| Securities:                                                    |       |                          |           |                                |        |   |   |   |   |   |   |   |   |
| Taxable securities                                             |       |                          |           |                                |        |   |   |   |   |   |   |   |   |
| U.S. Treasury and  government agencies                         | ** ** | **1,446,022**                 | ** **     | **26,862**                          | ** **  | **3.75** |   | 1,404,011 |   | 23,669 |   | 3.40 |   |
| Mortgage-backed                                                | ** ** | **1,597,164**                 | ** **     | **34,068**                          | ** **  | **4.30** |   | 1,334,525 |   | 26,697 |   | 4.03 |   |
| Other investments                                              | ** ** | **64,480**                    | ** **     | **1,338**                           | ** **  | **4.18** |   | 64,500 |   | 1,237 |   | 3.87 |   |
| Tax-exempt securities                                          |       |                          |           |                                |        |   |   |   |   |   |   |   |   |
| States and political  subdivisions                             | ** ** | **82,489**                    | ** **     | **2,552**                           | ** **  | **6.24** |   | 84,750 |   | 2,495 |   | 5.94 |   |
| Total securities                                               | ** ** | **3,190,155**                 | ** **     | **64,820**                          | ** **  | **4.10** |   | 2,887,786 |   | 54,098 |   | 3.78 |   |
| Interest-bearing  deposits in other banks                      | ** ** | **200**                       | ** **     | **1**                               | ** **  | **1.44** |   | 195 |   | 1 |   | 1.23 |   |
| Total earning assets                                           | ** ** | **15,039,758**                | ** **     | **473,383**                         | ** **  | **6.35** |   | 13,532,813 |   | 379,542 |   | 5.66 |   |
| Cash and due from banks                                        | ** ** | **302,726**                   |           |                                |        |   |   | 296,227 |   |   |   |   |   |
| Bank premises and  equipment, net                              | ** ** | **138,591**                   |           |                                |        |   |   | 142,895 |   |   |   |   |   |
| Other assets                                                   | ** ** | **1,287,146**                 |           |                                |        |   |   | 1,052,279 |   |   |   |   |   |
| Less: allowance for loan  losses                               | ** ** | **(149,751**                  | **)**          |                                |        |   |   | (151,281 | ) |   |   |   |   |
| Total assets                                                   | ** ** | **$**                         | **16,618,470** |                                |        |   |   |   | $ | 14,872,933 |   |   |   |   |   |
| Interest-bearing  liabilities                                  |       |                          |           |                                |        |   |   |   |   |   |   |   |   |
| Deposits:                                                      |       |                          |           |                                |        |   |   |   |   |   |   |   |   |
|                                                           |       |                          |           |                                |        |   |   |   |   |   |   |   |   |
| Savings                                                        | ** ** | **$**                         | **1,301,926**  | ** **                          | **3,007**   | ** ** | **0.47** |   | $ | 1,461,782 |   | 2,464 |   | 0.34 |   |
| Checking plus interest                                         | ** ** | **1,320,056**                 | ** **     | **1,265**                           | ** **  | **0.19** |   | 1,384,616 |   | 1,093 |   | 0.16 |   |
| Money market                                                   | ** ** | **1,898,316**                 | ** **     | **22,634**                          | ** **  | **2.40** |   | 1,562,736 |   | 8,087 |   | 1.04 |   |
| Time deposits $100,000  and over                               | ** ** | **1,974,472**                 | ** **     | **41,045**                          | ** **  | **4.19** |   | 1,523,393 |   | 21,315 |   | 2.82 |   |
| Other time deposits                                            | ** ** | **2,340,649**                 | ** **     | **38,895**                          | ** **  | **3.35** |   | 1,983,713 |   | 23,730 |   | 2.41 |   |
| Total interest-bearing  deposits                               | ** ** | **8,835,419**                 | ** **     | **106,846**                         | ** **  | **2.44** |   | 7,916,240 |   | 56,689 |   | 1.44 |   |
| Short-term borrowings                                          | ** ** | **1,372,322**                 | ** **     | **24,523**                          | ** **  | **3.60** |   | 1,011,161 |   | 9,526 |   | 1.90 |   |
| Long-term debt                                                 | ** ** | **701,761**                   | ** **     | **18,614**                          | ** **  | **5.35** |   | 715,859 |   | 14,644 |   | 4.13 |   |
| Total interest-bearing  funds                                  | ** ** | **10,909,502**                | ** **     | **149,983**                         | ** **  | **2.77** |   | 9,643,260 |   | 80,859 |   | 1.69 |   |
| Noninterest-bearing  deposits                                  | ** ** | **3,230,845**                 |           |                                |        |   |   | 3,081,292 |   |   |   |   |   |
| Other liabilities and  accrued expenses                        | ** ** | **192,594**                   |           |                                |        |   |   | 151,937 |   |   |   |   |   |
| Total liabilities                                              | ** ** | **14,332,941**                |           |                                |        |   |   | 12,876,489 |   |   |   |   |   |
| Shareholders’ equity                                      | ** ** | **2,285,529**                 |           |                                |        |   |   | 1,996,444 |   |   |   |   |   |
| Total liabilities &  shareholders’ equity   | ** ** | **$**                         | **16,618,470** |                                |        |   |   |   | $ | 14,872,933 |   |   |   |   |   |
| Net interest rate spread                                       | ** ** | ** **                    | ** **     | **$**                               | **323,400** |   | **3.58** | **%** |   |   | $ | 298,683 |   | 3.97 | % |
| Effect of  noninterest-bearing funds                           | ** ** | ** **                    |           |                                |        | **0.76** |   |   |   |   |   | 0.48 |   |
| Net interest margin on  earning assets                         | ** ** | ** **                    |           |                                |        | **4.34** | **%** |   |   |   |   | 4.45 | % |
| Tax-equivalent adjustment  included in:                        |       |                          |           |                                |        |   |   |   |   |   |   |   |   |
| Loan income                                                    | ** ** | ** **                    |           | **$**                               | **2,656**   |   |   |   |   |   | $ | 2,237 |   |   |   |
| Investment securities  income                                  | ** ** | ** **                    |           | **1,021**                           |        |   |   |   |   | 996 |   |   |   |
| Total                                                          | ** ** | ** **                    |           | **$**                               | **3,677**   |   |   |   |   |   | $ | 3,233 |   |   |   |

----

(1)             Presented on atax-equivalent basis using the statutory federal corporate income tax rate of35%; see *Reconciliation of Non-GAAP Measures*.

(2)             Averageinvestment securities are reported at amortized cost; excludes unrealized gains(losses) on securities available-for-sale. Nonaccrual loans are included inaverage loans.

27

----

**Analysisof Interest Rates and Interest Differentials**

The following table presentsthe distribution of the average consolidated balance sheet, interestincome/expense and annualized yields earned and rates paid for the three monthsended June 30, 2006 and 2005.

 
| ** **                                         | ** ** | **2006**                      | ** **     | **2005**                                   | ** ** |
|----------------------------------------------------|------------|-------------------------------|----------------|--------------------------------------------|------------|
| **(Dollars in thousands)**               | ** ** | **Average  Balance (2)** | ** **     | **Income (1)  / Expense**             | ** ** | **Yield (1)  / Rate** | ** ** | **Average  Balance (2)** | ** ** | **Income (1)  / Expense** | ** ** | **Yield (1)  / Rate** | ** ** |
| Earning assets                                     |       |                          |           |                                       |       |   |   |   |   |   |   |   |   |
| Loans:                                             |       |                          |           |                                       |       |   |   |   |   |   |   |   |   |
| Commercial                                         | ** ** | **$**                         | **2,956,420**  | ** **                                 | **$**      | **54,198** | ** ** | **7.35** | **%** | $ | 2,926,234 |   | $ | 46,021 |   | 6.31 | % |
| Commercial real estate                             | ** ** | **3,748,795**                 | ** **     | **65,611**                                 | ** ** | **7.02** |   | 3,363,924 |   | 54,609 |   | 6.51 |   |
| Construction                                       | ** ** | **1,808,734**                 | ** **     | **36,488**                                 | ** ** | **8.09** |   | 1,442,621 |   | 23,952 |   | 6.66 |   |
| Residential real estate                            | ** ** | **1,876,209**                 | ** **     | **28,803**                                 | ** ** | **6.16** |   | 1,762,991 |   | 26,141 |   | 5.95 |   |
| Home equity lines                                  | ** ** | **484,396**                   | ** **     | **9,241**                                  | ** ** | **7.65** |   | 502,917 |   | 7,333 |   | 5.85 |   |
| Consumer                                           | ** ** | **1,046,986**                 | ** **     | **15,093**                                 | ** ** | **5.78** |   | 900,576 |   | 12,957 |   | 5.77 |   |
| Total loans                                        | ** ** | **11,921,540**                | ** **     | **209,434**                                | ** ** | **7.05** |   | 10,899,263 |   | 171,013 |   | 6.29 |   |
| Federal funds sold, et  al                         | ** ** | **71,448**                    | ** **     | ** **                                 | ** ** | **6.16** |   | 40,904 |   | 442 |   | 4.33 |   |
|                                               | ** ** | ** **                    | ** **     | ** **                                 | ** ** | ** ** |   |   |   |   |   |   |   |
| Securities:                                        |       |                          |           | **1,098**                                  |       |   |   |   |   |   |   |   |   |
| Taxable securities                                 |       |                          |           |                                       |       |   |   |   |   |   |   |   |   |
| U.S. Treasury and  government agencies             | ** ** | **1,451,800**                 | ** **     | **13,927**                                 | ** ** | **3.85** |   | 1,382,037 |   | 11,600 |   | 3.37 |   |
| Mortgage-backed                                    | ** ** | **1,605,222**                 | ** **     | **17,208**                                 | ** ** | **4.30** |   | 1,365,012 |   | 13,774 |   | 4.05 |   |
| Other investments                                  | ** ** | **65,748**                    | ** **     | **705**                                    | ** ** | **4.30** |   | 65,051 |   | 588 |   | 3.63 |   |
| Tax-exempt securities                              |       |                          |           |                                       |       |   |   |   |   |   |   |   |   |
| States and political  subdivisions                 | ** ** | **81,038**                    | ** **     | **1,265**                                  | ** ** | **6.26** |   | 88,537 |   | 1,303 |   | 5.90 |   |
| Total securities                                   | ** ** | **3,203,808**                 | ** **     | **33,105**                                 | ** ** | **4.14** |   | 2,900,637 |   | 27,265 |   | 3.77 |   |
| Interest-bearing  deposits in other banks          | ** ** | **200**                       | ** **     | **—**                                 | ** ** | **1.51** |   | 187 |   | — |   | 1.31 |   |
| Total earning assets                               | ** ** | **15,196,996**                | ** **     | **243,637**                                | ** ** | **6.43** |   | 13,840,991 |   | 198,720 |   | 5.76 |   |
| Cash and due from banks                            | ** ** | **304,132**                   |           |                                       |       |   |   | 301,484 |   |   |   |   |   |
| Bank premises and  equipment, net                  | ** ** | **138,941**                   |           |                                       |       |   |   | 144,347 |   |   |   |   |   |
| Other assets                                       | ** ** | **1,301,459**                 |           |                                       |       |   |   | 1,099,607 |   |   |   |   |   |
| Less: allowance for  loan losses              | ** ** | **(142,556**                  | **)**          |                                       |       |   |   | (152,858 | ) |   |   |   |   |
| Total assets                                       | ** ** | **$**                         | **16,798,972** |                                       |       |   |   |   | $ | 15,233,571 |   |   |   |   |   |
| Interest-bearing  liabilities                      |       |                          |           |                                       |       |   |   |   |   |   |   |   |   |
| Deposits:                                          |       |                          |           |                                       |       |   |   |   |   |   |   |   |   |
| Savings                                            | ** ** | **$**                         | **1,282,700**  | ** **                                 | **1,537**  | ** ** | **0.48** |   | $ | 1,463,960 |   | 1,313 |   | 0.36 |   |
| Checking plus interest                             | ** ** | **1,298,636**                 | ** **     | **637**                                    | ** ** | **0.20** |   | 1,418,337 |   | 578 |   | 0.16 |   |
| Money market                                       | ** ** | **1,947,364**                 | ** **     | **12,699**                                 | ** ** | **2.62** |   | 1,574,422 |   | 4,498 |   | 1.15 |   |
| Time deposits $100,000  and over                   | ** ** | **2,044,074**                 | ** **     | **22,281**                                 | ** ** | **4.37** |   | 1,618,161 |   | 11,968 |   | 2.97 |   |
| Other time deposits                                | ** ** | **2,362,074**                 | ** **     | **20,449**                                 | ** ** | **3.47** |   | 2,060,974 |   | 13,027 |   | 2.54 |   |
| Total interest-bearing  deposits                   | ** ** | **8,934,848**                 | ** **     | **57,603**                                 | ** ** | **2.59** |   | 8,135,854 |   | 31,384 |   | 1.55 |   |
| Short-term borrowings                              | ** ** | **1,423,480**                 | ** **     | **13,500**                                 | ** ** | **3.80** |   | 1,021,281 |   | 5,484 |   | 2.15 |   |
| Long-term debt                                     | ** ** | **673,599**                   | ** **     | **9,280**                                  | ** ** | **5.53** |   | 742,056 |   | 7,829 |   | 4.23 |   |
| Total interest-bearing  funds                      | ** ** | **11,031,927**                | ** **     | **80,383**                                 | ** ** | **2.92** |   | 9,899,191 |   | 44,697 |   | 1.81 |   |
| Noninterest-bearing  deposits                      | ** ** | **3,255,345**                 |           |                                       |       |   |   | 3,137,366 |   |   |   |   |   |
| Other liabilities and  accrued expenses            | ** ** | **202,551**                   |           |                                       |       |   |   | 154,910 |   |   |   |   |   |
| Total liabilities                                  | ** ** | **14,489,823**                |           |                                       |       |   |   | 13,191,467 |   |   |   |   |   |
| Shareholders’ equity                          | ** ** | **2,309,149**                 |           |                                       |       |   |   | 2,042,104 |   |   |   |   |   |
| Total liabilities &  shareholders’ equity | ** ** | **$**                         | **16,798,972** |                                       |       |   |   |   | $ | 15,233,571 |   |   |   |   |   |
| Net interest rate  spread                          | ** ** | ** **                    | ** **     | **$     163,254** |       | **3.51** | **%** |   |   | $ | 154,023 |   | 3.95 | % |
| Effect of  noninterest-bearing funds               | ** ** | ** **                    |           |                                       |       | **0.80** |   |   |   |   |   | 0.51 |   |
| Net interest margin on  earning assets             | ** ** | ** **                    |           |                                       |       | **4.31** | **%** |   |   |   |   | 4.46 | % |
| Tax-equivalent  adjustment included in:            |       |                          |           |                                       |       |   |   |   |   |   |   |   |   |
| Loan income                                        | ** ** | ** **                    |           | **$**                                      | **1,338**  |   | ** ** |   |   |   | $ | 1,136 |   |   |   |
| Investment securities  income                      | ** ** | ** **                    |           | **506**                                    |       | ** ** |   |   |   | 520 |   |   |   |
| Total                                              | ** ** | ** **                    |           | **$**                                      | **1,844**  |   | ** ** |   |   |   | $ | 1,656 |   |   |   |

----

(1)             Presentedon a tax-equivalent basis using the statutory federal corporate income tax rateof 35%; see *Reconciliation of Non-GAAP Measures*.

(2)             Averageinvestment securities are reported at amortized cost; excludes unrealized gains(losses) on securities available-for-sale. Nonaccrual loans are included inaverage loans.

28

----

**Rate /Volume Analysis**

Arate/volume analysis, which demonstrates changes in interest income and expensefor significant assets and liabilities, appears below.

 
| ** **                               | ** ** | **For the 6 months ended June 30,  2006 vs. 2005** | ** ** | **For the 3 months ended June 30,  2006 vs. 2005** | ** ** |
|------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| ** **                               | ** ** | **Due to variances in**                                                          | ** ** | **Due to variances in**                                                     | ** ** |
| **(Dollars in thousands)**     | ** ** | **Total**                                                                                  | ** ** | **Rates**                                                                                  | ** ** | **Volumes (5),(6)** | ** ** | **Total** | ** ** | **Rates** | ** ** | **Volumes (5),(6)** | ** ** |
| Interest earned on:                      |       |                                                                                       |       |                                                                                       |       |   |   |   |   |   |   |   |   |
| Loans:                                   |       |                                                                                       |       |                                                                                       |       |   |   |   |   |   |   |   |   |
| Commercial (1)                           |       | $                                                                                          | 17,786     |                                                                                       | $          | 15,737 |   | $ | 2,049 |   | $ | 8,177 |   | $ | 7,610 |   | $ | 567 |   |
| Commercial real estate (2)               |       | 24,888                                                                                     |       | 8,951                                                                                      |       | 15,937 |   | 11,002 |   | 4,277 |   | 6,725 |   |
| Construction (3)                         |       | 24,669                                                                                     |       | 10,446                                                                                     |       | 14,223 |   | 12,536 |   | 5,148 |   | 7,388 |   |
| Residential real estate                  |       | 5,544                                                                                      |       | 1,986                                                                                      |       | 3,558 |   | 2,662 |   | 912 |   | 1,750 |   |
| Home equity lines                        |       | 4,230                                                                                      |       | 4,559                                                                                      |       | (329 | ) | 1,908 |   | 2,259 |   | (351 | ) |
| Consumer                                 |       | 5,032                                                                                      |       | (385                                                                                       | )          | 5,417 |   | 2,136 |   | 27 |   | 2,109 |   |
| Taxable securities                       |       | 10,665                                                                                     |       | 4,595                                                                                      |       | 6,070 |   | 5,878 |   | 2,710 |   | 3,168 |   |
| Tax-exempt securities (4)                |       | 57                                                                                         |       | 126                                                                                        |       | (69 | ) | (38 | ) | 79 |   | (117 | ) |
| Federal funds sold, et al                |       | 970                                                                                        |       | 206                                                                                        |       | 764 |   | 656 |   | 187 |   | 469 |   |
| Interest-bearing deposits in other banks |       | —                                                                                     |       | —                                                                                     |       | — |   | — |   | — |   | — |   |
| Total interest income                    |       | 93,841                                                                                     |       | 46,120                                                                                     |       | 47,721 |   | 44,917 |   | 23,178 |   | 21,739 |   |
|                                     |       |                                                                                       |       |                                                                                       |       |   |   |   |   |   |   |   |   |
| Interest paid on:                        |       |                                                                                       |       |                                                                                       |       |   |   |   |   |   |   |   |   |
| Savings deposits                         |       | 543                                                                                        |       | 912                                                                                        |       | (369 | ) | 224 |   | 441 |   | (217 | ) |
| Checking plus interest deposits          |       | 172                                                                                        |       | 228                                                                                        |       | (56 | ) | 59 |   | 118 |   | (59 | ) |
| Money market accounts                    |       | 14,547                                                                                     |       | 10,573                                                                                     |       | 3,974 |   | 8,201 |   | 5,769 |   | 2,432 |   |
| Time deposits $100,000 and over          |       | 19,730                                                                                     |       | 10,365                                                                                     |       | 9,365 |   | 10,313 |   | 5,670 |   | 4,643 |   |
| Other time deposits                      |       | 15,165                                                                                     |       | 9,256                                                                                      |       | 5,909 |   | 7,422 |   | 4,815 |   | 2,607 |   |
| Short-term borrowings                    |       | 14,997                                                                                     |       | 8,542                                                                                      |       | 6,455 |   | 8,016 |   | 4,202 |   | 3,814 |   |
| Long-term debt                           |       | 3,970                                                                                      |       | 4,327                                                                                      |       | (357 | ) | 1,451 |   | 2,394 |   | (943 | ) |
| Total interest expense                   |       | 69,124                                                                                     |       | 51,759                                                                                     |       | 17,365 |   | 35,686 |   | 27,432 |   | 8,254 |   |
| Net interest earned                      |       | $                                                                                          | 24,717     |                                                                                       | $          | (5,639 | ) | $ | 30,356 |   | $ | 9,231 |   | $ | (4,255 | ) | $ | 13,486 |   |

----

(1)             Interest year-to-date tax-equivalent adjustmentof $1.6 million and $1.5 million for 2006 and 2005, respectively, andquarter-to-date tax-equivalent adjustment of $0.8 million for 2006 and 2005 areincluded in the commercial loan rate variances.

(2)             Interest year-to-date tax-equivalent adjustmentof $0.5 million and $0.3 million for 2006 and 2005, respectively, andquarter-to-date tax-equivalent adjustment of $0.2 million and $0.1 million for 2006and 2005, respectively, are included in the commercial real estate loan ratevariances.

(3)             Interest year-to-date tax-equivalent adjustmentof $0.6 million and $0.4 million for 2006 and 2005, respectively, andquarter-to-date tax-equivalent adjustment of $0.3 million for 2006 and $0.2million for 2005 are included in the construction loan rate variances.

(4)             Interest year-to-date tax-equivalent adjustmentof $1.0 million for 2006 and 2005 and quarter-to-date tax-equivalent adjustmentof $0.5 million for 2006 and 2005 are included in the tax-exempt securitiesrate variances.

(5)             Changes attributable to mix (rate and volume) areincluded in the volume variances.

(6)             Categoriesdo not add due to the effect of changes in product mix.

29

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**NetInterest Income and Net Interest Margin**

Netinterest income for the quarter ended June 30, 2006, on a tax-equivalent basis,increased 6.0% to $163.3 million from $154.0 million for the second quarter of2005. The increase was due to average earning asset growth. The net interestmargin declined 15 basis points from 4.46% for the second quarter of 2005 to4.31% for the second quarter of 2006. The decline was due primarily to growth in premium money market accountsand certificates of deposit as customers shifted to these higher rate products;increased competition affecting yields on new loans and the increase in theoverall yield on the investment portfolio lagging the increase in fundingcosts.  Bankshares paid an average rateof 2.92% on interest-bearing liabilities during the second quarter of 2006, anincrease of 111 basis points over the second quarter of 2005.  By contrast, the yield on average loans andinvestments increased by 76 basis points and 37 basis points, respectively,from the second quarter of 2005.   Theamortization of deferred loan origination costs during the second quarter of2006 reduced the margin by three basis points compared with the second quarterof last year.  It is anticipated thatincreased amortization of deferred loan origination costs will continue toaffect the margin by an additional one to two basis points per quarter for thenext two to three years as the amount amortized builds over the average life ofthe originated loans.

On a linked-quarter basis,taxable equivalent net interest income increased by 1.9% to $163.3 million from$160.1 million.  The increase inlinked-quarter net interest income was attributable to average earning assetgrowth of $316.2 million partially offset by a five basis point decline in thenet interest margin.  The net interestmargin decline was attributable primarily to competition for deposits,continued pressure on loan yields and the increase in the investment portfolioyield lagging the increase in funding costs. The amortization of deferred loan origination costs reduced the netinterest margin by one basis point compared with the first quarter of 2006.

# Net interest income, on ataxable equivalent basis, for the first six months of 2006 increased to $323.4million, or 8.3%, over the $298.7 million for the first six months of 2005 dueprincipally to $1.2 billion in additional average loans outstanding.  The net interest margin decreased from 4.45%to 4.34% as increases in funding costs of 108 basis points outpaced the 69basis point increase in the yield on earning assets.  Loan yields also reflected the impact ofdeferred loan origination costs, which reduced the net interest margin by twobasis points for the first six months of 2006.

Averageearning assets in the second quarter of 2006 increased $1.4 billion, or 9.8%,over the same period in 2005.  Loansaveraged $11.9 billion for the second quarter of 2006, an increase of 9.4% overthe $10.9 billion for the second quarter of 2005 and an increase of $274.6million, or 2.4%, on a linked-quarter basis. The increase in average loans outstanding from the second quarter of2005 was driven by growth in commercial real estate of $384.9 million, or11.4%; construction loan growth of $366.1 million, or 25.4%; consumer loangrowth of $146.4 million, or 16.3%; and residential mortgage loan growth of$113.2 million, or 6.4%.

Averageinvestment securities for the second quarter of 2006 increased by $303.2 million,or 10.5%, compared with the same period of 2005.

Averagedeposits for the second quarter of 2006 increased 8.1% year-over-year. Averagenoninterest-bearing deposits for the second quarter of 2006 increased by $118.0million, or 3.8%, compared with the same period in 2005.  Total average interest-bearing depositsincreased by $799.0 million, or 9.8%, for the second quarter of 2006, comparedwith the same period in 2005.  Theyear-over-year increase in average interest-bearing deposits included increasesin time deposits and money market accounts partially offset by declines inchecking plus interest and savings accounts.

Giventhe current rate environment, the flatness of the yield curve and competitivepressure on both loan and deposit pricing, we anticipate that the net interestmargin will remain under some pressure throughout the year.

30

----

**NoninterestIncome**

Noninterestincome for the quarter ended June 30, 2006 increased by $4.4 million, or 7.3%,to $64.5 million compared with $60.1 million for the same period in 2005.  Noninterest income increased 6.4% comparedwith the first quarter of 2006.  

Thetable below shows the major components of noninterest income.

 
| ** **                                | ** ** | **For the 6 months ended   June 30,** | ** **  | ** ** | ** ** | **For the 3 months ended   June 30,** | ** ** | ** ** | ** ** |
|-------------------------------------------|------------|---------------------------------------------------------------------|-------------|------------|------------|---------------------------------------------------------------------|------------|------------|------------|
| **(Dollars in thousands)**      | ** ** | **2006**                                                            | ** **  | **2005**   | ** ** | **% Change  2006/2005**                                        | ** ** | **2006**   | ** ** | **2005** | ** ** | **% Change  2006/2005** | ** ** |
| Investment and  wealth management         | ** ** | **$**                                                               | **54,986**  |       | $          | 47,837                                                              |       | 14.9       | %          | **$** | **28,865** |   | $ | 23,780 |   | 21.4 | % |
| Service charges  on deposit accounts      | ** ** | **21,160**                                                          |        | 21,514     |       | (1.6                                                                | )          | **10,868** |       | 11,088 |   | (2.0 | ) |
| Mortgage banking  related fees:           |       |                                                                |        |       |       |                                                                |       |       |       |   |   |   |   |
| Commercial                                | ** ** | **3,671**                                                           |        | 3,930      |       | (6.6                                                                | )          | **1,792**  |       | 2,092 |   | (14.3 | ) |
| Residential                               | ** ** | **874**                                                             |        | 1,248      |       | (30.0                                                               | )          | **543**    |       | 803 |   | (32.4 | ) |
| Total mortgage banking related fees       | ** ** | **4,545**                                                           |        | 5,178      |       | (12.2                                                               | )          | **2,335**  |       | 2,895 |   | (19.3 | ) |
| Net investment  securities (losses) gains | ** ** | **(13**                                                             | **)**       | 490        |       | (102.7                                                              | )          | **—** |       | 76 |   | (100.0 | ) |
| Nonmarketable  investments:               |       |                                                                |        |       |       |                                                                |       |       |       |   |   |   |   |
| Private equity and other investments      | ** ** | **4,695**                                                           |        | 7,030      |       | (33.2                                                               | )          | **3,371**  |       | 4,569 |   | (26.2 | ) |
| Hedge funds                               | ** ** | **4,400**                                                           |        | 719        |       | 512.0                                                               | ** ** | **1,005**  |       | (1,245 | ) | 180.7 |   |
| Bank-owned life insurance                 | ** ** | **3,138**                                                           |        | 1,744      |       | 79.9                                                                | ** ** | **1,588**  |       | 898 |   | 76.8 |   |
| Total nonmarketable investments           | ** ** | **12,233**                                                          |        | 9,493      |       | 28.9                                                                | ** ** | **5,964**  |       | 4,222 |   | 41.3 |   |
| Other income:                             |       |                                                                |        |       |       |                                                                |       |       |       |   |   |   |   |
| Electronic banking fees                   | ** ** | **12,123**                                                          |        | 11,127     |       | 9.0                                                                 | ** ** | **6,487**  |       | 5,954 |   | 9.0 |   |
| Charges and fees on loans                 | ** ** | **5,871**                                                           |        | 5,815      |       | 1.0                                                                 | ** ** | **3,106**  |       | 3,020 |   | 2.8 |   |
| Insurance                                 | ** ** | **8,862**                                                           |        | 8,098      |       | 9.4                                                                 | ** ** | **3,761**  |       | 3,558 |   | 5.7 |   |
| All other income                          | ** ** | **5,307**                                                           |        | 8,383      |       | (36.7                                                               | )          | **3,082**  |       | 5,473 |   | (43.7 | ) |
| Total other income                        | ** ** | **32,163**                                                          |        | 33,423     |       | (3.8                                                                | )          | **16,436** |       | 18,005 |   | (8.7 | ) |
| Total                                     | ** ** | **$**                                                               | **125,074** |       | $          | 117,935                                                             |       | 6.1        | ** ** | **$** | **64,468** |   | $ | 60,066 |   | 7.3 |   |

 

Investment and wealthmanagement (“IWM”) revenue represents the largest source of noninterest incomeat 44.8%.  IWM revenue increased 21.4%,or $5.1 million, in the second quarter of 2006 over the same period lastyear.  The growth in IWM revenue was dueprincipally to $3.5 million of additional fees from the restructuring of theIWM real estate pension advisory relationship. Also contributing to the revenue growth was increased new sales inPrivate Wealth Management, increased brokerage activity and high asset flows inmanaged funds.

IWMrevenue increased 10.5%, or $2.7 million, over the first quarter of 2006.  This increase was due primarily to a $3.5million increase in real estate pension advisory fees arising out of therestructuring of the major advisory relationship.

Servicecharges on deposits decreased slightly from the prior year.  The decrease related to our retailcustomers.  For the second quarter of2006 compared with the first quarter of 2006, services charges increased $0.6million, or 5.6%.

Mortgagebanking-related fees were $0.6 million, or 19.3%, below the second quarter of2005.  Both commercial and residentialfees were less than last year due to lower profit margins.  Mortgage banking-related fees increasedslightly over the first quarter of 2006 due to higher residential volumesrelated to seasonality.

31

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Nonmarketableinvestments income increased $1.7 million, or 41.3%, over the second quarter of2005.  This increase was due to betterperformance from the hedge funds and higher income from bank-owned lifeinsurance due to better performance and the investment of an additional $50.0million in the third quarter of 2005. These increases were partially offset by a decline in private equityinvestment performance.  Nonmarketableinvestments income was slightly lower than the first quarter of 2006.  The decline was due to weaker performance bythe hedge funds, nearly offset by stronger private equity performance.

Otherincome for the second quarter of 2006 was $1.6 million less than the secondquarter of 2005.  The second quarter of2005 included a $3.4 million in gain from the sale of bank-owned premises.  Partially offsetting this decline were increasesin electronic banking fees, charges and fees on loans, insurance revenues andletters of credit fees.

Forthe six months ended June 30, 2006, noninterest income increased $7.1 million,or 6.1%, to $125.1 million compared with $117.9 million for the same period in2005.  This increase was largely due to a$7.1 million increase in IWM revenue; a $3.7 million increase in hedge fundinvestments; and higher electronic banking fees, insurance revenues andbank-owned life insurance.  Partiallyoffsetting these increases was a $2.3 million decrease in earnings from privateequity investments.  In 2005, $4.5million of gains from the sales of bank-owned premises was included.

**NoninterestExpenses**

Noninterestexpenses for the quarter ended June 30, 2006 increased by $5.5 million, or5.3%, to $109.4 million compared with $103.9 million for the quarter ended June30, 2005.  Noninterest expenses increased$2.7 million, or 2.5%, over the first quarter of 2006.  

Thetable below shows the major components of noninterest expenses.

 
| ** **                              | ** ** | **For the 6 months ended  June 30,** | ** **  | ** ** | ** ** | **For the 3 months ended  June 30,** | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|---------------------------------------------------------------|-------------|------------|------------|---------------------------------------------------------------|------------|------------|------------|
| **(Dollars in thousands)**    | ** ** | **2006**                                                      | ** **  | **2005**   | ** ** | **% Change  2006/2005**                                  | ** ** | **2006**   | ** ** | **2005** | ** ** | **% Change  2006/2005** | ** ** |
| Salaries                                | ** ** | **$**                                                         | **96,331**  |       | $          | 96,734                                                        |       | (0.4       | )%         | **$** | **47,232** |   | $ | 50,180 |   | (5.9 | )% |
| Employee benefits                       | ** ** | **29,027**                                                    |        | 23,853     |       | 21.7                                                          | ** ** | **14,292** |       | 11,956 |   | 19.5 |   |
| Net occupancy  expense of bank premises | ** ** | **15,702**                                                    |        | 13,779     |       | 14.0                                                          | ** ** | **7,931**  |       | 6,857 |   | 15.7 |   |
| Furniture and  equipment expenses       | ** ** | **16,399**                                                    |        | 15,203     |       | 7.9                                                           | ** ** | **8,094**  |       | 7,924 |   | 2.1 |   |
| Communications  and supplies            | ** ** | **8,287**                                                     |        | 8,059      |       | 2.8                                                           | ** ** | **4,469**  |       | 4,019 |   | 11.2 |   |
| Other expenses:                         |       |                                                          |        |       |       |                                                          |       |       |       |   |   |   |   |
| Professional services                   | ** ** | **11,913**                                                    |        | 10,007     |       | 19.0                                                          | ** ** | **6,743**  |       | 4,882 |   | 38.1 |   |
| Advertising and promotional expenses    | ** ** | **3,853**                                                     |        | 4,388      |       | (12.2                                                         | )          | **2,355**  |       | 2,677 |   | (12.0 | ) |
| Electronic banking expense              | ** ** | **6,656**                                                     |        | 6,418      |       | 3.7                                                           | ** ** | **3,529**  |       | 3,177 |   | 11.1 |   |
| Amortization of intangible assets       | ** ** | **4,542**                                                     |        | 4,251      |       | 6.8                                                           | ** ** | **2,217**  |       | 2,179 |   | 1.7 |   |
| Outsourcing expense                     | ** ** | **5,464**                                                     |        | 5,073      |       | 7.7                                                           | ** ** | **2,641**  |       | 2,383 |   | 10.8 |   |
| All other expenses                      | ** ** | **17,963**                                                    |        | 16,301     |       | 10.2                                                          | ** ** | **9,919**  |       | 7,679 |   | 29.2 |   |
| Total other expenses                    | ** ** | **50,391**                                                    |        | 46,438     |       | 8.5                                                           | ** ** | **27,404** |       | 22,977 |   | 19.3 |   |
| Total                                   | ** ** | **$**                                                         | **216,137** |       | $          | 204,066                                                       |       | 5.9        | ** ** | **$** | **109,422** |   | $ | 103,913 |   | 5.3 |   |

 

Theefficiency ratio, a key measure of expense management, improved in the secondquarter of 2006 compared with the same quarter of 2005.  The efficiency ratio is computed by dividingnoninterest expenses by the sum of net interest income on a tax-equivalentbasis and noninterest income.  Bankshares’efficiency ratio was 48.05% for the three months ended June 30, 2006 comparedwith 48.54% for the three months ended June 30, 2005.  On a non-GAAP basis, the cash operatingefficiency ratio excludes the amortization of intangible assets associated withpurchase accounting for business combinations; securities gains and losses; andother significant gains, losses or expenses (such as those associated withintegrating acquired entities’ operations into Bankshares) unrelated toBankshares’ core operations.  Bankshares’cash operating efficiency ratio was 47.08% for the three months ended June 30,2006 compared with 48.26% for the same period last year.  The reconciliation of GAAP to non-GAAPmeasures can be found at the end of this management’s discussion.

32

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Salaries, which include base compensation, commissions,incentive compensation and stock-based compensation, are the largest componentof noninterest expense at 43.2%.  Salaryexpense decreased $2.9 million, or 5.9%, from the second quarter of 2005.  The decrease was due to a reduction of $5.3million in salaries expense related to an increase in the amount of deferredloan origination costs and a decrease of $3.0 million in incentive compensationaccruals.  The lower incentivecompensation accrualswere reflective of the slower growth in net income and management’s expectationthat competitive and interest rate environments will continue to pressure netincome growth.  Partially offsettingthese decreases were a $3.0 million increase in salaries related to normalmerit and staff increases and a $1.7 million increase in stock basedcompensation.  Employee benefits increased$2.3 million due primarily to increased pension expense related to a lowerreturn on pension assets, higher health insurance costs, payroll taxes andother retirement-related expenses. Salaries expense decreased $1.9 million from the first quarter of 2006due primarily to lower incentive compensation and severance accruals.

Netoccupancy expense, which includes premises depreciation, rents, maintenance andutilities increased $1.1 million, or 15.7%, over the prior year.  This increase was due to increases inbank-leased premises throughout the organization.  Net occupancy expense was nearly flatcompared with the first quarter of 2006.

Totalother expenses consist of professional services, marketing, electronic bankingand several other categories such as travel and membership, amortization,licensing, insurance and sundry expenses. For the three months ended June 30, 2006 compared with the same periodlast year, total other expenses increased $4.4 million.  This increase was due to a $1.5 million increasein licensing fees related to the restructuring of the real estate pensionadvisory relationship.  Also contributingto the increase in other expenses was a $1.9 million increase in professionalfees primarily related to the restructuring of a major advisory relationshipand efforts to improve efficiency throughout the organization.  Total other expenses for the second quarterof 2006 were $4.4 million higher than the first quarter of 2006 substantiallyfor the same reasons stated previously.

Noninterestexpenses for the six months ended June 30, 2006 increased $12.1 million, or5.9%, to $216.1 million from $204.1 million for the six months ended June 30,2005.

Salaryexpenses for the six months ended June 30, 2006 were nearly unchanged from theprior year.  Normal merit and staffincreases resulted in $5.0 million in additional expense; stock-basedcompensation increased $2.1 million; the CBNV acquisition added $1.7 million;and severance expense increased $1.7 million. Offsetting these increases was a reduction of $10.0 million in salariesexpense due to an increase in the amount of deferred loan origination costs andlower incentive compensation accruals related to slower year-over-year incomegrowth.  Employee benefits expense was$5.2 million higher than 2005 due to increased payroll taxes of $1.0 million,health insurance costs of $1.5 million and pension related costs of $2.7million.

Netoccupancy expenses increased $1.9 million. The increase was due primarily to the CBNV acquisition and increased costsof leasing bank premises.

Totalother expenses for the first six months of 2006 were $4.0 million, or 8.5%,higher than the same period in 2005.  Theincrease was due primarily to $1.5 million in licensing fees related to therestructuring of the real estate pension advisory relationship and $1.9 millionin additional  professional feesprimarily related to the IWM restructuring and efforts to improve efficiencythroughout the organization.

33

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ANALYSISOF FINANCIAL CONDITION

AtJune 30, 2006 compared with June 30, 2005, total assets increased 5.7%, or$909.7 million.  At June 30, 2006compared with December 31, 2005, total assets increased 3.5%, or $581 million.

Acomparative schedule of average balances is included in the Analysis ofInterest Rates and Interest Differentials table.

**SecuritiesAvailable-for-Sale**

Thesecurities available-for-sale portfolio includes both debt and marketableequity securities.  Bankshares holds debtsecurities available-for-sale primarily for liquidity, interest rate risk managementand yield enhancement purposes. Accordingly, this portfolio primarily includes very liquid, high qualityfederal agency-backed debt securities. At June 30, 2006 and December 31, 2005, the portfolio totaled $3.1 billionof debt securities available-for-sale. One hundred ninety-four securities werein a continuous loss position for 12 months or more at June 30, 2006, whichconsisted primarily of mortgage-backed securities.  Management concluded that because thedeclines in fair value were due to changes in market interest rates, not inestimated cash flows, no other-than-temporary impairment was recorded at June30, 2006.  There was a net unrealizedloss on these debt securities available-for-sale of $52.7 million and$32.8 million at June 30, 2006 and December 31, 2005, respectively.

Theweighted-average expected maturity of debt securities available-for-sale was2.1 years at June 30, 2006.  Sinceapproximately 51% of this portfolio was mortgage-backed securities, theexpected remaining maturity may differ from contractual maturity becauseborrowers may have the right to prepay obligations before the underlyingmortgages mature.  See Note No. 4 -Investment Securities to the Financial Statements for securitiesavailable-for-sale by security type.

**LoanPortfolio**

Totalloans at June 30, 2006 were $12.1 billion, compared with $11.6 billion atDecember 31, 2005.  The increase in totalloans was primarily driven by growth in construction lending, commercial realestate and residential mortgages. Construction loans totaled $1.9 billion atJune 30, 2006, compared with $1.6 billion at December 31, 2005, an increase of$248 million, or 15.4%. Commercial real estate loans increased $123.0 million,or 3.3%, from December 31, 2005. Residential real estate loans increased $102.7million, or 5.7%, from December 31, 2005. Total loans at June 30, 2006 increased $685.9 million, or 6.0%, overJune 30, 2005.

 
| **(Dollars in thousands)** | ** ** | **June 30,  2006** | ** **     | **% of  Total  Loans** | ** ** | **December 31,  2005** | ** ** | **% of  Total  Loans** | ** ** | **June 30,  2005** | ** ** | **% of  Total  Loans** | ** ** |
|--------------------------------------|------------|-------------------------|----------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Commercial                           | ** ** | **$**                   | **2,935,369**  | ** **                  | **24.4**   | **%**                       | $          | 2,957,301                   |       | 25.5                    | %          | $                           | 2,923,419  |   | 25.7 | % |
| Commercial real  estate              | ** ** | **3,826,335**           | ** **     | **31.7**                    |       | 3,703,297                   |       | 31.9                        |       | 3,585,592               |       | 31.6                        |       |
| Construction                         | ** ** | **1,855,110**           | ** **     | **15.4**                    |       | 1,607,095                   |       | 13.8                        |       | 1,560,149               |       | 13.7                        |       |
| Residential real  estate             | ** ** | **1,905,032**           | ** **     | **15.8**                    |       | 1,802,373                   |       | 15.5                        |       | 1,776,959               |       | 15.6                        |       |
| Home equity  lines                   | ** ** | **479,011**             | ** **     | **4.0**                     |       | 505,508                     |       | 4.4                         |       | 517,342                 |       | 4.6                         |       |
| Consumer                             | ** ** | **1,049,323**           | ** **     | **8.7**                     |       | 1,032,271                   |       | 8.9                         |       | 1,000,845               |       | 8.8                         |       |
| Total loans at  end of period        | ** ** | **$**                   | **12,050,180** | ** **                  | **100.0**  | **%**                       | $          | 11,607,845                  |       | 100.0                   | %          | $                           | 11,364,306 |   | 100.0 | % |

 

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**Deposits**

Totaldeposits at June 30, 2006, were $12.4 billion, an increase of $366.7 million,or 3.0%, over December 31, 2005. Noninterest-bearing deposits were $3.4 billion at June 30, 2006,compared with $3.3 billion at December 31, 2005, an increase of $67.6 million,or 2.0%.  Interest-bearing depositstotaled $9.1 billion at June 30, 2006, compared with $8.8 billion at December31, 2005, an increase of $299.0 million, or 3.4%.

AtJune 30, 2006, total deposits increased 5.2%, or $613.3 million, compared withthe year-earlier period.  The increase intotal deposits was primarily driven by growth in money market accounts and timedeposits $100,000 and over. These products are priced at competitive rates,which move with the overall interest rate environment. Money market accountsand time deposits $100,000 and over increased $416.9 million, or 24.9%, and$342.9 million, or 20.4%, respectively, from June 30, 2005.  Traditional low-cost savings and checkingplus interest accounts declined by 11.1% and 13.1%, respectively, from June 30,2005 as customers moved liquidity to higher yielding alternative products.
| ** **                           | ** ** | ** **              | ** **     | ** **                  | ** ** | ** **              | ** ** | **% change**                                     | ** ** |
|--------------------------------------|------------|-------------------------|----------------|-----------------------------|------------|-------------------------|------------|-------------------------------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **June 30,  2006** | ** **     | **December 31,  2005** | ** ** | **June 30,  2005** | ** ** | **June 30, 2006 /  December 31, 2005** | ** ** | **June 30, 2006 /  June 30, 2005** | ** ** |
| Noninterest  bearing deposits        | ** ** | **$**                   | **3,392,286**  |                        | $          | 3,324,650               |       | $                                                     | 3,293,344  |   | 2.0 | % | 3.0 | % |
| Savings                              | ** ** | **1,286,316**           |           | 1,339,215                   |       | 1,447,105               |       | (4.0                                                  | )          | (11.1 | ) |
| Checking plus  interest              | ** ** | **1,289,250**           |           | 1,430,524                   |       | 1,482,850               |       | (9.9                                                  | )          | (13.1 | ) |
| Money market                         | ** ** | **2,089,985**           |           | 1,944,513                   |       | 1,673,044               |       | 7.5                                                   |       | 24.9 |   |
| Time deposits  $100,000 and over     | ** ** | **2,026,294**           |           | 1,743,885                   |       | 1,683,378               |       | 16.2                                                  |       | 20.4 |   |
| Other time  deposits                 | ** ** | **2,359,891**           |           | 2,294,563                   |       | 2,251,030               |       | 2.8                                                   |       | 4.8 |   |
| Total deposits  at end of period     | ** ** | **$**                   | **12,444,022** |                        | $          | 12,077,350              |       | $                                                     | 11,830,751 |   | 3.0 |   | 5.2 |   |

 

**Borrowings**

Banksharesutilizes both short-term and long-term borrowings to fund growth of earningassets in excess of deposit growth. Short-term borrowings, which include federal funds purchased, securitiessold under agreements to repurchase and other short-term borrowings, were $1.4billion at June 30, 2006, compared with $1.2 billion at December 31, 2005.  Short-term funding is managed to levelsdeemed appropriate given alternative funding sources.  Long-term debt was $650.8 million at June 30,2006, a decrease of $91.3 million, or 12.3%, compared with the $742.2 millionat December 31, 2005.

**Capital**

Shareholders’equity at June 30, 2006 was $2.3 billion. On June 13, 2006, Bankshares’ Board of Directors authorized therepurchase of up to 2,000,000 shares of the Corporation’s common stock.  This is in addition to the 677,000 shares remainingfrom a previously announced program. During the first half of 2006, Bankshares repurchased 37,252 shares inthe privately negotiated net settlement of the minimum tax liability for vestedrestricted stock awards.

OnJanuary 10, 2006, Bankshares announced a three-for-two stock split on itscommon stock payable in the form of a stock dividend on January 27, 2006 tostockholders of record as of the close of business on January 20, 2006.  For comparative purposes, certain share,average share and per share amounts have been restated.  At June 30, 2006 and December 31, 2005, thecash-dividend payout ratio was 46.15% and 43.42%, respectively.  For more details, see the Statements ofChanges in Consolidated Shareholders’ Equity.

 

35

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**RISKMANAGEMENT**

**CreditRisk Analysis**

Bankshares’loans and commitments are substantially to borrowers located in its immediateregion.  Bankshares has limited itsparticipation in multibank credits where Bankshares is not the managing oragent bank.  Central to the operation ofa sound and successful financial institution is the balanced management ofasset growth and credit quality. Responsibility for loan underwriting and monitoring is clearly fixed onkey management personnel in each of our affiliates and, ultimately, on theboard of directors of each affiliate. These responsibilities are supported at the holding company level byappropriate underwriting guidelines and ongoing loan review.  In addition, Bankshares has set an internallimit for each affiliate bank that is well below the regulatory limit on themaximum amount of credit that may be extended to a single borrower.

Formore information on credit risk see “Risk Management — Credit Risk Analysis” inBankshares’ 2005 Annual Report on Form 10-K.

**NonperformingAssets**

Nonperformingassets consist of nonaccrual loans, renegotiated loans and other real estateowned (i.e., real estate acquired in foreclosure or in lieu offoreclosure).  With respect to nonaccrualloans, Bankshares’ policy is that, regardless of the value of the underlyingcollateral and/or guarantees, no interest is accrued on the entire balance onceeither principal or interest payments on any loan become 90 days past due atthe end of a calendar quarter.  Allaccrued and uncollected interest on such loans is eliminated from the incomestatement and is recognized only as collected. If a loan is impaired and has a specific loss allocation based on ananalysis under SFAS No. 114, “**Accounting byCreditors for Impairment of a Loan—an amendment of FASB Statements No. 5 and15,**” all payments are then applied against the loan’sprincipal.  A loan may be placed onnonaccrual status sooner than this standard if, in management’s judgment, suchaction is warranted.

Nonperformingloans increased to $29.2 million at June 30, 2006 from $22.6 million atDecember 31, 2005. The increase resulted from two construction loans to asingle borrower aggregating $13.9 million placed on nonaccrual, partiallyoffset by a $7.6 million commercial loan returned to accruing status.

Otherreal estate owned declined to $49 thousand at June 30, 2006 from $667 thousandat December 31, 2005.  The declineresulted from the sale of an OREO property acquired from CBNV during theacquisition.

Duringthe six months ended June 30, 2006, total nonperforming assets increased to$29.3 million from $23.2 million at December 31, 2005.  Nonperforming assets as a percent ofperiod-end loans and other real estate owned was 0.24% at June 30, 2006 and0.20% at December 31, 2005.

AtJune 30, 2006 and December 31, 2005, monitored loans, or loans withcharacteristics suggesting that they could be classified as nonperforming inthe near future, were $13.5 million and $2.2 million, respectively.  The increase in monitored loans relates tothree relationships that are well secured. Loans past due 30-89 days were $38.6 million at June 30, 2006 comparedwith $65.2 million at December 31, 2005.

36

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Thetable below presents a comparison of nonperforming assets at June 30, 2006,December 31, 2005 and June 30, 2005.

 
| **(Dollars in thousands)**                                               | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** | **June 30,  2005** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|-------------------------|------------|
| Nonaccrual loans(1)                                                                |       |                    |       |                        |       |                    |       |
| Commercial                                                                         | ** ** | **$**                   | **8,399**  |                        | $          | 15,771                  |       | $ | 21,980 |   |
| Commercial real estate                                                             | ** ** | **3,623**               |       | 4,451                       |       | 2,848                   |       |
| Construction                                                                       | ** ** | **15,482**              |       | 376                         |       | 378                     |       |
| Residential real estate                                                            | ** ** | **1,094**               |       | 1,505                       |       | 1,238                   |       |
| Home equity lines                                                                  | ** ** | **332**                 |       | 88                          |       | 86                      |       |
| Consumer                                                                           | ** ** | **315**                 |       | 374                         |       | 379                     |       |
| Total                                                                              | ** ** | **29,245**              |       | 22,565                      |       | 26,909                  |       |
| Renegotiated  loans (1)                                                            | ** ** | **—**              |       | —                      |       | —                  |       |
| Loans contractually  past due 90 days or more and still accruing interest          | ** ** | **—**              |       | —                      |       | —                  |       |
|                                                                               | ** ** | ** **              |       |                        |       |                    |       |
| Total nonperforming loans                                                          | ** ** | **29,245**              |       | 22,565                      |       | 26,909                  |       |
| Other real  estate owned                                                           | ** ** | **49**                  |       | 667                         |       | 777                     |       |
| Total nonperforming assets                                                         | ** ** | **$**                   | **29,294** |                        | $          | 23,232                  |       | $ | 27,686 |   |
| Nonperforming loans as  a percent of period-end loans                              |       |                    |       |                        |       |                    |       |
|                                                                               | ** ** | **0.24**                | **%**      | 0.19                        | %          | 0.24                    | %          |
| Nonperforming assets as  a percent of period-end loans and other real estate owned |       |                    |       |                        |       |                    |       |
|                                                                               | ** ** | **0.24**                | **%**      | 0.20                        | %          | 0.24                    | %          |

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(1)             Aggregategross interest income of $1.2 million, $2.1 million and $1.2 million for thefirst six months of 2006, the year 2005 and the first six months of 2005,respectively, on nonaccrual and renegotiated loans, would have been recorded ifthese loans had been accruing on their original terms throughout the period orsince origination if held for part of the period.  The amount of interest income on the nonaccrualand renegotiated loans that was recorded totaled $0.3 million, $0.5 million and$0.3 million for the first six months of 2006, the year 2005 and the first sixmonths of 2005, respectively.

**NetRecoveries/Charge-offs**

Netrecoveries for the six months ended June 30, 2006 and 2005 were $1.1 millionand $257 thousand, respectively.  Netrecoveries as a percent of period end loans of 0.02%, for the six months endedJune 30, 2006, showed a two basis point improvement from the same period lastyear.

**Provisionfor Credit Losses**

Therewere no provisions for credit losses for the six months ended June 30, 2006compared with $756 thousand for the six months ended June 30, 2005, reflectingimproved loan quality and continued favorable economic conditions.

37

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**Allowancefor Loan Losses and Reserve for Unfunded Commitments**

Theallowance for loan losses declined $13.8 million to $142.9 million at June 30,2006, or 1.19% of period-end loans, compared with $156.7 million, or 1.35% ofperiod-end loans, at December 31, 2005 and $157.1 million, or 1.38% of periodend loans, at June 30, 2005.  The declinefrom year-end 2005 was primarily related to the reclassification of $14.0million out of the reserve for loan losses to establish the reserve forunfunded commitments in other liabilities.

Thefollowing table presents a summary of the activity in the Allowance for LoanLosses and the Reserve for Unfunded Commitments.

 
| ** **                                      | ** ** | **For the 6 months ended   June 30,** | ** **  | **For the 3 months ended   June 30,** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------------------------------|-------------|---------------------------------------------------------------------|------------|
| **(Dollars in thousands)**            | ** ** | **2006**                                                            | ** **  | **2005**                                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Allowance for  loan losses, beginning of period | ** ** | **$**                                                               | **156,673** |                                                                | $          | 149,002 | ** ** | **$** | **141,874** |   | $ | 149,017 |   |
| Allowance of  acquired bank                     | ** ** | **—**                                                          |        | 7,086                                                               | ** ** | **—** |   | 7,086 |   |
| Charge-offs:                                    |       |                                                                |        |                                                                |       |   |   |   |   |
| Commercial                                      | ** ** | **(594**                                                            | **)**       | (1,682                                                              | )          | **(193** | **)** | (383 | ) |
| Commercial real estate                          | ** ** | **(362**                                                            | **)**       | (32                                                                 | )          | **(153** | **)** | — |   |
| Construction                                    | ** ** | **—**                                                          |        | —                                                              | ** ** | **—** |   | — |   |
| Residential real estate                         | ** ** | **(2**                                                              | **)**       | (14                                                                 | )          | **—** |   | (3 | ) |
| Home equity lines                               | ** ** | **—**                                                          |        | (69                                                                 | )          | **—** |   | (69 | ) |
| Consumer                                        | ** ** | **(1,270**                                                          | **)**       | (1,318                                                              | )          | **(504** | **)** | (718 | ) |
| Total                                           | ** ** | **(2,228**                                                          | **)**       | (3,115                                                              | )          | **(850** | **)** | (1,173 | ) |
| Recoveries:                                     |       |                                                                |        |                                                                |       |   |   |   |   |
| Commercial                                      | ** ** | **2,082**                                                           |        | 1,580                                                               | ** ** | **1,174** |   | 985 |   |
| Commercial real estate                          | ** ** | **60**                                                              |        | 124                                                                 | ** ** | **27** |   | 118 |   |
| Construction                                    | ** ** | **1**                                                               |        | 1                                                                   | ** ** | **—** |   | 1 |   |
| Residential real estate                         | ** ** | **53**                                                              |        | 65                                                                  | ** ** | **28** |   | 30 |   |
| Home equity lines                               | ** ** | **24**                                                              |        | —                                                              | ** ** | **22** |   | — |   |
| Consumer                                        | ** ** | **1,153**                                                           |        | 1,602                                                               | ** ** | **585** |   | 1,037 |   |
| Total                                           | ** ** | **3,373**                                                           |        | 3,372                                                               | ** ** | **1,836** |   | 2,171 |   |
| Net recoveries                                  | ** ** | **1,145**                                                           |        | 257                                                                 | ** ** | **986** |   | 998 |   |
| Provision for  credit losses                    | ** ** | **(990**                                                            | **)**       | 756                                                                 | ** ** | **—** |   | — |   |
| Transfer to  reserve for unfunded commitments   | ** ** | **(13,968**                                                         | **)**       | —                                                              | ** ** | **—** |   | — |   |
| Allowance for loan  losses, end of period       | ** ** | **$**                                                               | **142,860** |                                                                | $          | 157,101 | ** ** | **$** | **142,860** |   | $ | 157,101 |   |

 
| ** **                                                                       | ** ** | **For the 6 months ended  June 30,** | ** **     | **For the 3 months ended   June 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|---------------------------------------------------------------|----------------|---------------------------------------------------------------------|------------|
| **(Dollars in thousands)**                                             | ** ** | **2006**                                                      | ** **     | **2005**                                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Reserve for  unfunded lending commitments, beginning of period                   | ** ** | **$**                                                         | **—**     |                                                                | $          | — | ** ** | **$** | **14,958** |   | $ | — |   |
| Provision for  credit losses                                                     | ** ** | **990**                                                       |           | —                                                              | ** ** | **—** |   | — |   |
| Transfer from  allowance for loan losses                                         | ** ** | **13,968**                                                    |           | —                                                              | ** ** | **—** |   | — |   |
| Reserve for  unfunded lending commitments, end of period     | ** ** | **$**                                                         | **14,958**     |                                                                | $          | — | ** ** | **$** | **14,958** |   | $ | — |   |
|                                                                             |       |                                                          |           |                                                                |       |   |   |   |   |
| Average loans                                                                    | ** ** | **$**                                                         | **11,784,981** |                                                                | $          | 10,608,428 | ** ** | **$** | **11,921,540** |   | $ | 10,899,263 |   |
| Period-end loans                                                                 | ** ** | **$**                                                         | **12,050,180** |                                                                | $          | 11,364,306 |   |   |   |   |   |
|                                                                             |       |                                                          |           |                                                                |       |   |   |   |   |
| **Allowance for loan losses**                                                    | ** ** | ** **                                                    | ** **     | ** **                                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Percent of net  (recoveries), (annualized), to average loans                     | ** ** | **(0.02)%**                                                   |           | —%                                                             | ** ** | **(0.03)%** |   | (0.04)% |   |
| Percent of allowance  for loan losses to period-end loans                        | ** ** | **1.19%**                                                     |           | 1.38%                                                               |       |   |   |   |   |

 

38

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**InterestRate Risk**

Theobjective of interest rate risk management is to contain the risks associatedwith interest rate fluctuations.  Theprocess involves identification and management of the sensitivity of netinterest income to changing interest rates 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 moreinformation see “Risk Management — Interest Rate Risk” in the MercantileBankshares Corporation’s 2005 Annual Report on Form 10-K.

EARNINGSSIMULATION MODEL PROJECTIONS

Banksharesassesses interest rate risk by comparing projected net interest income in thecurrent rate environment with various interest rate scenarios that differ inthe direction of interest rate changes, the degree of change over time, thespeed of the change and the projected shape of the yield curve. This analysisincorporates substantially all of Bankshares’ assets and liabilities andoff-balance sheet instruments. Through these simulations, management estimatesthe impact on net interest income of a 200 basis point upward and downwardchange in interest rates. The following table summarizes the effect that a +/–200 basis point change in interest rates would have on Bankshares’ net interestincome over the next 12 months.

 
| ** **                                                       | ** ** | **Calculated increase / (decrease) in  projected net interest income as of June 30,** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------|------------|
| **Change in interest rates  (basis points)** | ** ** | **2006**                                                                                                                                     | ** ** | **2005** | ** ** |
| +200                                                             | ** ** | **0.80**                                                                                                                                     | **%**      | 4.50 | % |
| +100                                                             | ** ** | **0.46**                                                                                                                                     | **%**      | 2.20 | % |
| -100                                                             | ** ** | **(0.89**                                                                                                                                    | **)%**     | -2.40 | % |
| -200                                                             | ** ** | **(2.52**                                                                                                                                    | **)%**     | N/A | % |

 

AtJune 30, 2006, Bankshares’ interest sensitivity position was less assetsensitive than it was at June 30, 2005. Based on its most recent simulation model, Bankshares’ net interestincome would increase by $3.0 million, or 0.46%, and $5.3 million, or 0.80%, ifinterest rates were to move up gradually over the next six months by 100 basispoints or 200 basis points, respectively. A downward movement of 100 basis points would reduce net interest incomeby $5.9 million, or 0.89%.  A downwardmovement of 200 basis points would reduce net interest income by $16.7 million,or 2.52%.  Bankshares manages theinterest rate risk profile within policy limits.  At June 30, 2006, and December 31, 2005,Bankshares was within its policy guidelines. In response to action by the Federal Reserve to increase short-terminterest rates, Bankshares’ prime interest rate continues to rise.  At June 30, 2006, Bankshares hadapproximately $4.6 billion in loans that will reprice daily or monthly asmarket rates change.  The effects of arising rate environment on interest expense are less predictable due tocustomer behavior that can result in changes in the mix of depositproducts.  Current trends have generatedgrowth in higher-rate premium money market and certificate of depositaccounts.  Given the current rateenvironment, the flatness of the yield curve and competitive pressure on bothloan and deposit pricing, we anticipate that the net interest margin willremain under some pressure throughout the year.

Banksharesalso utilizes interest rate derivatives to hedge interest rate riskexposures.  The credit risk amount andestimated net fair values of these derivatives as of June 30, 2006 and December31, 2005 are presented in Note No. 12 -Derivative Instruments and HedgingActivities.  Derivatives are used forasset/liability management in three ways:

·                  Toconvert long-term fixed-rate debt to floating-rate payments by entering intoreceive-fixed swaps at issuance;

·                  Toconvert the cash flows from selected asset and/or liabilityinstruments/portfolios from fixed to floating payments or vice versa; and

·                  Tohedge the mortgage origination pipeline by utilizing forward rate commitmentsfor loans held-for-sale.

39

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MARKETVALUE OF EQUITY MODELING

Banksharesalso utilizes the market value of equity as a measurement tool in managinginterest rate sensitivity.  The marketvalue of equity measures the degree to which the market values of Bankshares’assets and liabilities and off-balance sheet instruments will change given achange in interest rates. The Asset Liability Management Committee guidelineslimit the change in market value of equity in a 200 basis point parallel rateshock to 12.5% of the market value of equity assuming interest rates at June30, 2006.  The up 200 basis pointscenario resulted in a 4.42% decrease at June 30, 2006 compared with a 2.9%decrease at December 31, 2005.  The down200 basis point scenario resulted in a 0.47% decrease at June 30, 2006 and a 3.9%decrease at December 31, 2005.  At June30, 2006 and December 31, 2005, Bankshares was within its policy guidelines.

Thevaluation analysis is dependent upon certain key assumptions about the natureof indeterminate maturities of assets and liabilities. Management estimates theaverage life and rate characteristics of asset and liability accounts based onhistorical analysis and management’s expectation of rate behavior.  These assumptions are periodically validatedand updated.

**MarketRisk**

Marketrisk is defined as the constraint imposed by lower market values of assets andliabilities as interest rates and equity markets fluctuate.  Changes in market values also affect the feeincome earned by IWM, where a significant portion of the fee schedule is tiedto current asset values under management or administration.  Bankshares has designated substantially allof its investment portfolio as available-for-sale, and in accordance withfinancial reporting standards, this portfolio is reported at fair value.  Changes in fair value, net of tax, arereflected as a component of shareholders’ equity.

*TradingActivities*

Banksharesprovides capital market products to its customers. From a market riskperspective, Bankshares’ net income is exposed to changes in interest rates,credit spreads, and equities and their implied volatilities.  The primary purpose of Bankshares’ capitalmarkets business is to accommodate customers in the management of their marketprice risks.  Derivative transactionsexecuted with customers are simultaneously hedged in the capital markets.  All derivatives transacted with customersused to hedge capital market transactions with customers are carried at fairvalue.  The Asset/Liability ManagementCommittee establishes and monitors counterparty risk limits.  The notional amount, exposure amount andestimated net fair value of all customer accommodation derivatives at June 30,2006 are included in Note No. 12 — Derivative Instruments and HedgingActivities.

*EquityMarkets*

Banksharesis directly and indirectly affected by changes in the equity markets.  Bankshares has made investments in privateequities. These investments are made within capital allocations approved bymanagement.  Management reviews theseinvestments at least quarterly and assesses them for possible other-than-temporaryimpairment.  Private equity investmentstotaled $24.3 million at June 30, 2006 and $20.9 million at June 30, 2005.

Changesin equity market prices may also indirectly affect Bankshares’ net income byaffecting (1) the value of third party assets under management oradministration within IWM and, hence, fee income; (2) particular borrowers,whose ability to repay principal and/or interest may be affected by the stockmarket; or (3) brokerage activity, related commission income and other businessactivities.

40

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**LiquidityRisk**

Liquidityrisk is the possibility that Bankshares will not be able to fund present andfuture financial obligations.  Theobjective of liquidity management is to maintain the ability to meetcommitments to fund loans, purchase securities and repay deposits and otherliabilities in accordance with their terms. To achieve this objective, the Asset/Liability Management Committeeestablishes and monitors liquidity guidelines that require sufficientasset-based liquidity to cover potential funding requirements and to avoidover-reliance on volatile, less reliable funding markets.  Debt securities in the available-for-saleportfolio provide liquidity, in addition to the immediately liquid resources ofcash and due from banks and federal funds sold and securities purchased underresale agreements.  By limiting thematurity of securities and maintaining a conservative investment posture,management can rely on the investment portfolio to help meet any short-termfunding needs.  U.S. Treasury and agencysecurities, which provide the greatest liquidity, averaged $1.4 billion in eachof the second quarter of 2006, first quarter of 2006 and second quarter of2005.

Corecustomer deposits have historically provided a substantial source of relativelystable and low-cost funds.  For the threemonths ended June 30, 2006, core deposits (total deposits less certificates ofdeposit of $100,000 and over), averaged $10.1 billion compared with $10.0billion for the first quarter of 2006 and $9.7 billion for the second quarterof 2005.  Although not viewed as coredeposits, 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.  Long-term debt andshort-term borrowings funded the remaining assets.

Inaddition to these sources, Bankshares has access to national markets forcertificates of deposit, commercial paper and debt financing.  Should it need to supplement its liquidity,Bankshares has $2.1 billion in lines with the Federal Home Loan Bank of Atlanta(FHLB) and back-up commercial paper lines of $40 million with commercial banks.  Bankshares is required to obtain approval fromholders of Bankshares’ 6.80% unsecured senior notes if it incrementally borrowsin excess of $150 million under the FHLB lines.

Liquidityis also available through Bankshares’ ability to raise funds in the capitalmarkets.  Bankshares accesses capital marketsfor long-term funding by issuing registered debt and private placements.  In September 2005, Moody’s Investors Serviceaffirmed Bankshares’ commercial paper rating of “P-1” and Bankshares’subordinated debt rating of “A2.”  Alsoin September 2005, Standard & Poor’s Ratings Service affirmed Bankshares’rating of “A+/Stable/A-1”, and counterparty rating of “A+/Stable/A-1.”  Rating agencies base their ratings on manyquantitative and qualitative factors, including capital adequacy, liquidity,asset quality, quality of the management team, business mix and level andquality of earnings.

Foradditional information see “Risk Management — Liquidity Risk” in Bankshares’2005 Annual Report on Form 10-K.

**ContractualObligations and Commitments**

Inthe normal course of business, Bankshares enters into certain contractualobligations and other commitments.  Suchobligations generally relate to funding operations through debt arrangements aswell as leases of premises and equipment. As a financial services provider, Bankshares routinely enters intocommitments to extend credit, including loan commitments, standby letters ofcredit and financial guarantees.  For adiscussion of these commitments, see Note No. 7 Commitments and Contingenciesabove.  For a discussion of contractualcommitments see “Off-Balance Sheet Arrangements and Contractual Obligations” inBankshares’ 2005 Annual Report on Form 10-K. Items disclosed in the Annual Report on Form 10-K have not changedmaterially since the report was filed.

41

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**Cautionary Statement**

This report contains financial information determined bymethods other than in accordance with Generally Accepted Accounting Principles(“GAAP”).  Bankshares’ management usesthese non-GAAP measures in their analysis of the Company’s performance.  In particular, net interest income, netinterest margin and the cash operating efficiency ratio are calculated on afully tax-equivalent basis (“FTE”).  TheFTE basis is determined by adjusting net interest income to reflect tax-exemptinterest income on a before-tax equivalent basis.  These measures typically adjust GAAPperformance measures to exclude intangible assets and the amortization ofintangible assets related to the consummation of mergers.  These operating earnings measures may alsoexclude other significant gains, losses or expenses that are not consideredcomponents of core earnings.  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 aproper understanding of the operating results and financial position ofBankshares’ core businesses.  Thesedisclosures should not be viewed as a substitute for results determined inaccordance with GAAP, nor are they necessarily comparable to operating earningsperformance measures that may be presented by other companies.

Thisreport contains forward-looking statements within the meaning of and pursuantto the safe harbor provisions of the Private Securities Litigation Reform Actof 1995.  A forward-looking statementencompasses any estimate, prediction, opinion or statement of belief containedin this report and the underlying management assumptions.  Such statements in this report include:  identification of trends; loan growth;deposit retention; comments on adequacy of the allowance for loan losses;credit quality; effects of asset sensitivity and interest rate changes; andinformation concerning market risk referenced in Item 3.  Forward-looking statements are based oncurrent expectations and assessments of potential developments affecting marketconditions, interest rates and other economic conditions, and results mayultimately vary from the statements made in this report.  In addition, the following factors, amongothers, could cause actual results to differ materially from the anticipatedresults or expectations expressed in the forward-looking statements:administrative and operational efficiencies may not improve to the degreeprojected; and competitive pressures and regulatory complexities that affectour banks may be more severe than expected.

 

42

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**SupplementalInformation by Quarter**Select Financial DataIn thousands, except per share data(unaudited)
| ** **                                                                            | ** ** | **2Q 06** | ** **     | **1Q 06** | ** ** | **4Q 05** | ** ** | **3Q 05** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------|----------------|----------------|------------|----------------|------------|----------------|------------|
| **OPERATING RESULTS**                                                                 | ** ** | ** **     | ** **     | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** |
| Net interest  income (1)                                                              | ** ** | **$**          | **161,410**    |           | $          | 158,313        |       | $              | 162,434    |   | $ | 159,242 |   |
| Net interest  income - taxable equivalent (1)                                         | ** ** | **163,254**    |           | 160,146        |       | 164,267        |       | 161,023        |       |
| Provision for  credit losses                                                          | ** ** | **—**     |           | —         |       | —         |       | 820            |       |
| Net income                                                                            | ** ** | **73,092**     |           | 70,759         |       | 74,863         |       | 70,956         |       |
|                                                                                  | ** ** | ** **     |           |           |       |           |       |           |       |
| **PER COMMON SHARE DATA***                                                            | ** ** | ** **     | ** **     | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** |
| Basic net income                                                                      | ** ** | **$**          | **0.59**       |           | $          | 0.58           |       | $              | 0.61       |   | $ | 0.58 |   |
| Diluted net  income                                                                   | ** ** | **0.59**       |           | 0.57           |       | 0.60           |       | 0.57           |       |
| Dividends paid                                                                        | ** ** | **0.28**       |           | 0.26           |       | 0.25           |       | 0.25           |       |
| Book value at  period end                                                             | ** ** | **18.34**      |           | 18.05          |       | 17.81          |       | 17.47          |       |
| Market value at  period end                                                           | ** ** | **35.67**      |           | 38.45          |       | 37.63          |       | 35.92          |       |
| Market range:                                                                         |       |           |           |           |       |           |       |           |       |
| High                                                                                  | ** ** | **39.53**      |           | 39.82          |       | 40.09          |       | 37.46          |       |
| Low                                                                                   | ** ** | **35.00**      |           | 36.88          |       | 34.11          |       | 34.13          |       |
|                                                                                  | ** ** | ** **     |           |           |       |           |       |           |       |
| **AVERAGE BALANCE SHEET DATA**                                                        | ** ** | ** **     | ** **     | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** |
| Total loans                                                                           | ** ** | **$**          | **11,921,540** |           | $          | 11,646,904     |       | $              | 11,497,885 |   | $ | 11,389,731 |   |
| Total earning  assets                                                                 | ** ** | **15,196,996** |           | 14,880,775     |       | 14,698,731     |       | 14,490,736     |       |
| Total assets                                                                          | ** ** | **16,798,972** |           | 16,435,964     |       | 16,258,275     |       | 16,065,168     |       |
| Total deposits                                                                        | ** ** | **12,190,193** |           | 11,940,956     |       | 11,894,394     |       | 11,751,990     |       |
| Shareholders’  equity                                                            | ** ** | **2,309,149**  |           | 2,261,646      |       | 2,210,050      |       | 2,179,415      |       |
|                                                                                  | ** ** | ** **     |           |           |       |           |       |           |       |
| **STATISTICS AND RATIOS (Net  income annualized)**                                    | ** ** | ** **     | ** **     | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** |
| Return on average  assets                                                             | ** ** | **1.75**       | **%**          | 1.75           | %          | 1.83           | %          | 1.75           | %          |
| Return on  average equity (2)                                                         | ** ** | **12.70**      |           | 12.69          |       | 13.44          |       | 12.92          |       |
| Return on  average tangible equity (2)                                                | ** ** | **18.80**      |           | 18.97          |       | 20.26          |       | 19.62          |       |
| Average equity  to average assets (2)                                                 | ** ** | **13.75**      |           | 13.76          |       | 13.59          |       | 13.57          |       |
| Average tangible  equity to average tangible assets (2)                               | ** ** | **9.88**       |           | 9.81           |       | 9.61           |       | 9.53           |       |
| Net interest  rate spread - taxable equivalent                                        | ** ** | **3.51**       |           | 3.64           |       | 3.78           |       | 3.83           |       |
| Net interest  margin on earning assets - taxable equivalent                           | ** ** | **4.31**       |           | 4.36           |       | 4.43           |       | 4.41           |       |
| Efficiency ratio  (1),(3)                                                             | ** ** | **48.05**      |           | 48.34          |       | 47.87          |       | 48.36          |       |
| Cash operating  efficiency ratio (1),(3)                                              | ** ** | **47.08**      |           | 47.30          |       | 46.69          |       | 46.99          |       |
| Dividend payout  ratio*                                                               | ** ** | **47.46**      |           | 44.83          |       | 40.98          |       | 43.10          |       |
|                                                                                  | ** ** | ** **     |           |           |       |           |       |           |       |
| Bank offices                                                                          | ** ** | **237**        |           | 238            |       | 240            |       | 238            |       |
| Employees                                                                             | ** ** | **3,667**      |           | 3,658          |       | 3,606          |       | 3,607          |       |
|                                                                                  | ** ** | ** **     |           |           |       |           |       |           |       |
| **CREDIT QUALITY DATA AT PERIOD  END**                                                |       |           |           |           |       |           |       |           |       |
| Net charge-offs  / (recoveries)                                                       | ** ** | **$**          | **(986**       | **)**          | $          | (159           | )          | $              | 503        |   | $ | 745 |   |
| Nonaccrual loans                                                                      | ** ** | **29,245**     |           | 22,890         |       | 22,565         |       | 27,022         |       |
| Restructured  loans                                                                   | ** ** | **—**     |           | —         |       | —         |       | —         |       |
| Total  nonperforming loans                                                            | ** ** | **29,245**     |           | 22,890         |       | 22,565         |       | 27,022         |       |
| Other real  estate owned, net                                                         | ** ** | **49**         |           | 713            |       | 667            |       | 777            |       |
| Total  nonperforming assets                                                           | ** ** | **29,294**     |           | 23,603         |       | 23,232         |       | 27,799         |       |
|                                                                                  | ** ** | ** **     |           |           |       |           |       |           |       |
| **CREDIT QUALITY RATIOS**                                                             | ** ** | ** **     | ** **     | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** |
| Net charge-offs /  (recoveries), annualized, as a percent of period-end loans         | ** ** | **(0.03**      | **)%**         | (0.01          | )%         | 0.02           | %          | 0.03           | %          |
| Nonperforming  loans as a percent of period-end loans                                 | ** ** | **0.24**       |           | 0.20           |       | 0.19           |       | 0.24           |       |
| Allowance for  loan losses as a percent of period-end loans**                    | ** ** | **1.19**       |           | 1.21           |       | 1.35           |       | 1.37           |       |
| Allowance for  loan losses as a percent of nonperforming loans                        | ** ** | **488.49**     |           | 619.81         |       | 694.32         |       | 581.66         |       |
| Other real  estate owned as a percent of period-end loans and other real estate owned | ** ** | **—**     |           | 0.01           |       | 0.01           |       | 0.01           |       |
| Nonperforming  assets as a percent of period-end loans and other real estate owned    | ** ** | **0.24**       |           | 0.20           |       | 0.20           |       | 0.24           |       |
| Nonperforming assets as  a percent of total assets                                    | ** ** | **0.17**       |           | 0.14           |       | 0.14           |       | 0.17           |       |

 

43

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**SupplementalInformation by Quarter (continued)**Select Financial DataIn thousands, except per share data(unaudited)
| ** **                                                                            | ** ** | **2Q 05** | ** ** | **2Q 06  vs  1Q 06** | ** ** | **2Q 06  vs  2Q 05** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------|------------|--------------------------------|------------|--------------------------------|------------|
| **OPERATING RESULTS**                                                                 | ** ** | ** **     | ** ** | ** **                     | ** ** | ** **                     | ** ** |
| Net interest income  (1)                                                              |       | $              | 152,367    |                           | 2.0        | %                              | 5.9        | % |
| Net interest  income - taxable equivalent (1)                                         |       | 154,023        |       | 1.9                            |       | 6.0                            |       |
| Provision for  credit losses                                                          |       | —         |       | —                         |       | —                         |       |
| Net income                                                                            |       | 67,873         |       | 3.3                            |       | 7.7                            |       |
|                                                                                  |       |           |       |                           |       |                           |       |
| **PER COMMON SHARE DATA***                                                            | ** ** | ** **     | ** ** | ** **                     | ** ** | ** **                     | ** ** |
| Basic net income                                                                      |       | $              | 0.56       |                           | 1.7        | %                              | 5.4        | % |
| Diluted net  income                                                                   |       | 0.56           |       | 3.5                            |       | 5.4                            |       |
| Dividends paid                                                                        |       | 0.25           |       | 7.7                            |       | 12.0                           |       |
| Book value at  period end                                                             |       | 17.25          |       | 1.6                            |       | 6.3                            |       |
| Market value at  period end                                                           |       | 34.35          |       | (7.2                           | )          | 3.8                            |       |
| Market range:                                                                         |       |           |       |                           |       |                           |       |
| High                                                                                  |       | 35.20          |       | (0.7                           | )          | 12.3                           |       |
| Low                                                                                   |       | 32.39          |       | (5.1                           | )          | 8.1                            |       |
|                                                                                  |       |           |       |                           |       |                           |       |
| **AVERAGE BALANCE SHEET DATA**                                                        | ** ** | ** **     | ** ** | ** **                     | ** ** | ** **                     | ** ** |
| Total loans                                                                           |       | $              | 10,899,263 |                           | 2.4        | %                              | 9.4        | % |
| Total earning  assets                                                                 |       | 13,840,991     |       | 2.1                            |       | 9.8                            |       |
| Total assets                                                                          |       | 15,233,571     |       | 2.2                            |       | 10.3                           |       |
| Total deposits                                                                        |       | 11,273,220     |       | 2.1                            |       | 8.1                            |       |
| Shareholders’  equity                                                            |       | 2,042,104      |       | 2.1                            |       | 13.1                           |       |
|                                                                                  |       |           |       |                           |       |                           |       |
| **STATISTICS AND RATIOS (Net  income annualized)**                                    | ** ** | ** **     | ** ** | ** **                     | ** ** | ** **                     | ** ** |
| Return on  average assets                                                             |       | 1.79           | %          |                           |       |                           |       |
| Return on  average equity (2)                                                         |       | 13.33          |       |                           |       |                           |       |
| Return on  average tangible equity (2)                                                |       | 19.64          |       |                           |       |                           |       |
| Average equity  to average assets (2)                                                 |       | 13.41          |       |                           |       |                           |       |
| Average tangible  equity to average tangible assets (2)                               |       | 9.67           |       |                           |       |                           |       |
| Net interest  rate spread - taxable equivalent                                        |       | 3.95           |       |                           |       |                           |       |
| Net interest  margin on earning assets - taxable equivalent                           |       | 4.46           |       |                           |       |                           |       |
| Efficiency ratio  (1),(3)                                                             |       | 48.54          |       |                           |       |                           |       |
| Cash operating  efficiency ratio (1),(3)                                              |       | 48.26          |       |                           |       |                           |       |
| Dividend payout  ratio*                                                               |       | 44.64          |       |                           |       |                           |       |
|                                                                                  |       |           |       |                           |       |                           |       |
| Bank offices                                                                          |       | 239            |       | (1                             | )          | (2                             | )          |
| Employees                                                                             |       | 3,630          |       | 9                              |       | 37                             |       |
|                                                                                  |       |           |       |                           |       |                           |       |
| **CREDIT QUALITY DATA AT PERIOD  END**                                                | ** ** | ** **     | ** ** | ** **                     | ** ** | ** **                     | ** ** |
| Net charge-offs  / (recoveries)                                                       |       | $              | (998       | )                              | 520.1      | %                              | (1.2       | )% |
| Nonaccrual loans                                                                      |       | 26,909         |       | 27.8                           |       | 8.7                            |       |
| Restructured  loans                                                                   |       | —         |       | —                         |       | —                         |       |
| Total  nonperforming loans                                                            |       | 26,909         |       | 27.8                           |       | 8.7                            |       |
| Other real  estate owned, net                                                         |       | 777            |       | (93.1                          | )          | (93.7                          | )          |
| Total  nonperforming assets                                                           |       | 27,686         |       | 24.1                           |       | 5.8                            |       |
|                                                                                  |       |           |       |                           |       |                           |       |
| **CREDIT QUALITY RATIOS**                                                             | ** ** | ** **     | ** ** | ** **                     | ** ** | ** **                     | ** ** |
| Net charge-offs /  (recoveries), annualized, as a percent of period-end loans         |       | (0.04          | )%         |                           |       |                           |       |
| Nonperforming  loans as a percent of period-end loans                                 |       | 0.24           |       |                           |       |                           |       |
| Allowance for  loan losses as a percent of period-end loans**                         |       | 1.38           |       |                           |       |                           |       |
| Allowance for  loan losses as a percent of nonperforming loans                        |       | 583.82         |       |                           |       |                           |       |
| Other real  estate owned as a percent of period-end loans and other real estate owned |       | 0.01           |       |                           |       |                           |       |
| Nonperforming  assets as a percent of period-end loans and other real estate owned    |       | 0.24           |       |                           |       |                           |       |
| Nonperforming assets as  a percent of total assets                                    |       | 0.17           |       |                           |       |                           |       |

----

*                    In January 2006, Bankshares announced athree-for-two stock split on its common stock. Per share amounts and other applicable information have been adjusted togive effect to the split.

**             Thedecline in the allowance for loan losses was due primarily to thereclassification of $14.0 million out of the allowance for loan losses, duringthe first quarter of 2006, to a separate reserve for unfunded commitments,which is recorded in other liabilities in the consolidated balance sheet.

(1), (2), (3) See *Reconciliation of Non-GAAPMeasures*

44

----

**Statements ofConsolidated Income**In thousands, except per share data(unaudited)

 
| ** **                                                 | ** ** | **2Q 06** | ** **  | **1Q 06** | ** ** | **4Q 05** | ** ** | **3Q 05** | ** ** | **2Q 05** | ** ** | **2Q 06  vs  1Q 06** | ** ** | **2Q 06  vs  2Q 05** | ** ** |
|------------------------------------------------------------|------------|----------------|-------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|--------------------------------|------------|--------------------------------|------------|
| **INTEREST INCOME**                                        | ** ** | ** **     | ** **  | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **                     | ** ** | ** **                     | ** ** |
| Interest and  fees on loans                                | ** ** | **$**          | **208,096** |           | $          | 196,055        |       | $              | 192,697    |           | $          | 185,714                        |       | $                              | 169,877    |   | 6.1 | % | 22.5 | % |
| Interest and dividends  on investment securities:          |       |           |        |           |       |           |       |           |       |           |       |                           |       |                           |       |
| Taxable interest income                                    | ** ** | **31,135**     |        | 29,795         |       | 30,081         |       | 26,686         |       | 25,374         |       | 4.5                            |       | 22.7                           |       |
| Tax-exempt interest income                                 | ** ** | **765**        |        | 778            |       | 813            |       | 839            |       | 788            |       | (1.7                           | )          | (2.9                           | )          |
| Other investment income                                    | ** ** | **699**        |        | 627            |       | 722            |       | 526            |       | 583            |       | 11.5                           |       | 19.9                           |       |
|                                                       | ** ** | **32,599**     |        | 31,200         |       | 31,616         |       | 28,051         |       | 26,745         |       | 4.5                            |       | 21.9                           |       |
| Other interest  income                                     | ** ** | **1,098**      |        | 658            |       | 890            |       | 760            |       | 442            |       | 66.9                           |       | 148.4                          |       |
| Total interest income                                      | ** ** | **241,793**    |        | 227,913        |       | 225,203        |       | 214,525        |       | 197,064        |       | 6.1                            |       | 22.7                           |       |
|                                                       |       |           |        |           |       |           |       |           |       |           |       |                           |       |                           |       |
| **INTEREST EXPENSE**                                       | ** ** | ** **     | ** **  | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **                     | ** ** | ** **                     | ** ** |
| Interest on  deposits                                      | ** ** | **57,603**     |        | 49,243         |       | 44,637         |       | 38,591         |       | 31,384         |       | 17.0                           |       | 83.5                           |       |
| Interest on  short-term borrowings                         | ** ** | **13,500**     |        | 11,023         |       | 9,038          |       | 7,702          |       | 5,484          |       | 22.5                           |       | 146.2                          |       |
| Interest on  long-term debt                                | ** ** | **9,280**      |        | 9,334          |       | 9,094          |       | 8,990          |       | 7,829          |       | (0.6                           | )          | 18.5                           |       |
| Total interest expense                                     | ** ** | **80,383**     |        | 69,600         |       | 62,769         |       | 55,283         |       | 44,697         |       | 15.5                           |       | 79.8                           |       |
|                                                       |       |           |        |           |       |           |       |           |       |           |       |                           |       |                           |       |
| **NET  INTEREST INCOME**                                   | ** ** | **161,410**    |        | 158,313        |       | 162,434        |       | 159,242        |       | 152,367        |       | 2.0                            |       | 5.9                            |       |
| Provision for  credit losses                               | ** ** | **—**     |        | —         |       | —         |       | 820            |       | —         |       | —                         |       | —                         |       |
|                                                       |       |           |        |           |       |           |       |           |       |           |       |                           |       |                           |       |
| **NET  INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES** | ** ** | **161,410**    |        | 158,313        |       | 162,434        |       | 158,422        |       | 152,367        |       | 2.0                            |       | 5.9                            |       |
|                                                       |       |           |        |           |       |           |       |           |       |           |       |                           |       |                           |       |
| **NONINTEREST INCOME**                                     | ** ** | ** **     | ** **  | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **                     | ** ** | ** **                     | ** ** |
| Investment and  wealth management                          |       | **28,865**     |        | 26,121         |       | 24,251         |       | 23,668         |       | 23,780         |       | 10.5                           |       | 21.4                           |       |
| Service charges  on deposit accounts                       | ** ** | **10,868**     |        | 10,292         |       | 10,893         |       | 11,478         |       | 11,088         |       | 5.6                            |       | (2.0                           | )          |
| Mortgage  banking-related fees                             | ** ** | **2,335**      |        | 2,210          |       | 4,690          |       | 5,151          |       | 2,895          |       | 5.7                            |       | (19.3                          | )          |
| Investment  securities gains and (losses)                  | ** ** | **—**     |        | (13            | )          | (53            | )          | (32            | )          | 76             |       | 100.0                          |       | (100.0                         | )          |
| Nonmarketable  investments                                 | ** ** | **5,964**      |        | 6,269          |       | 6,199          |       | 4,190          |       | 4,222          |       | (4.9                           | )          | 41.3                           |       |
| Other income                                               | ** ** | **16,436**     |        | 15,727         |       | 16,131         |       | 18,619         |       | 18,005         |       | 4.5                            |       | (8.7                           | )          |
| Total noninterest income                                   | ** ** | **64,468**     | ** **  | 60,606         |       | 62,111         |       | 63,074         |       | 60,066         |       | 6.4                            |       | 7.3                            |       |
|                                                       |       |           |        |           |       |           |       |           |       |           |       |                           |       |                           |       |
| **NONINTEREST EXPENSES**                                   | ** ** | ** **     | ** **  | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **                     | ** ** | ** **                     | ** ** |
| Salaries                                                   | ** ** | **47,232**     |        | 49,099         |       | 51,740         |       | 51,748         |       | 50,180         |       | (3.8                           | )          | (5.9                           | )          |
| Employee  benefits                                         | ** ** | **14,292**     |        | 14,735         |       | 10,685         |       | 11,637         |       | 11,956         |       | (3.0                           | )          | 19.5                           |       |
| Net occupancy  expense of bank premises                    | ** ** | **7,931**      |        | 7,771          |       | 7,678          |       | 7,139          |       | 6,857          |       | 2.1                            |       | 15.7                           |       |
| Furniture and  equipment expenses                          | ** ** | **8,094**      |        | 8,305          |       | 8,491          |       | 7,965          |       | 7,924          |       | (2.5                           | )          | 2.1                            |       |
| Communications  and supplies                               | ** ** | **4,469**      |        | 3,818          |       | 4,414          |       | 3,933          |       | 4,019          |       | 17.1                           |       | 11.2                           |       |
| Other expenses                                             | ** ** | **27,404**     |        | 22,987         |       | 25,365         |       | 25,960         |       | 22,977         |       | 19.2                           |       | 19.3                           |       |
| Total noninterest expenses                                 | ** ** | **109,422**    |        | 106,715        |       | 108,373        |       | 108,382        |       | 103,913        |       | 2.5                            |       | 5.3                            |       |
|                                                       |       |           |        |           |       |           |       |           |       |           |       |                           |       |                           |       |
| Income before  income taxes                                | ** ** | **116,456**    |        | 112,204        |       | 116,172        |       | 113,114        |       | 108,520        |       | 3.8                            |       | 7.3                            |       |
| Applicable  income taxes                                   | ** ** | **43,364**     |        | 41,445         |       | 41,309         |       | 42,158         |       | 40,647         |       | 4.6                            |       | 6.7                            |       |
|                                                       |       |           |        |           |       |           |       |           |       |           |       |                           |       |                           |       |
| **NET  INCOME**                                            | ** ** | **$**          | **73,092**  |           | $          | 70,759         |       | $              | 74,863     |           | $          | 70,956                         |       | $                              | 67,873     |   | 3.3 |   | 7.7 |   |
|                                                       |       |           |        |           |       |           |       |           |       |           |       |                           |       |                           |       |
| Weighted average  shares outstanding*                      | ** ** | **123,222**    |        | 123,043        |       | 122,923        |       | 122,797        |       | 120,772        |       | 0.1                            |       | 2.0                            |       |
| Adjusted  weighted average shares outstanding*             | ** ** | **124,324**    |        | 124,294        |       | 124,134        |       | 123,953        |       | 121,741        |       | —                         |       | 2.1                            |       |
|                                                       |       |           |        |           |       |           |       |           |       |           |       |                           |       |                           |       |
| **NET INCOME PER COMMON SHARE:***                          | ** ** | ** **     | ** **  | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **                     | ** ** | ** **                     | ** ** |
| Basic                                                      | ** ** | **$**          | **0.59**    |           | $          | 0.58           |       | $              | 0.61       |           | $          | 0.58                           |       | $                              | 0.56       |   | 1.7 |   | 5.4 |   |
| Diluted                                                    | ** ** | **$**          | **0.59**    |           | $          | 0.57           |       | $              | 0.60       |           | $          | 0.57                           |       | $                              | 0.56       |   | 3.5 |   | 5.4 |   |

----

*                    In January 2006, Bankshares announced athree-for-two stock split on its common stock. Per share amounts and other applicable information have been adjusted togive effect to the split.

 

45

----

 

**Statementsof Consolidated Noninterest Income and Noninterest Expenses**In thousands(unaudited)
| ** **                               | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | **2Q 06** | ** ** | **2Q 06** | ** ** |
|------------------------------------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|
| ** **                               | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | **vs**         | ** ** | **vs**         | ** ** |
| **Noninterest Income**              | ** ** | **2Q 06** | ** ** | **1Q 06** | ** ** | **4Q 05** | ** ** | **3Q 05** | ** ** | **2Q 05** | ** ** | **1Q 06** | ** ** | **2Q 05** | ** ** |
| Investment and wealth management         | ** ** | **$**          | **28,865** |           | $          | 26,121         |       | $              | 24,251     |           | $          | 23,668         |       | $              | 23,780     |   | 10.5 | % | 21.4 | % |
| Service charges on deposit accounts      | ** ** | **10,868**     |       | 10,292         |       | 10,893         |       | 11,478         |       | 11,088         |       | 5.6            |       | (2.0           | )          |
| Mortgage banking-related  fees:          |       |           |       |           |       |           |       |           |       |           |       |           |       |           |       |
| Commercial                               |       | **1,792**      | ** ** | 1,879          |       | 4,000          |       | 4,086          |       | 2,092          |       | (4.6           | )          | (14.3          | )          |
| Residential                              |       | **543**        | ** ** | 331            |       | 690            |       | 1,065          |       | 803            |       | 64.0           |       | (32.4          | )          |
| Total mortgage banking-related fees      |       | **2,335**      | ** ** | 2,210          |       | 4,690          |       | 5,151          |       | 2,895          |       | 5.7            |       | (19.3          | )          |
| Investment securities gains and (losses) | ** ** | **—**     |       | (13            | )          | (53            | )          | (32            | )          | 76             |       | 100.0          |       | (100.0         | )          |
| Nonmarketable investments:               |       |           |       |           |       |           |       |           |       |           |       |           |       |           |       |
| Private equity and other investments     |       | **3,371**      | ** ** | 1,324          |       | 3,310          |       | 39             |       | 4,569          |       | 154.6          |       | (26.2          | )          |
| Hedge funds                              |       | **1,005**      | ** ** | 3,395          |       | 1,104          |       | 2,897          |       | (1,245         | )          | (70.4          | )          | 180.7          |       |
| Bank-owned life insurance                |       | **1,588**      | ** ** | 1,550          |       | 1,785          |       | 1,254          |       | 898            |       | 2.5            |       | 76.8           |       |
| Total nonmarketable investments          |       | **5,964**      | ** ** | 6,269          |       | 6,199          |       | 4,190          |       | 4,222          |       | (4.9           | )          | 41.3           |       |
| Other income:                            |       |           |       |           |       |           |       |           |       |           |       |           |       |           |       |
| Electronic banking fees                  |       | **6,487**      | ** ** | 5,636          |       | 5,832          |       | 7,010          |       | 5,954          |       | 15.1           |       | 9.0            |       |
| Charges and fees on loans                |       | **3,106**      | ** ** | 2,765          |       | 3,063          |       | 3,786          |       | 3,020          |       | 12.3           |       | 2.8            |       |
| Insurance                                |       | **3,761**      | ** ** | 5,101          |       | 3,439          |       | 3,480          |       | 3,558          |       | (26.3          | )          | 5.7            |       |
| All other income                         |       | **3,082**      | ** ** | 2,225          |       | 3,797          |       | 4,343          |       | 5,473          |       | 38.5           |       | (43.7          | )          |
| Total other income                       |       | **16,436**     | ** ** | 15,727         |       | 16,131         |       | 18,619         |       | 18,005         |       | 4.5            |       | (8.7           | )          |
| Total                                    |       | **$**          | **64,468** | ** **     | $          | 60,606         |       | $              | 62,111     |           | $          | 63,074         |       | $              | 60,066     |   | 6.4 |   | 7.3 |   |

 
| ** **                             | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **2Q 06** | ** ** | **2Q 06** | ** ** |
|----------------------------------------|------------|------------|-------------|------------|------------|------------|------------|------------|------------|------------|------------|-----------|------------|-----------|------------|
| ** **                             | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **vs**    | ** ** | **vs**    | ** ** |
| **Noninterest Expenses**               | ** ** | **2Q 06**  | ** **  | **1Q 06**  | ** ** | **4Q 05**  | ** ** | **3Q 05**  | ** ** | **2Q 05**  | ** ** | **1Q 06** | ** ** | **2Q 05** | ** ** |
| Salaries                               | ** ** | **$**      | **47,232**  |       | $          | 49,099     |       | $          | 51,740     |       | $          | 51,748    |       | $         | 50,180     |   | (3.8 | )% | (5.9 | )% |
| Employee benefits                      | ** ** | **14,292** |        | 14,735     |       | 10,685     |       | 11,637     |       | 11,956     |       | (3.0      | )          | 19.5      |       |
| Net occupancy expense of bank premises | ** ** | **7,931**  |        | 7,771      |       | 7,678      |       | 7,139      |       | 6,857      |       | 2.1       |       | 15.7      |       |
| Furniture and equipment expenses       | ** ** | **8,094**  |        | 8,305      |       | 8,491      |       | 7,965      |       | 7,924      |       | (2.5      | )          | 2.1       |       |
| Communications and supplies            | ** ** | **4,469**  |        | 3,818      |       | 4,414      |       | 3,933      |       | 4,019      |       | 17.1      |       | 11.2      |       |
| Other expenses:                        |       |       |        |       |       |       |       |       |       |       |       |      |       |      |       |
| Professional services                  |       | **6,743**  | ** **  | 5,170      |       | 5,867      |       | 6,040      |       | 4,882      |       | 30.4      |       | 38.1      |       |
| Advertising and promotional expenses   |       | **2,355**  | ** **  | 1,498      |       | 2,553      |       | 2,162      |       | 2,677      |       | 57.2      |       | (12.0     | )          |
| Electronic banking expenses            |       | **3,529**  | ** **  | 3,127      |       | 3,503      |       | 4,025      |       | 3,177      |       | 12.9      |       | 11.1      |       |
| Amortization of intangible assets      |       | **2,217**  | ** **  | 2,325      |       | 2,291      |       | 2,231      |       | 2,179      |       | (4.6      | )          | 1.7       |       |
| Outsourcing expenses                   |       | **2,641**  | ** **  | 2,823      |       | 3,065      |       | 3,093      |       | 2,383      |       | (6.4      | )          | 10.8      |       |
| All other expenses                     |       | **9,919**  | ** **  | 8,044      |       | 8,086      |       | 8,409      |       | 7,679      |       | 23.3      |       | 29.2      |       |
| Total other expenses                   |       | **27,404** | ** **  | 22,987     |       | 25,365     |       | 25,960     |       | 22,977     |       | 19.2      |       | 19.3      |       |
| Total                                  |       | **$**      | **109,422** | ** ** | $          | 106,715    |       | $          | 108,373    |       | $          | 108,382   |       | $         | 103,913    |   | 2.5 |   | 5.3 |   |

46

----

** **

**ConsolidatedAverage Balance Sheet**In thousands(unaudited)
| ** **                                        | ** ** | **2Q 06** | ** **     | **1Q 06**  | ** ** | **4Q 05** | ** ** |
|---------------------------------------------------|------------|----------------|----------------|-----------------|------------|----------------|------------|
| ** **                                        | ** ** | **Average**    | ** **     | **Yield(1)**    | ** ** | **Average**    | ** ** | **Yield(1)** | ** ** | **Average** | ** ** | **Yield(1)** | ** ** |
| ** **                                        | ** ** | **Balance**    | ** **     | **/ Rate** | ** ** | **Balance**    | ** ** | **/ Rate** | ** ** | **Balance** | ** ** | **/ Rate** | ** ** |
| Earning assets                                    | ** ** | ** **     | ** **     | ** **      | ** ** |           |       |   |   |   |   |   |   |
| Loans:                                            | ** ** | ** **     | ** **     | ** **      | ** ** |           |       |   |   |   |   |   |   |
| Commercial and leasing                            | ** ** | **$**          | **2,956,420**  | ** **      | **7.35**   | **%**          | $          | 2,933,214 |   | 7.06 | % | $ | 2,912,089 |   | 6.86 | % |
| Commercial real estate                            | ** ** | **3,748,795**  | ** **     | **7.02**        |       | 3,673,385      |       | 6.89 |   | 3,664,491 |   | 6.79 |   |
| Construction                                      | ** ** | **1,808,734**  | ** **     | **8.09**        |       | 1,681,253      |       | 7.86 |   | 1,574,597 |   | 7.56 |   |
| Residential real estate                           | ** ** | **1,876,209**  | ** **     | **6.16**        |       | 1,831,603      |       | 6.16 |   | 1,798,686 |   | 6.05 |   |
| Home equity lines                                 | ** ** | **484,396**    | ** **     | **7.65**        |       | 496,526        |       | 7.25 |   | 511,673 |   | 6.73 |   |
| Consumer                                          | ** ** | **1,046,986**  | ** **     | **5.78**        |       | 1,030,923      |       | 5.73 |   | 1,036,349 |   | 5.68 |   |
| Total loans                                       | ** ** | **11,921,540** | ** **     | **7.05**        |       | 11,646,904     |       | 6.87 |   | 11,497,885 |   | 6.69 |   |
| Federal funds sold, et al                         | ** ** | **71,448**     | ** **     | **6.16**        |       | 57,318         |       | 4.65 |   | 76,062 |   | 4.64 |   |
| Securities: (2)                                   | ** ** | ** **     |           |            |       |           |       |   |   |   |   |   |   |
| Taxable securities:                               |       |           |           |            |       |           |       |   |   |   |   |   |   |
| U.S. Treasury and government agencies             | ** ** | **1,451,800**  | ** **     | **3.85**        |       | 1,440,180      |       | 3.64 |   | 1,429,583 |   | 3.41 |   |
| Mortgage-backed                                   | ** ** | **1,605,222**  | ** **     | **4.30**        |       | 1,589,017      |       | 4.30 |   | 1,545,324 |   | 4.56 |   |
| Other investments                                 | ** ** | **65,748**     | ** **     | **4.30**        |       | 63,199         |       | 4.06 |   | 60,998 |   | 4.77 |   |
| Tax-exempt securities:                            | ** ** | ** **     |           |            |       |           |       |   |   |   |   |   |   |
| States and political subdivisions                 | ** ** | **81,038**     | ** **     | **6.26**        |       | 83,957         |       | 6.22 |   | 88,679 |   | 6.01 |   |
| Total securities                                  | ** ** | **3,203,808**  | ** **     | **4.14**        |       | 3,176,353      |       | 4.05 |   | 3,124,584 |   | 4.08 |   |
| Interest-bearing deposits in other banks          | ** ** | **200**        | ** **     | **1.51**        |       | 200            |       | 1.36 |   | 200 |   | 1.35 |   |
| Total earning assets                              | ** ** | **15,196,996** | ** **     | **6.43**        |       | 14,880,775     |       | 6.26 |   | 14,698,731 |   | 6.13 |   |
| Cash and due from banks                           | ** ** | **304,132**    | ** **     | ** **      |       | 301,305        |       |   |   | 319,176 |   |   |   |
| Bank premises and equipment, net                  | ** ** | **138,941**    | ** **     | ** **      |       | 138,237        |       |   |   | 139,662 |   |   |   |
| Other assets                                      | ** ** | **1,301,459**  | ** **     | ** **      |       | 1,272,673      |       |   |   | 1,258,868 |   |   |   |
| Less: allowance for loan losses                   | ** ** | **(142,556**   | **)**          | ** **      |       | (157,026       | )          |   |   | (158,162 | ) |   |   |
| Total assets                                      | ** ** | **$**          | **16,798,972** | ** **      | ** ** |           | $          | 16,435,964 |   |   |   | $ | 16,258,275 |   |   |   |
|                                              |       |           |           |            |       |           |       |   |   |   |   |   |   |
| Interest-bearing  liabilities                     |       |           |           |            |       |           |       |   |   |   |   |   |   |
| Deposits:                                         |       |           |           |            |       |           |       |   |   |   |   |   |   |
| Savings                                           | ** ** | **$**          | **1,282,700**  | ** **      | **0.48**   |           | $          | 1,321,364 |   | 0.45 |   | $ | 1,371,020 |   | 0.45 |   |
| Checking plus interest                            | ** ** | **1,298,636**  | ** **     | **0.20**        |       | 1,341,714      |       | 0.19 |   | 1,398,809 |   | 0.18 |   |
| Money market                                      | ** ** | **1,947,364**  | ** **     | **2.62**        |       | 1,848,724      |       | 2.18 |   | 1,785,001 |   | 1.86 |   |
| Time deposits $100,000 and over                   | ** ** | **2,044,074**  | ** **     | **4.37**        |       | 1,904,098      |       | 4.00 |   | 1,784,340 |   | 3.66 |   |
| Other time deposits                               | ** ** | **2,362,074**  | ** **     | **3.47**        |       | 2,318,985      |       | 3.23 |   | 2,300,075 |   | 3.03 |   |
| Total interest-bearing deposits                   | ** ** | **8,934,848**  | ** **     | **2.59**        |       | 8,734,885      |       | 2.29 |   | 8,639,245 |   | 2.05 |   |
| Short-term borrowings                             | ** ** | **1,423,480**  | ** **     | **3.80**        |       | 1,320,595      |       | 3.39 |   | 1,213,396 |   | 2.96 |   |
| Long-term debt                                    | ** ** | **673,599**    | ** **     | **5.53**        |       | 730,236        |       | 5.18 |   | 766,451 |   | 4.71 |   |
| Total interest-bearing funds                      | ** ** | **11,031,927** | ** **     | **2.92**        |       | 10,785,716     |       | 2.62 |   | 10,619,092 |   | 2.35 |   |
| Noninterest-bearing deposits                      | ** ** | **3,255,345**  |           |            |       | 3,206,071      |       |   |   | 3,255,149 |   |   |   |
| Other liabilities and accrued expenses            | ** ** | **202,551**    |           |            |       | 182,531        |       |   |   | 173,984 |   |   |   |
| Total liabilities                                 | ** ** | **14,489,823** |           |            |       | 14,174,318     |       |   |   | 14,048,225 |   |   |   |
| Shareholders’ equity                         | ** ** | **2,309,149**  |           |            |       | 2,261,646      |       |   |   | 2,210,050 |   |   |   |
| Total liabilities & shareholders’ equity | ** ** | **$**          | **16,798,972** |            |       |           | $          | 16,435,964 |   |   |   | $ | 16,258,275 |   |   |   |
|                                              |       |           |           |            |       |           |       |   |   |   |   |   |   |
| Net interest rate spread                          | ** ** | ** **     |           | **3.51**        | **%**      |           |       | 3.64 | % |   |   | 3.78 | % |
| Effect of noninterest-bearing funds               | ** ** | ** **     |           | **0.80**        |       |           |       | 0.72 |   |   |   | 0.65 |   |
| Net interest  margin on earning assets            | ** ** | ** **     |           | **4.31**        | **%**      |           |       | 4.36 | % |   |   | 4.43 | % |

47

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**Consolidated Average BalanceSheets (continued)**In thousands(unaudited)
| ** **                                        | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | **Average Balance** | ** ** |
|---------------------------------------------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|--------------------------|------------|
| ** **                                        | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | **2Q 06**           | ** ** | **2Q 06** | ** ** |
| ** **                                        | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | **vs**                   | ** ** | **vs** | ** ** |
| ** **                                        | ** ** | **3Q 05** | ** ** | **2Q 05** | ** ** | **1Q 06** | ** ** | **2Q 05** | ** ** |
| ** **                                        | ** ** | **Average**    | ** ** | **Yield(1)**   | ** ** | **Average**    | ** ** | **Yield(1)**   | ** ** | ** **               | ** ** | ** ** | ** ** |
| ** **                                        | ** ** | **Balance**    | ** ** | **/Rate**      | ** ** | **Balance**    | ** ** | **/Rate**      | ** ** | ** **               | ** ** | ** ** | ** ** |
| Earnings assets                                   |       |           |       |           |       |           |       |           |       |                     |       |   |   |
| Loans:                                            |       |           |       |           |       |           |       |           |       |                     |       |   |   |
| Commercial and leasing                            |       | $              | 2,914,761  |           | 6.62       | %              | $          | 2,926,234      |       | 6.31                     | %          | 0.8 | % | 1.0 | % |
| Commercial real estate                            |       | 3,610,170      |       | 6.65           |       | 3,363,924      |       | 6.51           |       | 2.1                      |       | 11.4 |   |
| Construction                                      |       | 1,544,082      |       | 7.21           |       | 1,442,621      |       | 6.66           |       | 7.6                      |       | 25.4 |   |
| Residential real estate                           |       | 1,775,023      |       | 5.98           |       | 1,762,991      |       | 5.95           |       | 2.4                      |       | 6.4 |   |
| Home equity lines                                 |       | 517,798        |       | 6.23           |       | 502,917        |       | 5.85           |       | (2.4                     | )          | (3.7 | ) |
| Consumer                                          |       | 1,027,897      |       | 5.71           |       | 900,576        |       | 5.77           |       | 1.6                      |       | 16.3 |   |
| Total loans                                       |       | 11,389,731     |       | 6.51           |       | 10,899,263     |       | 6.29           |       | 2.4                      |       | 9.4 |   |
| Federal funds sold, et al                         |       | 57,932         |       | 5.20           |       | 40,904         |       | 4.33           |       | 24.7                     |       | 74.7 |   |
| Securities: (2)                                   |       |           |       |           |       |           |       |           |       |                     |       |   |   |
| Taxable securities:                               |       |           |       |           |       |           |       |           |       |                     |       |   |   |
| U.S. Treasury and government agencies             |       | 1,431,397      |       | 3.35           |       | 1,382,037      |       | 3.37           |       | 0.8                      |       | 5.0 |   |
| Mortgage-backed                                   |       | 1,455,475      |       | 3.98           |       | 1,365,012      |       | 4.05           |       | 1.0                      |       | 17.6 |   |
| Other investments                                 |       | 62,318         |       | 3.35           |       | 65,051         |       | 3.63           |       | 4.0                      |       | 1.1 |   |
| Tax-exempt securities:                            |       |           |       |           |       |           |       |           |       |                     |       |   |   |
| States and political subdivisions                 |       | 93,683         |       | 5.89           |       | 88,537         |       | 5.90           |       | (3.5                     | )          | (8.5 | ) |
| Total securities                                  |       | 3,042,873      |       | 3.73           |       | 2,900,637      |       | 3.77           |       | 0.9                      |       | 10.5 |   |
| Interest-bearing deposits in other banks          |       | 200            |       | 1.02           |       | 187            |       | 1.31           |       | —                   |       | 7.0 |   |
| Total earning assets                              |       | 14,490,736     |       | 5.92           |       | 13,840,991     |       | 5.76           |       | 2.1                      |       | 9.8 |   |
| Cash and due from banks                           |       | 326,515        |       |           |       | 301,484        |       |           |       | 0.9                      |       | 0.9 |   |
| Bank premises and equipment, net                  |       | 147,248        |       |           |       | 144,347        |       |           |       | 0.5                      |       | (3.7 | ) |
| Other assets                                      |       | 1,257,846      |       |           |       | 1,099,607      |       |           |       | 2.3                      |       | 18.4 |   |
| Less: allowance for loan losses                   |       | (157,177       | )          |           |       | (152,858       | )          |           |       | (9.2                     | )          | (6.7 | ) |
| Total assets                                      |       | $              | 16,065,168 |           |       |           | $          | 15,233,571     |       |                     |       | 2.2 |   | 10.3 |   |
|                                              |       |           |       |           |       |           |       |           |       |                     |       |   |   |
| Interest-bearing  liabilities                     |       |           |       |           |       |           |       |           |       |                     |       |   |   |
| Deposits:                                         |       |           |       |           |       |           |       |           |       |                     |       |   |   |
| Savings                                           |       | $              | 1,420,283  |           | 0.42       |           | $          | 1,463,960      |       | 0.36                     |       | (2.9 | ) | (12.4 | ) |
| Checking plus interest                            |       | 1,428,344      |       | 0.17           |       | 1,418,337      |       | 0.16           |       | (3.2                     | )          | (8.4 | ) |
| Money market                                      |       | 1,692,684      |       | 1.54           |       | 1,574,422      |       | 1.15           |       | 5.3                      |       | 23.7 |   |
| Time deposits $100,000 and over                   |       | 1,674,265      |       | 3.30           |       | 1,618,161      |       | 2.97           |       | 7.4                      |       | 26.3 |   |
| Other time deposits                               |       | 2,295,608      |       | 2.76           |       | 2,060,974      |       | 2.54           |       | 1.9                      |       | 14.6 |   |
| Total interest-bearing deposits                   |       | 8,511,184      |       | 1.80           |       | 8,135,854      |       | 1.55           |       | 2.3                      |       | 9.8 |   |
| Short-term borrowings                             |       | 1,185,142      |       | 2.58           |       | 1,021,281      |       | 2.15           |       | 7.8                      |       | 39.4 |   |
| Long-term debt                                    |       | 797,527        |       | 4.47           |       | 742,056        |       | 4.23           |       | (7.8                     | )          | (9.2 | ) |
| Total interest-bearing funds                      |       | 10,493,853     |       | 2.09           |       | 9,899,191      |       | 1.81           |       | 2.3                      |       | 11.4 |   |
| Noninterest-bearing deposits                      |       | 3,240,806      |       |           |       | 3,137,366      |       |           |       | 1.5                      |       | 3.8 |   |
| Other liabilities and accrued expenses            |       | 151,094        |       |           |       | 154,910        |       |           |       | 11.0                     |       | 30.8 |   |
| Total liabilities                                 |       | 13,885,753     |       |           |       | 13,191,467     |       |           |       | 2.2                      |       | 9.8 |   |
| Shareholders’ equity                         |       | 2,179,415      |       |           |       | 2,042,104      |       |           |       | 2.1                      |       | 13.1 |   |
| Total liabilities & shareholders’ equity |       | $              | 16,065,168 |           |       |           | $          | 15,233,571     |       |                     |       | 2.2 |   | 10.3 |   |
|                                              |       |           |       |           |       |           |       |           |       |                     |       |   |   |
| Net interest rate spread                          |       |           |       | 3.83           | %          |           |       | 3.95           | %          |                     |       |   |   |
| Effect of noninterest-bearing funds               |       |           |       | 0.58           |       |           |       | 0.51           |       |                     |       |   |   |
| Net interest  margin on earning assets            |       |           |       | 4.41           | %          |           |       | 4.46           | %          |                     |       |   |   |

----

(1)Presented on a tax-equivalent basis using the statutory federal corporateincome tax rate of 35%; see *Reconciliation of Non-GAAPMeasures*.

(2)Average investment securities are reported at amortized cost; excludesunrealized gains (losses) on securities available-for-sale.  Nonaccrual loans are included in averageloans.

48

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**Reconciliationof Non-GAAP Measures**

Webelieve the non-GAAP measures we use provide information useful to investors inunderstanding our ongoing core business and operational performancetrends.  These measures should not beviewed as a substitute for GAAP. Management believes presentations of financial measures excluding theimpact of certain items provide useful supplemental information and betterreflect its core operating activities. In order to arrive at core business operating results, the effects of certainnon-core business transactions such as gains and losses on the sales ofsecurities, amortization of intangibles, restructuring charges andmerger-related expenses, have been excluded. Management reviews these same measures internally.  For instance, the cash operating efficiencyratio, rather than the GAAP basis efficiency ratio, is used to measuremanagement’s success at controlling ongoing, core operating expenses.  Additionally, management believes thatreporting several key measures based on tangible assets (total assets lessintangible assets) and tangible equity (total equity less intangible assets) isimportant as this more closely approximates the basis for measuring theadequacy of capital for regulatory purposes.

 
| ** ** | ** ** | **YTD**  | ** ** | **YTD**  | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** |
|------------|------------|----------|------------|----------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|
| ** ** | ** ** | **2006** | ** ** | **2005** | ** ** | **2Q 06** | ** ** | **1Q 06** | ** ** | **4Q 05** | ** ** | **3Q 05** | ** ** | **2Q 05** | ** ** |

 

(1)The net interest margin and efficiency ratios arepresented on a fully taxable-equivalent (FTE) and annualized basis. The FTEbasis adjusts for the tax-favored status of income from certain loans andinvestments. Management believes this measure to be the preferred industrymeasurement of net interest income and provides a relevant comparison betweentaxable and nontaxable investments.

 
| Net interest income (GAAP basis)         | ** ** | **$**     | **319,723** |   | $          | 295,450   | ** ** | **$** | **161,410** |   | $      | 158,313 |   | $     | 162,434 |   | $ | 159,242 |   | $ | 152,367 |   |
|------------------------------------------|------------|-----------|-------------|--------|------------|-----------|------------|-------|-------------|--------|--------|---------|--------|-------|---------|--------|---|---------|--------|---|---------|--------|
| Taxable-equivalent adjustment            | ** ** | **3,677** |        | 3,233  | ** ** | **1,844** |       | 1,833 |        | 1,833  |   | 1,781   |   | 1,656 |    |
| Net interest income - taxable equivalent | ** ** | **$**     | **323,400** |   | $          | 298,683   | ** ** | **$** | **163,254** |   | $      | 160,146 |   | $     | 164,267 |   | $ | 161,023 |   | $ | 154,023 |   |

 

(2) Management excludes the balance of intangible assetsand their related amortization expense from its calculation of return onaverage tangible equity and average tangible equity to average tangible assets.This adjustment allows management to review the core operating results and corecapital position of Bankshares. This is consistent with the treatment by thebank regulatory agencies that excludes goodwill and other intangible assetsfrom their calculation of risk-based capital ratios.

 

 
| Return on average equity (GAAP basis)                           | ** ** | **12.69** | **%**  | 13.18  | %          | **12.70** | **%**  | 12.69  | %      | 13.44  | %      | 12.92  | %      | 13.33  | %      |
|-----------------------------------------------------------------|------------|-----------|--------|--------|------------|-----------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Impact of excluding average intangible assets and  amortization | ** ** | **6.20**  |   | 5.93   | ** ** | **6.10**  |   | 6.28   |   | 6.82   |   | 6.70   |   | 6.31   |   |
| Return on average tangible equity                               | ** ** | **18.89** | **%**  | 19.11  | %          | **18.80** | **%**  | 18.97  | %      | 20.26  | %      | 19.62  | %      | 19.64  | %      |
|                                                            |       |      |   |   |       |      |   |   |   |   |   |   |   |   |   |
|                                                            |       |      |   |   |       |      |   |   |   |   |   |   |   |   |   |
| Average equity to average assets  (GAAP basis)                  | ** ** | **13.75** | **%**  | 13.42  | %          | **13.75** | **%**  | 13.76  | %      | 13.59  | %      | 13.57  | %      | 13.41  | %      |
| Impact of excluding average intangible assets and  amortization | ** ** | **(3.90** | **)**  | (3.59  | )          | **(3.87** | **)**  | (3.95  | )      | (3.98  | )      | (4.04  | )      | (3.74  | )      |
| Average tangible equity to average  tangible assets             | ** ** | **9.85**  | **%**  | 9.83   | %          | **9.88**  | **%**  | 9.81   | %      | 9.61   | %      | 9.53   | %      | 9.67   | %      |

 

(3) The efficiency ratio is measured by dividingnoninterest expenses by the sum of net interest income on an FTE basis andnoninterest income. When computing the cash operating efficiency ratio and cashoperating earnings, management excludes the amortization of intangible assets,restructuring charges, merger-related expenses, and gains and losses on salesof premises and from the sales of investment securities in order to assess thecore operating results of Bankshares and because of the uncertainty as totiming and amount of gain or loss to be recognized.

 
| Efficiency ratio (GAAP basis)                                                                                                               | ** ** | **48.19**  | **%**  | 48.98  | %          | **48.05**  | **%**  | 48.34  | %      | 47.87  | %      | 48.36  | %      | 48.54  | %      |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|--------|--------|------------|------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Impact of excluding: Securities gains and (losses)                                                                                          | ** ** | **—** |   | 0.06   | ** ** | **—** |   | — |   | (0.01  | )      | — |   | 0.02   |   |
|           Gains/(losses)  on sales of         premises | ** ** | **0.01**   |   | 0.53   | ** ** | **0.01**   |   | 0.02   |   | — |   | (0.05  | )      | 0.78   |   |
|           Amortization  of deposit         intangibles | ** ** | **(0.66**  | **)**  | (0.68  | )          | **(0.66**  | **)**  | (0.68  | )      | (0.66  | )      | (0.65  | )      | (0.69  | )      |
|           Amortization  of other         intangibles   | ** ** | **(0.35**  | **)**  | (0.35  | )          | **(0.32**  | **)**  | (0.38  | )      | (0.35  | )      | (0.34  | )      | (0.34  | )      |
|           Restructuring  charges                                                               | ** ** | **—** |   | — | ** ** | **—** |   | — |   | — |   | — |   | — |   |
|           Merger-related  expenses                                                             | ** ** | **—** |   | (0.08  | )          | **—** |   | — |   | (0.16  | )      | (0.33  | )      | (0.05  | )      |
| Cash operating efficiency ratio                                                                                                             | ** ** | **47.19**  | **%**  | 48.46  | %          | **47.08**  | **%**  | 47.30  | %      | 46.69  | %      | 46.99  | %      | 48.26  | %      |

 

(4) Bankshares presents cash operating earnings inorder to assess its core operating results.

 
| Net income (GAAP basis)                               | ** ** | **$**      | **143,851** |   | $          | 130,500    | ** ** | **$**  | **73,092** |   | $      | 70,759 |   | $      | 74,863 |   | $ | 70,956 |   | $ | 67,873 |   |
|-------------------------------------------------------|------------|------------|-------------|--------|------------|------------|------------|--------|------------|--------|--------|--------|--------|--------|--------|--------|---|--------|--------|---|--------|--------|
| Less: Securities (gains) and losses, net  of tax      | ** ** | **8**      |        | (296   | )          | **—** |       | 8      |       | 32     |   | 19     |   | (46    | )      |
| (Gains)/losses on sales of premises, net of tax       | ** ** | **(62**    | **)**       | (2,741 | )          | **(14**    | **)**      | (48    | )          | — |   | 117    |   | (2,048 | )      |
| Plus: Amortization of deposit intangibles, net of tax | ** ** | **1,798**  |        | 1,701  | ** ** | **899**    |       | 899    |       | 899    |   | 892    |   | 875    |   |
| Amortization of other intangibles, net of tax         | ** ** | **947**    |        | 868    | ** ** | **440**    |       | 507    |       | 486    |   | 458    |   | 442    |   |
| Restructuring charges, net of tax                     | ** ** | **—** |        | — | ** ** | **—** |       | — |       | — |   | — |   | — |   |
| Merger-related expenses, net of tax                   | ** ** | **—** |        | 212    | ** ** | **—** |       | — |       | 216    |   | 449    |   | 56     |   |
| Cash operating  earnings                              | ** ** | **$**      | **146,542** |   | $          | 130,244    | ** ** | **$**  | **74,417** |   | $      | 72,125 |   | $      | 76,496 |   | $ | 72,891 |   | $ | 67,152 |   |

 

49

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# I**tem 3.Quantitative and Qualitative Disclosures About Market Risk**

Informationresponsive to this item as of December 31, 2005 appears under the captions “Asset/Liabilityand Market Risk Management” of Bankshares’ Form 10-K for the year endedDecember 31, 2005. There was no material change in such information as of June30, 2006.

# **Item 4. Controls andProcedures**

Asof June 30, 2006, Bankshares’ management, under the supervision and with theparticipation of Bankshares’ principal executive officer and principalfinancial officer, evaluated the effectiveness of the design and operation ofour disclosure controls and procedures, (as that term is defined in Rules13a-15(e) and 15d-15(e)) and internal control over financial reporting (asdefined in Rules 13a-15(f) and 15d-15(f)) under the Securities and Exchange Actof 1934, as amended. Based on the evaluation, the principal executive officerand principal financial officer concluded that Bankshares’ disclosure controlsand procedures are effective. There were no significant changes in Bankshares’internal controls over financial reporting during the quarter.

# **PART II — OTHERINFORMATION**

# **Item 1. Legal Proceedings**

# **Item 1A. Risk Factors**

Therehas been no material change in the risk factors previously disclosed under Item1A.of Bankshares’ 2005 Form 10-K.

**Item 4. Submission ofMatters to a Vote of Security Holders**

At Bankshares’ Annual Meeting of Shareholders held on May 9, 2006,shareholders voted on the following matters. There were 123,305,202 shares of Common Stock entitled to vote at themeeting and a total of 101,712,023 shares, or 82.5%, were represented at themeeting.

(1)  To elect the followingindividuals as directors of Bankshares to serve until the 2009 Annual Meetingof Shareholders and until successors are duly elected and qualify.  The results of voting for election ofdirectors were:
|                          | ** ** | **For**     | ** ** | **Withheld** | ** ** | ** ** | ** ** |
|--------------------------|------------|-------------|------------|--------------|------------|------------|------------|
| R. Carl Benna            |       | 100,658,899 |       | 1,050,764    |       |       |       |
| George L.  Bunting, Jr.  |       | 100,531,306 |       | 1,178,357    |       |       |       |
| Darrell D.  Friedman     |       | 100,534,137 |       | 1,175,526    |       |       |       |
| Robert A.  Kinsley       |       | 100,529,453 |       | 1,180,210    |       |       |       |
| Alexander T.  Mason      |       | 100,434,785 |       | 1,274,878    |       |       |       |
| Christian H.  Poindexter |       | 100,291,070 |       | 1,418,593    |       |       |       |
| James L. Shea            |       | 95,059,885  |       | 6,652,138    |       |       |       |

 

Thefollowing directors’ terms of office continued after the meeting and they didnot stand for reelection:
| Cynthia A.  Archer      |   | Anthony W. Deering        |   | Clayton S. Rose   |
|-------------------------|--------|---------------------------|--------|-------------------|
| Richard O.  Brendt      |   | Freeman A. Hrabowski, III |   | Donald J. Shepard |
| Howard B. Bowen         |   | Edward J. Kelly, III      |   | Jay M. Wilson     |
| William R.  Brody, M.D. |   | Jenny G. Morgan           |   |              |
| Eddie C. Brown          |   | Morton B. Plant           |   |              |

50

----

(2)  To ratify the appointment of Ernst &Young LLP as Bankshares’ independent registered public accounting firm for2006.  The voting results of sharesrepresented by proxy were:

| For         | ** ** | **Against** | ** ** | **Abstained** | ** ** | **Broker nonvotes** | ** ** |
|-------------|------------|-------------|------------|---------------|------------|--------------------------|------------|
| 100,871,878 |       | 321,655     |       | 516,128       |       | 2,362                    |       |

 

(3)  To approve the Mercantile BanksharesCorporation Annual Cash Incentive Plan. The voting results of shares represented by proxy were:

| For        | ** ** | **Against** | ** ** | **Abstained** | ** ** | **Broker nonvotes** | ** ** |
|------------|------------|-------------|------------|---------------|------------|--------------------------|------------|
| 95,287,715 |       | 4,650,427   |       | 1,771,513     |       | 2,369                    |       |

 

(4)To approve an amendment to the charter of Bankshares to increase the authorizedshares of common stock from 130,000,000 to 200,000,000.  The voting results of shares represented byproxy were:

| For        | ** ** | **Against** | ** ** | **Abstained** | ** ** | **Broker nonvotes** | ** ** |
|------------|------------|-------------|------------|---------------|------------|--------------------------|------------|
| 96,916,760 |       | 4,058,854   |       | 734,043       |       | 2,365                    |       |

 

**Item 6.        Exhibits**

Exhibits

3.17 Articles of Amendment effective May 19, 2006(Filed herewith).

31.1 Section 302 Certification of ChiefExecutive Officer. Filed as an exhibit hereto and incorporated herein byreference.

31.2 Section 302 Certification of ChiefFinancial Officer. Filed as an exhibit hereto and incorporated herein byreference.

32.1 Section 906 Certification of ChiefExecutive Officer. Filed as an exhibit hereto and incorporated herein byreference.

32.2 Section 906 Certification of ChiefFinancial Officer. Filed as an exhibit hereto and incorporated herein byreference.

51

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**Signatures**

Pursuantto the requirements of the Securities Exchange Act of 1934 the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.
| ** **     |   | **Mercantile Bankshares Corporation** |
|----------------|--------|---------------------------------------|
|           |   | (Registrant)                          |
|           |   |                                  |
|           |   |                                  |
| August 4, 2006 |   | /s/ Edward J. Kelly, III              |
| Date           |   | By: Edward J. Kelly, III              |
|           |   | Chairman of the Board,                |
|           |   | President and Chief Executive Officer |
|           |   |                                  |
|           |   |                                  |
| August 4, 2006 |   | /s/ Terry L. Troupe                   |
| Date           |   | By: Terry L. Troupe                   |
|           |   | Executive Vice President and          |
|           |   | Chief Financial Officer               |
|           |   |                                  |
|           |   |                                  |
| August 4, 2006 |   | /s/ William T. Skinner, Jr.           |
| Date           |   | By: William T. Skinner, Jr.           |
|           |   | Controller                            |
|           |   |                                  |

 

52

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