**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

**(MARK ONE)**

**ý****                                ****QUARTERLY REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For thequarterly period ended September 30, 2003**

 

**OR**

 

**o****                                ****TRANSITION****REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

 

**For the transitionperiod from           to         **

** **

**Commissionfile number 0-5127**

** **

**MERCANTILE BANKSHARES CORPORATION**

(Exactname of registrant as specified in its charter)

 

| **Maryland**                                                     |   | **52-0898572**                         |
|------------------------------------------------------------------|--------|----------------------------------------|
| (State  or other jurisdiction of  incorporation or organization) |   | (I.R.S.  Employer  Identification No.) |
|                                                             |   |                                   |
| **2 Hopkins Plaza**                                              |
| **Baltimore, Maryland 21201**                                    |
| (Address  of principal executive offices) (Zip Code)             |

 

**(410) 237-5900**

(Registrant’stelephone number, including area code)

 

**NONE**

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

 

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days.  Yes ý  No o

 

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

 

**APPLICABLE ONLY TOCORPORATE ISSUERS:**

Indicate the number of shares outstanding ofeach of the issuer’s classes of common stock, as of the latest practical date.  As of October 21, 2003, registrant hadoutstanding 79,617,141 shares of Common Stock.

 

 

----

 

# **PART I – FINANCIAL INFORMATION**

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

 

**MERCANTILE BANKSHARESCORPORATION**

**CONSOLIDATED BALANCESHEET**

** **
| **(Dollars  in thousands, except per share data)**                                                                                                                                                                                                  |   | **September 30,  2003** |           | **December 31,  2002** |   | **September 30,  2002** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|----------------|------------------------|--------|-------------------------|--------|
| **ASSETS**                                                                                                                                                                                                                                          |   |                    | ** **     |                   |   |                    |   |
| Cash and due from banks                                                                                                                                                                                                                             |   | **$**                   | **375,627**    | ** **             | $      | 281,130                 |   | $ | 333,824 |   |
| Interest-bearing deposits in  other banks                                                                                                                                                                                                           |   | **50,518**              | ** **     | 358                    |   | 358                     |   |
| Federal funds sold                                                                                                                                                                                                                                  |   | **350,825**             | ** **     | 264,293                |   | 272,134                 |   |
| Securities purchased under  resale agreements                                                                                                                                                                                                       |   | **—**              | ** **     | —                 |   | —                  |   |
| Total cash and cash equivalents                                                                                                                                                                                                                     |   | **776,970**             | ** **     | 545,781                |   | 606,316                 |   |
| Investment securities  available-for-sale (Note 4)                                                                                                                                                                                                  |   | **3,128,594**           | ** **     | 2,511,192              |   | 2,411,941               |   |
| Investment securities held-to-maturity  (Note 4)                                                                                                                                                                                                    |   | **56,057**              | ** **     | 53,391                 |   | 52,454                  |   |
| Loans held-for-sale                                                                                                                                                                                                                                 |   | **26,288**              | ** **     | —                 |   | 94                      |   |
| Loans:                                                                                                                                                                                                                                              |   |                    | ** **     |                   |   |                    |   |
| Commercial                                                                                                                                                                                                                                          |   | **5,145,346**           | ** **     | 4,317,263              |   | 4,213,108               |   |
| Construction                                                                                                                                                                                                                                        |   | **1,043,522**           | ** **     | 810,985                |   | 790,318                 |   |
| Residential real estate                                                                                                                                                                                                                             |   | **1,299,665**           | ** **     | 1,066,694              |   | 1,067,868               |   |
| Consumer                                                                                                                                                                                                                                            |   | **1,445,004**           | ** **     | 1,014,905              |   | 1,009,040               |   |
| Lease financing                                                                                                                                                                                                                                     |   | **81,545**              | ** **     | 102,180                |   | 120,456                 |   |
| Total loans                                                                                                                                                                                                                                         |   | **9,015,082**           | ** **     | 7,312,027              |   | 7,200,790               |   |
| Less: allowance for loan losses                                                                                                                                                                                                                     |   | **(155,754**            | **)**          | (138,601               | )      | (136,587                | )      |
| Loans, net                                                                                                                                                                                                                                          |   | **8,859,328**           | ** **     | 7,173,426              |   | 7,064,203               |   |
| Bank premises and equipment,  less accumulated depreciation of $161,720 (2003), $119,666 (December 2002)  and $116,687 (September 2002)                                                                                                             |   | **137,100**             | ** **     | 102,428                |   | 102,223                 |   |
| Other real estate owned, net                                                                                                                                                                                                                        |   | **397**                 | ** **     | 132                    |   | 123                     |   |
| Goodwill, net                                                                                                                                                                                                                                       |   | **510,406**             | ** **     | 102,705                |   | 102,705                 |   |
| Other intangible assets, net  (Note 7)                                                                                                                                                                                                              |   | **57,359**              | ** **     | 7,530                  |   | 7,999                   |   |
| Other assets                                                                                                                                                                                                                                        |   | **323,649**             | ** **     | 293,791                |   | 234,816                 |   |
| Total assets                                                                                                                                                                                                                                        |   | **$**                   | **13,876,148** | ** **             | $      | 10,790,376              |   | $ | 10,582,874 |   |
|                                                                                                                                                                                                                                                |   |                    | ** **     |                   |   |                    |   |
| **LIABILITIES**                                                                                                                                                                                                                                     |   |                    | ** **     |                   |   |                    |   |
| Deposits:                                                                                                                                                                                                                                           |   |                    | ** **     |                   |   |                    |   |
| Noninterest-bearing deposits                                                                                                                                                                                                                        |   | **$**                   | **2,698,277**  | ** **             | $      | 2,086,745               |   | $ | 2,040,521 |   |
| Interest-bearing deposits                                                                                                                                                                                                                           |   | **7,597,565**           | ** **     | 6,174,195              |   | 6,004,976               |   |
| Total deposits                                                                                                                                                                                                                                      |   | **10,295,842**          | ** **     | 8,260,940              |   | 8,045,497               |   |
| Short-term borrowings                                                                                                                                                                                                                               |   | **958,506**             | ** **     | 823,385                |   | 811,840                 |   |
| Accrued expenses and other  liabilities                                                                                                                                                                                                             |   | **140,913**             | ** **     | 94,479                 |   | 105,803                 |   |
| Long-term debt                                                                                                                                                                                                                                      |   | **658,565**             | ** **     | 287,214                |   | 289,313                 |   |
| Total liabilities                                                                                                                                                                                                                                   |   | **12,053,826**          | ** **     | 9,466,018              |   | 9,252,453               |   |
|                                                                                                                                                                                                                                                |   |                    | ** **     |                   |   |                    |   |
| **SHAREHOLDERS’ EQUITY**                                                                                                                                                                                                                       |   |                    | ** **     |                   |   |                    |   |
| Preferred stock, no par value;  authorized 2,000,000 shares; issued and outstanding - None                                                                                                                                                          |   |                    | ** **     |                   |   |                    |   |
| Common stock, $2 par value;  authorized 130,000,000 shares; issued shares - 79,602,236 (2003), 68,836,092  (December 2002) and 69,612,217 (September 2002); restricted shares - 123,442  (2003), 76,250 (December 2002) and 67,215 (September 2002) |   | **159,204**             | ** **     | 137,672                |   | 139,224                 |   |
| Capital surplus                                                                                                                                                                                                                                     |   | **544,818**             | ** **     | 120,577                |   | 150,592                 |   |
| Retained earnings                                                                                                                                                                                                                                   |   | **1,085,979**           | ** **     | 1,010,248              |   | 982,408                 |   |
| Accumulated other comprehensive  income (loss)                                                                                                                                                                                                      |   | **32,321**              | ** **     | 55,861                 |   | 58,197                  |   |
| Total shareholders’ equity                                                                                                                                                                                                                     |   | **1,822,322**           | ** **     | 1,324,358              |   | 1,330,421               |   |
| Total liabilities and  shareholders’ equity                                                                                                                                                                                                    |   | **$**                   | **13,876,148** | ** **             | $      | 10,790,376              |   | $ | 10,582,874 |   |

** **

See notes to consolidatedfinancial statements

 

2

----

 

**MERCANTILE BANKSHARESCORPORATION**

**STATEMENT OFCONSOLIDATED INCOME**

 
|                                                     |   | **For the 9 Months  Ended September 30,** |        | **For the 3 Months  Ended September 30,** |       |
|----------------------------------------------------------|--------|-------------------------------------------|-------------|-------------------------------------------|------------|
| **(Dollars  in thousands, except per share data)**       |   | **2003**                                  |        | **2002**                                  |       | **2003** |   | **2002** |   |
| **INTEREST INCOME**                                      |   |                                      | ** **  |                                      |       |   | ** ** |   |   |
| Interest and fees on loans                               |   | **$**                                     | **343,091** | ** **                                | $          | 352,220 | ** ** | **$** | **120,137** | ** ** | $ | 118,398 |   |
| Interest and dividends on  investment securities:        |   |                                      | ** **  |                                      |       |   | ** ** |   |   |
| Taxable interest income                                  |   | **81,107**                                | ** **  | 82,478                                    | ** ** | **27,285** | ** ** | 27,487 |   |
| Tax-exempt interest income                               |   | **1,747**                                 | ** **  | 1,429                                     | ** ** | **783** | ** ** | 470 |   |
| Dividends                                                |   | **640**                                   | ** **  | 800                                       | ** ** | **212** | ** ** | 258 |   |
| Other investment income                                  |   | **4,390**                                 | ** **  | 156                                       | ** ** | **1,508** | ** ** | 52 |   |
| Total interest and dividends on  investment securities   |   | **87,884**                                | ** **  | 84,863                                    | ** ** | **29,788** | ** ** | 28,267 |   |
| Other interest income                                    |   | **3,331**                                 | ** **  | 4,039                                     | ** ** | **1,291** | ** ** | 1,372 |   |
| Total interest income                                    |   | **434,306**                               | ** **  | 441,122                                   | ** ** | **151,216** | ** ** | 148,037 |   |
| **INTEREST EXPENSE**                                     |   |                                      | ** **  |                                      |       |   | ** ** |   |   |
| Interest on deposits                                     |   | **70,892**                                | ** **  | 94,268                                    | ** ** | **22,313** | ** ** | 30,659 |   |
| Interest on short-term  borrowings                       |   | **4,317**                                 | ** **  | 9,074                                     | ** ** | **1,303** | ** ** | 2,834 |   |
| Interest on long-term debt                               |   | **13,016**                                | ** **  | 8,253                                     | ** ** | **5,368** | ** ** | 2,630 |   |
| Total interest expense                                   |   | **88,225**                                | ** **  | 111,595                                   | ** ** | **28,984** | ** ** | 36,123 |   |
| **NET INTEREST INCOME**                                  |   | **346,081**                               | ** **  | 329,527                                   | ** ** | **122,232** | ** ** | 111,914 |   |
| Provision for loan losses                                |   | **9,072**                                 | ** **  | 11,443                                    | ** ** | **3,005** | ** ** | 3,244 |   |
| **NET INTEREST INCOME AFTER PROVISION FOR  LOAN LOSSES** |   | **337,009**                               | ** **  | 318,084                                   | ** ** | **119,227** | ** ** | 108,670 |   |
| **NONINTEREST INCOME**                                   |   |                                      | ** **  |                                      |       |   | ** ** |   |   |
| Investment and wealth  management                        |   | **57,450**                                | ** **  | 51,521                                    | ** ** | **20,577** | ** ** | 17,166 |   |
| Service charges on deposit  accounts                     |   | **26,072**                                | ** **  | 23,161                                    | ** ** | **9,701** | ** ** | 7,972 |   |
| Mortgage banking related fees                            |   | **8,298**                                 | ** **  | 7,395                                     | ** ** | **3,403** | ** ** | 2,306 |   |
| Investment securities gains and  (losses)                |   | **7,015**                                 | ** **  | 846                                       | ** ** | **(336** | **)** | (203 | ) |
| Other income                                             |   | **30,358**                                | ** **  | 24,107                                    | ** ** | **12,558** | ** ** | 8,145 |   |
| Total noninterest income                                 |   | **129,193**                               | ** **  | 107,030                                   | ** ** | **45,903** | ** ** | 35,386 |   |
| **NONINTEREST EXPENSES**                                 |   |                                      | ** **  |                                      |       |   | ** ** |   |   |
| Salaries                                                 |   | **114,602**                               | ** **  | 98,825                                    | ** ** | **43,870** | ** ** | 32,809 |   |
| Employee benefits                                        |   | **28,891**                                | ** **  | 25,076                                    | ** ** | **10,144** | ** ** | 8,476 |   |
| Net occupancy expense of bank  premises                  |   | **13,451**                                | ** **  | 12,214                                    | ** ** | **5,136** | ** ** | 4,245 |   |
| Furniture and equipment  expenses                        |   | **21,974**                                | ** **  | 18,062                                    | ** ** | **8,432** | ** ** | 6,003 |   |
| Communications and supplies                              |   | **10,506**                                | ** **  | 10,014                                    | ** ** | **3,889** | ** ** | 3,351 |   |
| Other expenses                                           |   | **48,595**                                | ** **  | 38,567                                    | ** ** | **19,718** | ** ** | 13,753 |   |
| Total noninterest expenses                               |   | **238,019**                               | ** **  | 202,758                                   | ** ** | **91,189** | ** ** | 68,637 |   |
| Income before income taxes                               |   | **228,183**                               | ** **  | 222,356                                   | ** ** | **73,941** | ** ** | 75,419 |   |
| Applicable income taxes                                  |   | **82,014**                                | ** **  | 80,621                                    | ** ** | **26,768** | ** ** | 26,804 |   |
| **NET INCOME**                                           |   | **$**                                     | **146,169** | ** **                                | $          | 141,735 | ** ** | **$** | **47,173** | ** ** | $ | 48,615 |   |
| **NET INCOME PER SHARE OF COMMON STOCK (Note  3):**      |   |                                      | ** **  |                                      |       |   | ** ** |   |   |
| Basic                                                    |   | **$**                                     | **2.07**    | ** **                                | $          | 2.03 | ** ** | **$** | **.64** | ** ** | $ | .70 |   |
| Diluted                                                  |   | **$**                                     | **2.05**    | ** **                                | $          | 2.02 | ** ** | **$** | **.63** | ** ** | $ | .69 |   |
| **DIVIDENDS PAID PER COMMON SHARE**                      |   | **$**                                     | **.96**     | ** **                                | $          | .88 | ** ** | **$** | **.33** | ** ** | $ | .30 |   |

 

See notes to consolidatedfinancial statements

 

3

----

 

**MERCANTILE BANKSHARESCORPORATION**

**STATEMENT OFCONSOLIDATED CASH FLOW**

 
| **Increase  (Decrease) in Cash and Cash Equivalents**                              |   | **For The 9 Months Ended  September 30,** |        |
|------------------------------------------------------------------------------------|--------|-------------------------------------------|-------------|
| **(Dollars  in thousands)**                                                        |   | **2003**                                  |        | **2002** |   |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                          |   |                                      | ** **  |   |   |
| Net income                                                                         |   | **$**                                     | **146,169** | ** ** | $ | 141,735 |   |
| Adjustments to reconcile net  income to net cash provided by operating activities: |   |                                      | ** **  |   |   |
| Provision for loan losses                                                          |   | **9,072**                                 | ** **  | 11,443 |   |
| Depreciation and amortization                                                      |   | **10,028**                                | ** **  | 9,679 |   |
| Amortization of other  intangible assets                                           |   | **3,097**                                 | ** **  | 1,561 |   |
| Investment securities gains                                                        |   | **(7,015**                                | **)**       | (846 | ) |
| Write-downs of investments in  private equity funds                                |   | **78**                                    | ** **  | 2,494 |   |
| Write-downs of other real  estate owned                                            |   | **7**                                     | ** **  | 2 |   |
| Gains on sales of other real  estate owned                                         |   | **(350**                                  | **)**       | (51 | ) |
| Gains on sales of buildings                                                        |   | **(228**                                  | **)**       | (456 | ) |
| Net (increase) decrease in  assets:                                                |   |                                      | ** **  |   |   |
| Interest receivable                                                                |   | **2,727**                                 | ** **  | (2,170 | ) |
| Other receivables                                                                  |   | **(10,743**                               | **)**       | (2,999 | ) |
| Bank owned life insurance                                                          |   | **(1,337**                                | **)**       | (868 | ) |
| Other assets                                                                       |   | **(16,485**                               | **)**       | (15,529 | ) |
| Loans held-for-sale                                                                |   | **19,733**                                | ** **  | 137,856 |   |
| Net increase (decrease) in  liabilities:                                           |   |                                      | ** **  |   |   |
| Interest payable                                                                   |   | **8,422**                                 | ** **  | (3,520 | ) |
| Accrued expenses                                                                   |   | **(18,974**                               | **)**       | (5,262 | ) |
| Taxes payable                                                                      |   | **(12,496**                               | **)**       | (588 | ) |
| Net cash provided by operating  activities                                         |   | **131,705**                               | ** **  | 272,481 |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                          |   |                                      | ** **  |   |   |
| Proceeds from maturities of  investment securities held-to-maturity                |   | **8,406**                                 | ** **  | 2,667 |   |
| Proceeds from maturities of  investment securities available-for-sale              |   | **772,637**                               | ** **  | 419,357 |   |
| Proceeds from sales of  investment securities   available-for-sale            |   | **558,481**                               | ** **  | 79,253 |   |
| Purchases of investment  securities held-to-maturity                               |   | **(2,486**                                | **)**       | (2,852 | ) |
| Purchases of investment  securities available-for-sale                             |   | **(1,274,441**                            | **)**       | (570,227 | ) |
| Net increase in customer loans                                                     |   | **(403,404**                              | **)**       | (310,983 | ) |
| Proceeds from sales of other  real estate owned                                    |   | **748**                                   | ** **  | 227 |   |
| Capital expenditures                                                               |   | **(9,311**                                | **)**       | (11,126 | ) |
| Proceeds from sales of  buildings                                                  |   | **602**                                   | ** **  | 975 |   |
| Purchase of bank owned life  insurance                                             |   | **—**                                | ** **  | (50,000 | ) |
| Business acquisitions                                                              |   | **(152,654**                              | **)**       | — |   |
| Cash from acquired bank                                                            |   | **70,450**                                | ** **  | — |   |
| Other investing activity                                                           |   | **(3,515**                                | **)**       | (11,654 | ) |
| Net cash used in investing  activities                                             |   | **(434,487**                              | **)**       | (454,363 | ) |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                          |   |                                      | ** **  |   |   |
| Net increase in  noninterest-bearing deposits                                      |   | **315,196**                               | ** **  | 156,643 |   |
| Net increase in checking plus  interest and savings accounts                       |   | **110,249**                               | ** **  | 398,525 |   |
| Net (decrease) increase in  certificates of deposit                                |   | **(82,637**                               | **)**       | 42,957 |   |
| Net decrease in short-term  borrowings                                             |   | **(37,889**                               | **)**       | (41,438 | ) |
| Proceeds from issuance of  long-term debt                                          |   | **300,000**                               | ** **  | — |   |
| Repayment of long-term debt                                                        |   | **(8,400**                                | **)**       | (8,300 | ) |
| Proceeds from issuance of  shares                                                  |   | **7,232**                                 | ** **  | 6,566 |   |
| Repurchase of common shares                                                        |   | **(212**                                  | **)**       | (19,754 | ) |
| Dividends paid                                                                     |   | **(69,568**                               | **)**       | (61,348 | ) |
| Net cash provided by financing  activities                                         |   | **533,971**                               | ** **  | 473,851 |   |
| Net increase in cash and cash  equivalents                                         |   | **231,189**                               | ** **  | 291,969 |   |
| Cash and cash equivalents at  beginning of period                                  |   | **545,781**                               | ** **  | 314,347 |   |
| Cash and cash equivalents at end  of period                                        |   | **$**                                     | **776,970** | ** ** | $ | 606,316 |   |

 

See notes to consolidatedfinancial statements 

 

4

----

 

**MERCANTILE BANKSHARESCORPORATION**

**STATEMENT OF CHANGESIN CONSOLIDATED SHAREHOLDERS’ EQUITY**

 

**FOR THE 9 MONTHSENDED SEPTEMBER 30, 2003 AND 2002**

** **
| **(Dollars in thousands, except per  share data)**                                                                     |   | **Total** | ** **    | **Common  Stock** |   | **Capital  Surplus** |       | **Retained  Earnings** |        | **Accumulated Other  Comprehensive  Income (Loss)** |   |
|------------------------------------------------------------------------------------------------------------------------|--------|-----------|---------------|-------------------|--------|----------------------|------------|------------------------|-------------|-----------------------------------------------------|--------|
| BALANCE, DECEMBER 31, 2001                                                                                             |   | $         | 1,230,206     |              | $      | 139,551              |       | $                      | 159,947     |                                                | $      | 904,479 |   | $ | 26,229 |   |
|                                                                                                                   |   |      |          |              |   |                 |       |                   |        |                                                |   |
| Net income                                                                                                             |   | 141,735   |          |              |   |                 |       | 141,735                |        |                                                |   |
| Unrealized gains(losses) on  securities available-for-sale, net of reclassification adjustment, net of  taxes          |   | 31,968    |          |              |   |                 |       |                   |        | 31,968                                              |   |
| Comprehensive income                                                                                                   |   | 173,703   |          |              |   |                 |       |                   |        |                                                |   |
| Cash dividends paid:                                                                                                   |   |      |          |              |   |                 |       |                   |        |                                                |   |
| Common stock ($.88 per share)                                                                                          |   | (61,348   | )             |              |   |                 |       | (61,348                | )           |                                                |   |
| Issuance of 80,889 shares for  dividend reinvestment and stock purchase plan                                           |   | 2,889     |          | 162               |   | 2,727                |       |                   |        |                                                |   |
| Issuance of 16,981 shares for  employee stock purchase dividend reinvestment plan                                      |   | 684       |          | 34                |   | 650                  |       |                   |        |                                                |   |
| Issuance of 175,922 shares for  employee stock option plan                                                             |   | 2,993     |          | 352               |   | 2,641                |       |                   |        |                                                |   |
| Issuance of 67,215 shares for  restricted stock awards                                                                 |   | 3,019     |          | 134               |   | 2,885                |       |                   |        |                                                |   |
| Deferred compensation - restricted  stock awards                                                                       |   | (2,458    | )             |              |   |                 |       | (2,458                 | )           |                                                |   |
| Purchase of 504,500 shares  under stock repurchase plan                                                                |   | (19,754   | )             | (1,009            | )      | (18,745              | )          |                   |        |                                                |   |
| Vested stock options                                                                                                   |   | 487       |          | —            |   | 487                  |       | —                 |        | —                                              |   |
| BALANCE, SEPTEMBER 30, 2002                                                                                            |   | $         | 1,330,421     |              | $      | 139,224              |       | $                      | 150,592     |                                                | $      | 982,408 |   | $ | 58,197 |   |
| BALANCE, DECEMBER 31, 2002                                                                                             |   | $         | 1,324,358     |              | $      | 137,672              |       | $                      | 120,577     |                                                | $      | 1,010,248 |   | $ | 55,861 |   |
|                                                                                                                   |   |      |          |              |   |                 |       |                   |        |                                                |   |
| Net income                                                                                                             |   | 146,169   |          |              |   |                 |       | 146,169                |        |                                                |   |
| Unrealized gains(losses) on  securities available-for-sale, net of reclassification adjustment, net of  taxes (Note 8) |   | (23,540   | )             |              |   |                 |       |                   |        | (23,540                                             | )      |
| Comprehensive income                                                                                                   |   | 122,629   |          |              |   |                 |       |                   |        |                                                |   |
| Cash dividends paid:                                                                                                   |   |      |          |              |   |                 |       |                   |        |                                                |   |
| Common stock ($.96 per share)                                                                                          |   | (69,568   | )             |              |   |                 |       | (69,568                | )           |                                                |   |
| Issuance of 10,379,710 shares  for bank acquisition                                                                    |   | 428,059   |          | 20,759            |   | 407,300              |       |                   |        |                                                |   |
| Fair value of 322,528 converted  options related to employee stock option plan of acquired bank                        |   | 5,944     |          |              |   | 5,944                |       |                   |        |                                                |   |
| Issuance of 95,070 shares for  dividend reinvestment and stock purchase plan                                           |   | 3,427     |          | 190               |   | 3,237                |       |                   |        |                                                |   |
| Issuance of 17,185 shares for  employee stock purchase dividend reinvestment plan                                      |   | 675       |          | 35                |   | 640                  |       |                   |        |                                                |   |
| Issuance of 178,512 shares for  employee stock option plan                                                             |   | 3,130     |          | 357               |   | 2,773                |       |                   |        |                                                |   |
| Issuance of 100,537 shares for  restricted stock awards                                                                |   | 3,561     |          | 202               |   | 3,359                |       |                   |        |                                                |   |
| Deferred compensation -  restricted stock awards                                                                       |   | (870      | )             |              |   |                 |       | (870                   | )           |                                                |   |
| Purchase of 5,500 shares under  stock repurchase plan                                                                  |   | (212      | )             | (11               | )      | (201                 | )          |                   |        |                                                |   |
| Vested stock options                                                                                                   |   | 1,189     |          | —            |   | 1,189                |       | —                 |        | —                                              |   |
| **BALANCE, SEPTEMBER 30, 2003**                                                                                        |   | **$**     | **1,822,322** | ** **        | **$**  | **159,204**          | ** ** | **$**                  | **544,818** | ** **                                          | **$**  | **1,085,979** | ** ** | **$** | **32,321** | ** ** |

 

See notes to consolidatedfinancial statements

 

5

----

 

**MERCANTILE BANKSHARESCORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

1. Basis of Presentation

 

The consolidated financial statements, which include the accounts ofMercantile Bankshares Corporation (“Bankshares”) (Nasdaq: MRBK) and all of itsaffiliates, are prepared in conformity with accounting principles generally acceptedin the United 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 the national economy, theeffect of actions taken by regulatory authorities and normal seasonal factors,the results for the interim period are not necessarily indicative of annualperformances.  For comparability,certain prior period amounts have been reclassified to conform with currentperiod presentation.

 

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

 

2. Mergers and Acquisitions

 

In March and April 2003, Bankshares acquired in separatetransactions, Boyd Watterson Asset Management, LLC (“BW”), an investmentmanagement firm, and Peremel & Company (“Peremel”), a directed and discountbrokerage company.  In the aggregate,the companies were purchased for approximately $29 million in cash.  The Boyd Watterson acquisition has apotential additional contingent payment of up to $8.6 million.  The contingent payment will be recorded whenamounts are resolved and become payable three years from the acquisitiondate.  Bankshares finalized and recordedapproximately $10.1 million of identified intangibles, mostly clientrelationships, as a result of these acquisitions.  These intangibles are being amortized on a straight-line basisover a range of 3 to 8 years.  Goodwillrecorded on these transactions totaled approximately $17.0 million atSeptember 30, 2003.

 

On August 12, 2003, Bankshares completed its acquisition ofF&M Bancorp (“F&M”), a bank holding company headquartered in Frederick,Maryland.  The total consideration to bepaid to F&M stockholders in connection with the acquisition was fixed atthe time the merger agreement was executed at approximately $123.5 million incash and 10.3 million shares of Bankshares common stock.  F&M transactions have been included inBankshares’ financial results since August 13, 2003.  Acquired assets on August 12, 2003totaled $2.2 billion, including $1.4 billion of loans and leases; liabilitiesassumed were $2.0 billion, including $1.7 billion of deposits.  As part of the purchase price allocation atAugust 12, 2003, Bankshares recorded $41.7 million of core depositintangible, and goodwill totaled approximately $390.6 million.  This is a preliminary estimate pending finalanalysis that is due in the fourth quarter and is subject to change pending theresults. The weighted average amortization period for newly acquired coredeposit intangible is seven years and is also subject to change pending finalresults of analysis.

 

On October 24, 2003, certain assets and liabilities of F&Mwere transferred to other Bankshares affiliates in order to align customers’accounts with the Bankshares affiliate serving the geographic area where thosecustomers reside.  As a result of thetransfers, future financial statements of Bankshares will not report results ofthe former F&M as a stand-alone entity.

 

6

----

 

F&M, newly acquired in a business combination, falls under theguidance of the Emerging Issues Task Force (“EITF”) in EITF Issue No. 94-3, *“LiabilityRecognition for Certain Employee Termination Benefits and Other Costs to Exitan Activity (including Certain Costs Incurred in a Restructuring)”*.Under EITF Issue No. 94-3, an entity recognizes a liability for an exit cost onthe date that the entity commits itself to an exit plan. “Exit costs” aredefined to include those costs recorded by F&M prior to the merger date andtherefore are not included in Bankshares results of operations.  F&M has recorded exit costs of $34.0million relating to severance, systems conversion, branch consolidation andcosts associated with terminating contracts (including leases). $18.1 millionof these exit costs were paid as of September 30, 2003.

 

Bankshares’ exit costs, referred to herein as “merger-related” costs,are defined to include those costs for its branch closings and relatedseverance, combining operations such as systems conversions, integrationplanning consultant’s fees and marketing consultant’s fees incurred byBankshares prior to and after the merger date and are included in Banksharesresults of operations.  Banksharesexpensed merger-related costs totaling $3.3 million and $2.4 million for thenine and three-month periods ended September 30, respectively. The costsassociated with these activities are included in noninterest expenses.Merger-related expenses incurred year to date consisted largely of expenses forprofessional services rendered in connection with the merger integration plan.Bankshares will incur additional merger-related expenses in the fourth quarteras systems conversions, branch closings and integration of operations continueand will be reflected as expense when incurred.

 

Disclosed below is certain pro forma information for 2003 as if F&Mhad been acquired on January 1, 2003 and 2002. These results combine thehistorical results of F&M into Bankshares consolidated statement ofincome.  This table reflects noninterestexpenses adjusted for exit costs and intangible amortization. This is notnecessarily what would have occurred had the acquisition taken place on theindicated dates and is not indicative of future results.

 
|                       |   | **For the 9 Months  Ended September 30,** |        | **For the 3 Months  Ended September 30,** |       |
|----------------------------|--------|------------------------------------------------|-------------|------------------------------------------------|------------|
| **(Dollars in thousands)** |   | **2003**                                       | ** **  | **2002**                                       | ** ** | **2003** | ** ** | **2002** | ** ** |
| Interest  income           |   | **$**                                          | **500,141** |                                           | $          | 525,206 | ** ** | **$** | **163,344** |   | $ | 176,339 |   |
| Interest  expense          |   | **106,950**                                    |        | 139,701                                        | ** ** | **32,382** |   | 45,061 |   |
| **NET INTEREST INCOME**    |   | **393,191**                                    |        | 385,505                                        | ** ** | **130,962** |   | 131,278 |   |
| Noninterest  income        |   | **151,291**                                    |        | 130,633                                        | ** ** | **50,424** |   | 43,046 |   |
| Noninterest  expenses      |   | **283,219**                                    |        | 257,771                                        | ** ** | **100,328** |   | 87,096 |   |
| **NET INCOME**             |   | **160,369**                                    |        | 156,069                                        | ** ** | **49,316** |   | 53,647 |   |
|                            |        |                                                |             |                                                |            |  |  |  |  |  |  |  |  |

 

Disclosed below is certain pro forma information for 2003 as if F&Mhad been included in each interim period presented as of January 1, 2003 and2002. These results combine the historical results of F&M into Banksharesconsolidated balance sheet statement. This is not necessarily what would haveoccurred had the acquisition taken place on the indicated dates.

 
| **(Dollars in thousands)** |   | **September 30,  2003** |          | **December 31,  2002** |   | **September 30,  2002** |   |
|----------------------------|--------|------------------------------|---------------|-----------------------------|--------|------------------------------|--------|
| Total loans                |   | **$**                        | **9,015,082** |                        | $      | 8,617,375                    |   | $ | 8,434,582 |   |
| Total earning  assets      |   | **12,627,364**               |          | 12,097,158                  |   | 11,808,689                   |   |
| Total assets               |   | **13,876,148**               |          | 13,135,104                  |   | 12,826,592                   |   |
| Total deposits             |   | **10,295,842**               |          | 9,856,079                   |   | 9,606,415                    |   |
| Shareholders’  equity |   | **1,822,322**                |          | 1,758,356                   |   | 1,764,419                    |   |
|                            |        |                              |               |                             |        |                              |        |  |  |  |

 

7

----

 

3. Earnings Per Share

 

Basic earnings per share (“EPS”) are computed by dividing incomeavailable to common shareholders by weighted average common sharesoutstanding.  Diluted EPS are computedusing the same components as basic EPS with the denominator adjusted for thedilutive effect of stock awards.  Thefollowing tables provide reconciliation between the computation of basis EPSand diluted EPS for the nine months and quarter ended September 30, 2003and 2002, respectively.

 
|                                                          |   | **For the 9 Months Ended September 30,** |        |
|---------------------------------------------------------------|--------|-----------------------------------------------|-------------|
|                                                          |   | **2003**                                      |        | **2002** |   |
| **(In thousands, except per share data)**                     |   | **Net  Income**                               | ** **  | **Weighted Average  Common Shares** | ** ** | **EPS** | ** ** | **Net  Income** | ** ** | **Weighted Average  Common Shares** | ** ** | **EPS** | ** ** |
| Basic EPS                                                     |   | **$**                                         | **146,169** | ** ** | **70,647** | ** ** | **$** | **2.07** |   | $ | 141,735 |   | 69,750 |   | $ | 2.03 |   |
| Dilutive  effect of stock options and restricted stock awards |   |                                          |        | **510** |   |   |   |   |   | 530 |   |   |   |
| Diluted EPS                                                   |   | **$**                                         | **146,169** | ** ** | **71,157** | ** ** | **$** | **2.05** |   | $ | 141,735 |   | 70,280 |   | $ | 2.02 |   |

 
|                                                          |   | **For the 3 Months Ended September 30,** | ** ** |
|---------------------------------------------------------------|--------|-----------------------------------------------|------------|
|                                                          |   | **2003**                                      | ** ** | **2002** | ** ** |
| **(In thousands, except per share data)**                     |   | **Net  Income**                               | ** ** | **Weighted Average  Common Shares** | ** ** | **EPS** | ** ** | **Net  Income** | ** ** | **Weighted Average  Common Shares** | ** ** | **EPS** | ** ** |
| Basic EPS                                                     |   | **$**                                         | **47,173** | ** ** | **74,253** | ** ** | **$** | **.64** |   | $ | 48,615 |   | 69,637 |   | $ | .70 |   |
| Dilutive  effect of stock options and restricted stock awards |   |                                          |       | **587** |   |   |   |   |   | 474 |   |   |   |
| Diluted EPS                                                   |   | **$**                                         | **47,173** | ** ** | **74,840** | ** ** | **$** | **.63** |   | $ | 48,615 |   | 70,111 |   | $ | .69 |   |

 

Antidilutive options and awards excluded in the computation of dilutedearnings per share were 238,838 and 129,657 for year-to-date September 30,2003 and 2002, respectively, and 170,313 and 261,875 for quarter-to-dateSeptember 30, 2003 and 2002, respectively.

 

4. InvestmentSecurities

 

The amortized cost and fair value of investment securities atSeptember 30, 2003, December 31, 2002 and September 30, 2002 areshown below:

 
|                               |   | **September 30, 2003** |          | **December 31, 2002** |       | **September 30, 2002** |       |
|------------------------------------|--------|-----------------------------|---------------|----------------------------|------------|-----------------------------|------------|
| **(Dollars in thousands)**         |   | **Amortized  Cost**         | ** **    | **Fair  Value**            | ** ** | **Amortized  Cost**         | ** ** | **Fair  Value** | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
| Securities  available-for-sale     |   |                        |          |                       |       |                        |       |   |   |   |   |   |   |
| U.S. Treasury                      |   | **$**                       | **869,760**   | ** **                 | **$**      | **901,384**                 |       | $ | 1,375,703 |   | $ | 1,421,890 |   | $ | 1,437,544 |   | $ | 1,488,636 |   |
| U.S.  Government agencies          |   | **752,861**                 | ** **    | **773,894**                |       | 695,970                     |       | 727,627 |   | 677,547 |   | 708,647 |   |
| Mortgage-backed  securities        |   | **1,243,745**               | ** **    | **1,240,215**              |       | 341,805                     |       | 348,323 |   | 194,984 |   | 201,718 |   |
| States and  political subdivisions |   | **88,691**                  | ** **    | **90,696**                 |       | 549                         |       | 577 |   | 549 |   | 579 |   |
| Other  investments                 |   | **121,377**                 | ** **    | **122,405**                |       | 7,683                       |       | 12,775 |   | 7,716 |   | 12,361 |   |
| Total                              |   | **$**                       | **3,076,434** | ** **                 | **$**      | **3,128,594**               |       | $ | 2,421,710 |   | $ | 2,511,192 |   | $ | 2,318,340 |   | $ | 2,411,941 |   |
|                               |   |                        |          |                       |       |                        |       |   |   |   |   |   |   |
| Securities  held-to-maturity       |   |                        |          |                       |       |                        |       |   |   |   |   |   |   |
| States and  political subdivisions |   | **$**                       | **33,421**    | ** **                 | **$**      | **36,030**                  |       | $ | 38,299 |   | $ | 41,150 |   | $ | 36,993 |   | $ | 40,071 |   |
| Other  investments                 |   | **22,636**                  | ** **    | **22,636**                 |       | 15,092                      |       | 15,092 |   | 15,461 |   | 15,461 |   |
| Total                              |   | **$**                       | **56,057**    | ** **                 | **$**      | **58,666**                  |       | $ | 53,391 |   | $ | 56,242 |   | $ | 52,454 |   | $ | 55,532 |   |

 

8

----

 

5. ImpairedLoans

 

A loan is considered impaired, based on current information and events,if it is probable that Bankshares will not collect all principal and interestpayments according to the contractual terms of the loan agreement.  Generally, a loan is considered impairedonce either principal or interest payments become 90 days past due at the endof a calendar quarter.  A loan may beconsidered impaired sooner if, in management’s judgment, such action iswarranted.  The impairment of a loan ismeasured based on the present value of expected future cash flows discounted atthe loan’s effective interest rate, or fair value of the collateral if therepayment is expected to be provided predominantly by the underlyingcollateral.  A majority of Bankshares’impaired loans are measured by reference to the fair value of thecollateral.  If a loan is deemed to beimpaired a valuation allowance is established for the amount of theimpairment.  Accrued interest onimpaired loans is reversed and is recognized on a cash basis.  Information with respect to impaired loansand the related valuation allowance (if the measure of the impaired loan isless that the recorded investment) at September 30, and June 30, 2003and at the end of December 2002, is shown below.  See Form 10-K for more detail.

 
| **(Dollars in thousands)**                                                       |   | **September 30,  2003** |        | **June 30,  2003** |   | **December 31,  2002** |   |
|----------------------------------------------------------------------------------|--------|------------------------------|-------------|-------------------------|--------|-----------------------------|--------|
| Impaired loans  with a specific valuation allowance                              |   | **$**                        | **27,869**  |                    | $      | 18,523                      |   | $ | 13,751 |   |
| All other  impaired loans                                                        |   | **18,609**                   |        | 15,066                  |   | 16,813                      |   |
| Total impaired  loans                                                            |   | **$**                        | **46,478**  |                    | $      | 33,589                      |   | $ | 30,564 |   |
|                                                                             |   |                         |        |                    |   |                        |   |
| Specific  allowance for loan losses applicable to impaired loans                 |   | **$**                        | **14,766**  |                    | $      | 8,840                       |   | $ | 5,251 |   |
| Allowance for  loan losses applicable to other than impaired loans               |   | **140,988**                  |        | 133,421                 |   | 133,350                     |   |
| Total  allowance for loan losses                                                 |   | **$**                        | **155,754** |                    | $      | 142,261                     |   | $ | 138,601 |   |
|                                                                             |   |                         |        |                    |   |                        |   |
| Year-to-date  interest income on impaired loans recorded on the cash basis       |   | **$**                        | **220**     |                    | $      | 155                         |   | $ | 563 |   |
| Year-to-date  average recorded investment in impaired loans during the period    |   | **$**                        | **29,194**  |                    | $      | 26,438                      |   | $ | 53,777 |   |
| Quarter-to-date  interest income on impaired loans recorded on the cash basis    |   | **$**                        | **65**      |                    | $      | 58                          |   | $ | 143 |   |
| Quarter-to-date  average recorded investment in impaired loans during the period |   | **$**                        | **34,707**  |                    | $      | 28,822                      |   | $ | 44,263 |   |

 

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

 

6. Commitments

 

Various commitments to extend credit (lines of credit) are made in thenormal course of the banking business. Total unused lines of creditapproximated $3.4 billion, $3.0 billion and $2.9 billion at September 30,2003, December 31, 2002 and September 30, 2002, respectively.  The lines of credit commitments are shown atfair value.  These amounts are notrecorded on the books of Bankshares.  Inaddition, letters of credit are issued for the benefit of customers byaffiliated banks. These outstanding letters of credit were $284.3 million atSeptember 30, 2003, $241.1 million at December 31, 2002 and $232.9million at September 30, 2002.  Inaccordance with FASB Interpretation No. 45, *Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness of Others*,the fees received for issuing letters of credit are deferred and amortized overthe life of the commitment.  The lettersof credit at September 30, 2003 had a carrying value of $745 thousandrepresenting unamortized fees.

 

9

----

 

Bankshares’ mortgage banking subsidiary, as a Fannie Mae DelegatedUnderwriting and Servicing lender, has a loss sharing arrangement for loansoriginated on behalf of and sold to Fannie Mae.  The unamortized principal balance of the underlying loans totaled$150.0 million at September 30, 2003. No allowance has been established for possible losses since there havebeen no losses recognized during the six-year history of the arrangement andnone are expected as of September 30, 2003. The mortgage subsidiary hasalso originated and loans sold with recourse in the event of foreclosure on theunderlying real estate.  The unamortizedamount of principal balance of loans sold with recourse totaled $2.5 million atSeptember 30, 2003.  Thesemortgages are generally in good standing and are well collateralized, no losshas ensued and no future loss is expected.

 

Bankshares has committed to invest funds in third-party private equityinvestments.  At September 30,2003, December 31, 2002 and September 30, 2002, $17.8 million, $15.2million and $10.4 million, respectively, remained unfunded.

 

7. IntangibleAssets

 

The following table discloses the gross carrying amount and accumulatedamortization of intangible assets subject to amortization at September 30,2003 and December 31, 2002:

 
|                       |   | **September 30, 2003** |       | **December 31, 2002**    |       |
|----------------------------|--------|-----------------------------|------------|-------------------------------|------------|
| **(Dollars in thousands)** |   | **Gross Carrying  Amount**  | ** ** | **Accumulated  Amortization** | ** ** | **Net  Amount** | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Amount** | ** ** |
| Deposit  intangibles       |   | **$**                       | **55,556** | ** **                    | **$**      | **(7,679** | **)** | **$** | **47,877** |   | $ | 13,846 |   | $ | (6,581 | ) | $ | 7,265 |   |
| Mortgage  servicing rights |   | **1,914**                   | ** ** | **(1,524**                    | **)**      | **390** |   | 1,543 |   | (1,282 | ) | 261 |   |
| Customer list              |   | **10,110**                  | ** ** | **(1,018**                    | **)**      | **9,092** |   | 50 |   | (46 | ) | 4 |   |
| Total                      |   | **$**                       | **67,580** | ** **                    | **$**      | **(10,221** | **)** | **$** | **57,359** |   | $ | 15,439 |   | $ | (7,909 | ) | $ | 7,530 |   |

 

The projections of amortization expense shown for mortgage servicingrights are based on asset balances and the interest rate environment as of September 30,2003. Future amortization expense may be significantly different depending uponchanges in the mortgage servicing portfolio, mortgage interest rates and marketconditions.

 

The following table shows the current period and estimated futureamortization expense for amortized intangible assets. Core deposit intangiblesare amortized based on useful lives of up to seven years. Bankshares recordedan estimated $41.7 million of core deposit intangibles in conjunction with theF&M acquisition.  Future estimatedamortization expense amounts are contingent on the final results of thevaluation study being conducted in concert with the previously mentionedplanned transfer of selected F&M assets and liabilities to Banksharesaffiliates in the fourth quarter. Management reviews other intangible assetsfor impairment yearly (except mortgage servicing rights, which are reviewedmonthly), or whenever events or changes in circumstances indicate that theircarrying amounts may not be recoverable. For those intangible assets subject toamortization, impairment is indicated if the sum of undiscounted estimatedfuture net cash flow is less than the carrying amount of the asset. Impairmentis recognized by accelerating the write off of the asset to the extent that thecarrying value exceeds the estimated fair value.

 

10

----

 
| **(Dollars in thousands)**                          |   | **Core  deposit  intangibles** | ** ** | **Mortgage  servicing  intangibles** | ** ** | **Customer list  intangibles** | ** ** | **Total** | ** ** |
|-----------------------------------------------------|--------|--------------------------------|------------|--------------------------------------|------------|--------------------------------|------------|-----------|------------|
| Nine months  ended September 30, 2003 (actual) |   | $                              | 1,904      |                                 | $          | 218                            |       | $         | 975        |   | $ | 3,097 |   |
| Quarter ended  December 31, 2003 (estimated)   |   | 1,883                          |       | 98                                   |       | 420                            |       | 2,727     |       |
|                                                |   |                           |       |                                 |       |                           |       |      |       |
| Estimate for  year ended December 31,          | 2003   |                           | 3,787      |                                 | 316        |                           | 1,395      |      | 5,824      |   |
|                                                | 2004   |                           | 7,531      |                                 | 292        |                           | 1,659      |      | 9,580      |   |
|                                                | 2005   |                           | 7,531      |                                 | —     |                           | 1,659      |      | 9,190      |   |
|                                                | 2006   |                           | 7,531      |                                 | —     |                           | 1,494      |      | 9,025      |   |
|                                                | 2007   |                           | 7,384      |                                 | —     |                           | 1,323      |      | 8,707      |   |
|                                                | 2008   |                           | 6,669      |                                 | —     |                           | 1,317      |      | 7,986      |   |
|                                                     |        |                                |            |                                      |            |                                |            |           |            |  |  |  |  |  |

 

8.Comprehensive Income

 

The following table summarizes the related tax effect of unrealizedgains (losses) on securities available-for-sale for the nine months endedSeptember 30, 2003 and 2002.  Thenet amount is included in accumulated other comprehensive income (loss) in theStatement of Changes in Consolidated Shareholders’ Equity.

 
|                                                                   |   | **For the 9 Months Ended September 30,** |        |
|------------------------------------------------------------------------|--------|-----------------------------------------------|-------------|
|                                                                   |   | **2003**                                      |        | **2002** |   |
| **(Dollars in thousands)**                                             |   | **Pretax  Amount**                            | ** **  | **Tax  (Expense)   Benefit** |   | **Net  Amount** | ** ** | **Pretax  Amount** | ** ** | **Tax  (Expense)   Benefit** |   | **Net  Amount** | ** ** |
| Unrealized  gains (losses) on securities available-for-sale:           |   |                                          |        |   |   |   | ** ** |   |   |   |   |   |   |
| Unrealized  holding gains (losses) arising during the period           |   | **$**                                         | **(30,309** | **)** | **$** | **11,010** | ** ** | **$** | **(19,299** | **)** | $ | 51,629 |   | $ | (19,150 | ) | $ | 32,479 |   |
| Reclassification  adjustment for (gains) losses included in net income |   | **(7,015**                                    | **)**       | **2,774** | ** ** | **(4,241** | **)** | (846 | ) | 335 |   | (511 | ) |
| Total                                                                  |   | **$**                                         | **(37,324** | **)** | **$** | **13,784** | ** ** | **$** | **(23,540** | **)** | $ | 50,783 |   | $ | (18,815 | ) | $ | 31,968 |   |

 

9. CapitalAdequacy

 

Bankshares and its bank affiliates are subject to various regulatorycapital adequacy requirements administered by federal and state bankingagencies.  These requirements includemaintaining certain capital ratios above minimum levels.  These capital ratios include tier I capitaland total risk-based capital as percents of net risk-weighted assets and tier Icapital as a percent of adjusted average total assets (leverage ratio).  The minimum ratios for capital adequacypurposes are 4.00%, 8.00% and 4.00%, for the tier I capital, total capital andleverage ratios, respectively.  To becategorized as *well capitalized,* a bank must maintain minimum ratios of6.00%, 10.00% and 5.00%, for its tier I capital, total capital and leverageratios, respectively.  As ofSeptember 30, 2003, Bankshares and all of its bank affiliates except one,F&M, exceeded all capital adequacy requirements to be considered wellcapitalized.   Although adequately capitalized,F&M did not meet the total risk-based capital threshold to be consideredwell capitalized.  As part of thepurchase price allocation F&M recorded core deposit intangibles of $41.7million, which is deducted from regulatory capital.  This deduction reduced F&M’s total risk-based capital ratioto 9.3%, slightly below the 10.0% threshold needed to be considered wellcapitalized.  As a result of thetransfers referred to in Footnote 2 to the Consolidated Financial Statements,F&M’s total risk-based capital ratio was 18.0% at October 31, 2003.

 

11

----

 

Capital ratios and the amounts used to calculate them are presented inthe following table for Bankshares and Mercantile-Safe Deposit & TrustCompany (MSD&T), the lead bank, as of September 30, 2003 andDecember 31, 2002.

 
|                           |   | **September 30, 2003** |          | **December 31, 2002** |   |
|--------------------------------|--------|-----------------------------|---------------|----------------------------|--------|
| **(Dollars in thousands)**     |   | **Bankshares**              |          | **MSD&T**              |   | **Bankshares** |   | **MSD&T** |   |
| Tier I capital                 |   | **$**                       | **1,215,504** |                       | $      | 394,407 |   | $ | 1,151,831 |   | $ | 430,375 |   |
| Total  risk-based capital      |   | **1,638,254**               |          | 438,456                    |   | 1,250,550 |   | 473,185 |   |
| Net  risk-weighted assets      |   | **9,824,821**               |          | 3,515,440                  |   | 7,677,476 |   | 3,407,691 |   |
| Adjusted  average total assets |   | **11,966,146**              | ** **    | 4,473,499                  |   | 10,281,071 |   | 4,246,480 |   |
|                           |   |                        | ** **    |                       |   |   |   |   |   |
| Tier I capital  ratio          |   | **12.37**                   | **%**         | 11.22                      | %      | 15.00 | % | 12.63 | % |
| Total capital  ratio           |   | **16.67**                   | **%**         | 12.47                      | %      | 16.29 | % | 13.89 | % |
| Leverage ratio                 |   | **10.16**                   | **%**         | 8.82                       | %      | 11.20 | % | 10.13 | % |
|                                |        |                             |               |                            |        |  |  |  |  |  |  |  |  |

 

10. Segment Reporting

 

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

 

The following table presents selected segment information for the ninemonths ended September 30, 2003 and 2002. The components in the “Other” column consist of amounts for thenonbanking affiliates and intercompany eliminations.   Certain expense amounts such as operations overhead have beenreclassified from internal financial reporting in order to provide for fullcost absorption.  Thesereclassifications are shown in the “Adjustments” line.  F&M is included in the column “CommunityBanks” whereas BW and Peremel are included in the column “MSD&T IWM”.

 
|                               |   | **For the 9 Months Ended September 30, 2003** |        |
|------------------------------------|--------|----------------------------------------------------|-------------|
| **(Dollars in thousands)**         |   | **MSD&T  Banking**                             | ** **  | **MSD&T  IWM** | ** ** | **Total  MSD&T** | ** ** | **Community  Banks** | ** ** | **Other** | ** ** | **Total** | ** ** |
| Net interest  income               |   | **$**                                              | **106,701** | ** ** | **$** | **—** | ** ** | **$** | **106,701** | ** ** | **$** | **240,278** | ** ** | **$** | **(898** | **)** | **$** | **346,081** | ** ** |
| Provision for  loan losses         |   | **(5,253**                                         | **)**       | **—** | ** ** | **(5,253** | **)** | **(3,819** | **)** | **—** | ** ** | **(9,072** | **)** |
| Noninterest  income                |   | **32,070**                                         | ** **  | **57,560** | ** ** | **89,630** | ** ** | **50,151** | ** ** | **(10,588** | **)** | **129,193** | ** ** |
| Noninterest  expenses              |   | **(69,145**                                        | **)**       | **(50,014** | **)** | **(119,159** | **)** | **(127,627** | **)** | **8,767** | ** ** | **(238,019** | **)** |
| Adjustments                        |   | **13,589**                                         | ** **  | **(2,457** | **)** | **11,132** | ** ** | **(7,796** | **)** | **(3,336** | **)** | **—** | ** ** |
| Income (loss)  before income taxes |   | **77,962**                                         | ** **  | **5,089** | ** ** | **83,051** | ** ** | **151,187** | ** ** | **(6,055** | **)** | **228,183** | ** ** |
| Income tax  (expense) benefit      |   | **(28,075**                                        | **)**       | **(2,035** | **)** | **(30,110** | **)** | **(52,125** | **)** | **221** | ** ** | **(82,014** | **)** |
| Net income  (loss)                 |   | **$**                                              | **49,887**  | ** ** | **$** | **3,054** | ** ** | **$** | **52,941** | ** ** | **$** | **99,062** | ** ** | **$** | **(5,834** | **)** | **$** | **146,169** | ** ** |
| Average assets                     |   |                                               |        |   |   | **$** | **4,390,264** | ** ** | **$** | **7,156,379** | ** ** | **$** | **(145,612** | **)** | **$** | **11,401,031** | ** ** |
| Average equity                     |   |                                               |        |   |   | **454,583** | ** ** | **846,404** | ** ** | **90,134** | ** ** | **1,391,121** | ** ** |

 

12

----

 
|                               |   | **For the 9 Months Ended September 30, 2002** |    |
|------------------------------------|--------|----------------------------------------------------|---------|
| **(Dollars  in thousands)**        |   | **MSD&T  Banking**                             |    | **MSD&T  IWM** |   | **Total  MSD&T** |   | **Community  Banks** |   | **Other** |   | **Total** |   |
| Net interest income                |   | $                                                  | 109,942 |   | $ | — |   | $ | 109,942 |   | $ | 221,296 |   | $ | (1,711 | ) | $ | 329,527 |   |
| Provision for loan losses          |   | (6,800                                             | )       | — |   | (6,800 | ) | (4,643 | ) | — |   | (11,443 | ) |
| Noninterest income                 |   | 29,987                                             |    | 51,195 |   | 81,182 |   | 37,375 |   | (11,527 | ) | 107,030 |   |
| Noninterest expenses               |   | (68,215                                            | )       | (32,261 | ) | (100,476 | ) | (112,988 | ) | 10,706 |   | (202,758 | ) |
| Adjustments                        |   | 12,720                                             |    | (1,252 | ) | 11,468 |   | (6,376 | ) | (5,092 | ) | — |   |
| Income (loss) before income  taxes |   | 77,634                                             |    | 17,682 |   | 95,316 |   | 134,664 |   | (7,624 | ) | 222,356 |   |
| Income tax (expense) benefit       |   | (28,045                                            | )       | (7,073 | ) | (35,118 | ) | (47,035 | ) | 1,532 |   | (80,621 | ) |
| Net income (loss)                  |   | $                                                  | 49,589  |   | $ | 10,609 |   | $ | 60,198 |   | $ | 87,629 |   | $ | (6,092 | ) | $ | 141,735 |   |
| Average assets                     |   |                                               |    |   |   | $ | 4,101,243 |   | $ | 6,157,184 |   | $ | (253,236 | ) | $ | 10,005,191 |   |
| Average equity                     |   |                                               |    |   |   | 435,080 |   | 774,514 |   | 42,913 |   | 1,252,507 |   |

 

11. DerivativeInstruments and Hedging Activities

 

FASB Statement No. 133 (SFASNo. 133), *Accountingfor Derivative Instruments and Hedging Activities,*FASB StatementNo. 138 (SFAS No. 138), *Accounting for Certain Derivative Instruments andCertain Hedging Activities – an amendment to FASB Statement No. 133 and*FASBStatement No. 149 (SFAS No. 149), *Amendment of Statement 133 on Derivative Instrumentsand Hedging Activities *(collectivelyreferred to as derivatives), establishes accounting and reporting standards forderivative instruments and for hedging activities. Bankshares maintains anoverall interest rate risk management strategy that incorporates the use ofderivative instruments to minimize significant unplanned fluctuations inearnings that are caused by interest rate volatility.  Derivative instruments that are used as part of the interest raterisk management strategy have been restricted to interest rate swaps.  Interest rate swaps generally involve theexchange of fixed-rate and variable-rate interest payments between two parties,based on a common notional principal amount and maturity date. Bankshares enteredinto interest rate swaps to convert fixed-rate loans made to borrowers tofloating-rate loans and convert its nonprepayable fixed-rate debt tofloating-rate debt.

 

The fair value of derivativeinstruments recorded in other assets was $14.1 million (notional $203.1million) and $11.4 million (notional $203.2 million) at September 30, 2003and December 31, 2002, respectively. The fair value of derivative instruments recorded in other liabilitieswas $5.4 million (notional $100.0 million) and $0 at September 30, 2003and December 31, 2002, respectively. For the nine months ended September 30, 2003, Bankshares recognizeda net gain of $50 thousand, included in interest and fees on loans, whichrepresented the ineffective portion of the fair-value hedge of fixed-rate loansmade to borrowers.  For the year endedDecember 31, 2002, Bankshares recognized a net loss of $40 thousand.  The fair-value hedges of nonprepayablefixed-rate debt were 100% effective for the reported periods.

 

12.Stock-based Compensation Expense

 

Bankshares has several stock-basedcompensation programs for its directors, management and employees.  These programs include the use of stockoptions, restricted stock awards and phantom stock.  The compensation costs associated with Bankshares’ Omnibus StockPlan and the granting of restricted stock awards are included in salaryexpense.  Restricted stock award expensefor the third quarter of 2003 includes $1.0 million related to the acceleratedvesting of certain awards in the IWM Division. The costs associated with Bankshares’ deferred directors’ compensationplan are included in professional fees as part of other expenses on the incomestatement.  These amounts are summarizedin the table below:

 

13

----

 
|                                           |   | **For the 9 Months  Ended September 30,** |      | **For the 3 Months  Ended September 30,** |       |
|------------------------------------------------|--------|------------------------------------------------|-----------|------------------------------------------------|------------|
| **(Dollars  in thousands)**                    |   | **2003**                                       |      | **2002**                                       |       | **2003** |   | **2002** |   |
| Option related expense                         |   | **$**                                          | **1,218** |                                           | $          | 981 | ** ** | **$** | **353** |   | $ | 269 |   |
| Restricted stock award expense                 |   | **2,576**                                      |      | 561                                            | ** ** | **1,654** |   | 262 |   |
| Sub-total included in salaries  expense        |   | **3,794**                                      |      | 1,542                                          | ** ** | **2,007** |   | 531 |   |
| Directors’ deferred  compensation expense |   | **512**                                        |      | (615                                           | )          | **198** |   | (354 | ) |
| Total stock-based compensation  expense        |   | **$**                                          | **4,306** |                                           | $          | 927 | ** ** | **$** | **2,205** |   | $ | 177 |   |

 

13.  Recent Accounting Standards

 

InApril 2003, the Financial Accounting Standards Board (“FASB”) issued SFASNo. 149 (SFAS No. 149), Amendment of Statement No.133 on *Derivative Instruments and HedgingActivities*.  SFAS No. 149amends and clarifies accounting for derivative instruments, including certainderivative instruments embedded in other contracts, and for hedging activitiesunder SFAS No. 133.  In particular, SFASNo. 149 clarifies under what circumstances a contract with an initial netinvestment meets the characteristic of a derivative and when a derivativecontains a financing component that warrants special reporting in the statementof cash flows. This Statement is generally effective for contracts entered intoor modified after June 30, 2003 and did not have a material impact onBankshares’ financial statements.

 

In May 2003, the FASBissued SFAS No. 150 (SFAS No. 150), *Accounting for Certain Financial Instruments withCharacteristics of both Liabilities and Equity*.  SFAS No. 150 establishes standards for howan issuer classifies and measures certain financial instruments withcharacteristics of both liabilities and equity.  This Statement is not expected to have a material impact onBankshares’ financial statements.

 

On January 17, 2003, FASBissued FASB Interpretation No. 46 Consolidation of Variable Interest Entities __an interpretation of ARB No. 51 (FIN 46).  The FASB has deferred the implementation of FIN 46 for all publicentities to the first reporting period ending after December 15, 2003.  This deferral applies to all variableinterest entities both financial and non-financial in nature.  Bankshares is currently in the process ofevaluating the impact of FIN 46. This Statement is not expected to have amaterial impact on Bankshares’ financial statements.

 

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

** **

**MERCANTILE BANKSHARESCORPORATION**

 

**Consolidated Financial Results**

 

In March, April andAugust of 2003, Bankshares acquired in separate transactions, BoydWatterson Asset Management, LLC (“BW”), Peremel & Company (“Peremel”), andF&M Bancorp (“F&M”), respectively, which are collectively referred toherein as, “the Acquisitions”.  TheAcquisitions were accounted for under the purchase method of accounting andtheir transactions have been included in Bankshares’ financial results sincetheir respective closings. On October 24, 2003, certain assets andliabilities of F&M were transferred to other Bankshares affiliates in orderto align customers’ accounts with the Bankshares affiliate serving thegeographic area where those customers reside. As a result of the transfers, future financial statements of Bankshareswill

 

14

----

 

not report results of theformer F&M as a stand-alone entity. (See Footnote 2 to the Consolidated Financial Statements included inthis report.)

 

Net income for the quarterended September 30, 2003 was $47.2 million, a 3.0% decrease from netincome of $48.6 million for the same period in 2002.  For the quarter ended September 30, 2003, diluted net incomeper share was $.63, a decrease of 8.7% from the $.69 reported for the thirdquarter last year.  Weighted averageshares outstanding increased from 69,637,482 for the quarter endedSeptember 30, 2002, to 74,252,653 for the quarter ended September 30,2003 as a result of the Acquisitions. The results of operations for the Acquisitions are included from theirrespective merger dates forward.

 

Factors affecting earnings forthe third quarter included: $1.5 million or $.02 per share of after-taxexpenses related to F&M; $2.2 million or $.03 per share of after-taxseverance expenses related to the Investment & Wealth Management Divisionand continued compression of the net interest margin to 4.19% in the thirdquarter 2003 from 4.60% in the third quarter 2002.

 

Bankshares also reportsoperating earnings, defined as “GAAP” (Generally Accepted AccountingPrinciples) earnings excluding the amortization of intangible assets associatedwith purchase accounting for business combinations, securities gains andlosses, and other significant gains, losses or expenses that are unusual innature (such as merger-related expenses). Net operating earnings totaled $49.9 million for the quarter, anincrease of 1.7% compared to $49.0 million in the same period for 2002.  Diluted net operating earnings per share forthe third quarter were $.67, a decrease of 4.3% from $.70 earned in the thirdquarter of 2002.  A reconciliation ofnet income (GAAP basis) to net operating earnings can be found on page 23 ofthis filing.

 

For the three months endedSeptember 30, 2003, return on average tangible assets was 1.56%, return onaverage tangible equity was 15.70% and average tangible equity to averagetangible assets was 9.91%.  Comparableratios for the three months ended September 30, 2002 were 1.90%, 16.67%and 11.42%, respectively.  Areconciliation of these ratios to their respective GAAP basis ratios can befound on page 23 of this filing.

 

For the nine months endedSeptember 30, 2003, net income was $146.2 million, an increase of 3.1%over the $141.7 million reported for the comparable period in 2002.  Diluted net income per share for the firstthree quarters of 2003 was $2.05, a 1.5% increase over the $2.02 reported forthe same period last year. The Acquisitions added $10.7 million to net interestincome, $9.9 million to noninterest income and $14.0 million to noninterestexpenses for the nine months ended September 30, 2003.

 

For the nine months endedSeptember 30, 2003, return on average assets was 1.71%, return on averageequity was 14.05% and average equity to average assets was 12.20%.  Comparable ratios for the nine months endedSeptember 30, 2002 were 1.89%, 15.13% and 12.52%, respectively.

 

Management believes thatreporting several key measures based on tangible equity (equity less intangibleassets) is important, as this is the basis for measuring the adequacy ofcapital for regulatory purposes.  Forthe nine months ended September 30, 2003, return on average tangibleassets was 1.77% compared to 1.93% for the same period last year.  The ratio of average tangible equity toaverage tangible assets was 10.66% compared to 11.53% for the same period lastyear.  The return on average tangibleequity for the nine months ended September 30, 2003 and 2002 was 16.57%and 16.72%, respectively.

 

On the date of purchase,F&M had total loans of  $1.4billion, total earning assets of $2.0 billion, and total deposits of $1.7billion.  There were 10,379,710 sharesissued for the acquisition, accounted for under the purchase method, resultingin total consideration paid of $558.1 million giving rise to the creation ofapproximately $432.4 million of intangible assets. See Footnote No. 2 for moredetails on the impact of the Acquisitions on Bankshares’ consolidated financialstatements.  The following tables setforth information regarding the F&M portion of the Acquisitions for theperiods indicated.

 

15

----

 

**SupplementalInformation**

**Farmers &Mechanics Affiliate**

**Selected BalanceSheet Data**

** **
| **(Dollars  in thousands)**                  |   | **At  September 30, 2003** |    | **Average for the  3 months ended  September 30, 2003 (1)** |   |
|----------------------------------------------|--------|---------------------------------|---------|------------------------------------------------------------------|--------|
| **Investment securities available-for-sale** |   | $                               | 442,003 |                                                             | $      | 292,535 |   |
| **Loans:**                                   |   |                            |    |                                                             |   |
| Commercial                                   |   | 623,808                         |    | 336,508                                                          |   |
| Construction                                 |   | 107,755                         |    | 59,191                                                           |   |
| Residential real estate                      |   | 194,917                         |    | 103,446                                                          |   |
| Consumer                                     |   | 392,416                         |    | 213,234                                                          |   |
| Lease financing                              |   | —                          |    | —                                                           |   |
| Total loans                                  |   | 1,318,896                       |    | 712,379                                                          |   |
| Less: allowance for loan losses              |   | (12,660                         | )       | (7,107                                                           | )      |
| Loans, net                                   |   | 1,306,236                       |    | 705,272                                                          |   |
| **Total assets**                             |   | 2,117,364                       |    | 1,177,084                                                        |   |
| **Deposits:**                                |   |                            |    |                                                             |   |
| Noninterest-bearing deposits                 |   | 310,542                         |    | 167,133                                                          |   |
| Interest-bearing deposits                    |   | 1,353,723                       |    | 740,578                                                          |   |
| Total deposits                               |   | 1,664,265                       |    | 907,711                                                          |   |
| **Total liabilities**                        |   | 1,948,448                       |    | 1,085,024                                                        |   |
|                                              |        |                                 |         |                                                                  |        |  |  |

 

**Selected IncomeStatement Data**

 
| **(Dollars  in thousands)**               |   | **For the  3 months ended  September 30, 2003 (1)** |   |
|-------------------------------------------|--------|----------------------------------------------------------|--------|
| Total interest income                     |   | $                                                        | 13,151 |   |
| Total interest expense                    |   | 2,242                                                    |   |
| **NET INTEREST INCOME**                   |   | 10,909                                                   |   |
| **NONINTEREST INCOME**                    |   |                                                     |   |
| Investment and wealth  management         |   | 266                                                      |   |
| Service charges on deposit  accounts      |   | 1,232                                                    |   |
| Mortgage banking related fees             |   | 1,011                                                    |   |
| Investment securities gains and  (losses) |   | (335                                                     | )      |
| Other income                              |   | 2,177                                                    |   |
| Total noninterest income                  |   | 4,351                                                    |   |
| **NONINTEREST EXPENSES**                  |   |                                                     |   |
| Salaries                                  |   | 4,278                                                    |   |
| Employee benefits                         |   | 700                                                      |   |
| Net occupancy expense of bank  premises   |   | 790                                                      |   |
| Furniture and equipment  expenses         |   | 660                                                      |   |
| Communications and supplies               |   | 394                                                      |   |
| Other expenses                            |   | 2,125                                                    |   |
| Total noninterest expenses                |   | 8,947                                                    |   |
| **NET INCOME**                            |   | 4,305                                                    |   |
|                                           |        |                                                          |        |  |

 

----

(1) F&M is included fromacquisition date, August 12, 2003, through September 30, 2003.

 

**Note:** Although not arequired disclosure, this is intended solely as an aid to help the readers’understanding of the impact of F&M on Bankshares’ third quarterresults.  As a result of the transfersdiscussed in Footnote 2 to the Consolidated Financial Statements, futurefinancial statements of Bankshares will not report financial data of the formerF&M as a stand-alone entity.

 

16

----

 

**Net Interest Income and Net Interest Margin**

 

Net interest income for the quarterended September 30, 2003 increased 9.2% or $10.3 million from the thirdquarter last year primarily as a result of the Acquisitions ($10.7million).  Net interest income isaffected by both changes in the amount and composition of interest-earning assetsand interest-bearing liabilities and by changes in the level of interest rates.The growth in net interest income was attributable to the growth in averageearning assets, particularly in the loan portfolio largely as a result ofF&M.  Average total loans increased$1.2 billion or 16.3% compared to the prior period.  Included in this increase is $712.4 million relating toF&M.  While the growth in theaverage loan portfolio shows signs of improvement, management expects loangrowth to remain in the mid-single digit range for the next severalquarters.  Average investment securitiesfor the third quarter 2003 increased by $598.4 million or 25.1% to $3.0 billioncompared to the third quarter 2002. Approximately one half of the increase in average securities was due toF&M.

 

Growth in net interest incomewas partially offset by a 41 basis point (bp) decline in net interest marginfrom 4.60% for the third quarter 2002 to 4.19% for the current quarter.  The year-over-year decline in net interestincome was negatively affected by the Federal Reserve’s 75 bp reduction inshort-term interest rates in the last twelve months.  In addition, historically low interest rates led to increasedrefinancing activity, particularly in the residential real estate loan portfolio,commercial and consumer portfolios. Finally, lower reinvestment yields on maturing investment securities andprepayments of mortgage-related securities reduced yields in the investmentportfolio.  Based on current marketconditions, which include a recent slowing of mortgage refinancing activity anda steepening of the yield curve, management expects the net interest margin tobegin to stabilize in the fourth quarter of 2003.

 

Net interest income for thenine months ended September 30, 2003 increased $16.6 million or 5.0% overthe prior nine month period.  The growthin net interest income was attributable to a 9.9% growth in average loans and a16.8% growth in average securities. Core internal growth accounted fortwo-thirds of the growth in average loans and three-fourths of the growth inaverage securities for the nine months ended September 30, 2003 over thenine months ended September 30, 2002. Growth in net interest income was partially offset by a 31 bp decline inthe net interest margin from 4.68% for the nine months ended September 30,2002 to 4.37% for the nine months ended September 30, 2003.  Nearly two-thirds of the decline in the netinterest margin was attributable to the reduced benefit derived fromnoninterest-bearing funds.  This benefitfell from 61 bp for the nine months ended September 30, 2002 to 42 bp forthe nine months ended September 30, 2003.

 

The Analysis of Interest Ratesand Interest Differentials and The Rate/Volume Analysis on pages 25 through 27present further details supporting this discussion.

 

**NoninterestIncome**

 
|                                      |   | **For the 9 Months Ended September 30,  2003 vs. 2002** |   | **For the 3 Months Ended September 30,  2003 vs. 2002** |   |
|-------------------------------------------|--------|--------------------------------------------------------------|--------|--------------------------------------------------------------|--------|
|                                      |   | **Increase /  (Decrease)**                                   |   | **Increase /  (Decrease)**                                   |   |
| **(Dollars  in thousands)**               |   | **Amount**                                                   |   | **%**                                                        |   | **Amount** |   | **%** |   |
| Investment and wealth  management         |   | $                                                            | 5,929  |                                                         | 11.5   |   | $ | 3,411 |   | 19.9 |   |
| Service charges on deposit  accounts      |   | 2,911                                                        |   | 12.6                                                         |   | 1,729 |   | 21.7 |   |
| Mortgage banking related fees             |   | 903                                                          |   | 12.2                                                         |   | 1,097 |   | 47.6 |   |
| Investment securities gains and  (losses) |   | 6,169                                                        |   | 729.2                                                        |   | (133 | ) | (65.5 | ) |
| Other income                              |   | 6,251                                                        |   | 25.9                                                         |   | 4,413 |   | 54.2 |   |
| Total noninterest income                  |   | $                                                            | 22,163 |                                                         | 20.7   |   | $ | 10,517 |   | 29.7 |   |

 

17

----

 

Noninterest income increased$10.5 million or 29.7% to $45.9 million for the third quarter 2003 versus thecomparable period in 2002.  TheAcquisitions added $6.9 million to noninterest income for the third quarter, ofwhich $4.4 million was attributable to F&M.  Investment and wealth management (“IWM”) revenues increased 19.9%to $20.6 million for the quarter ended September 30, 2003, $2.8 million ofwhich is attributable to the Acquisitions.

 

Service charges on depositaccounts increased 21.7% to $9.7 million for the current quarter compared tothe prior year, of which $1.2 million was attributable to F&M.  Business checking, overdraft and ATM feesare the major contributors to this growth. Mortgage banking fees increased to $3.4 million for the quarter, ofwhich $1.0 million related to F&M while $2.4 million was attributable tocontinuing production in Bankshares.

 

Other income, which includesnon-deposit fees, insurance income and bank owned life insurance, increased54.2% to $12.6 million for the quarter compared to the same period of 2002.F&M contributed $2.2 million of this increase, the largest portion beinginsurance revenue totaling $1.4 million.

 

For the nine months endedSeptember 30, 2003 noninterest income increased $22.2 million, or20.7%.  Excluding gains from the sale ofinvestment securities resulting from the ongoing balance sheet managementprocess, noninterest income rose 15.1%. This was due to a $5.9 million increase in IWM fees, a $2.9 millionincrease in service charges on deposit accounts and a $6.3 million increase inother income.  The Acquisitionscontributed $5.8 million, nearly all of the increase, in IWM revenues for thenine months ended September 30, 2003. The improvement in other income is due to reduced writedowns in privateequity fund investments.

 

**NoninterestExpenses**

 
|                                    |   | **For the 9 Months Ended September 30,  2003 vs. 2002** |   | **For the 3 Months Ended September 30,  2003 vs. 2002** |   |
|-----------------------------------------|--------|--------------------------------------------------------------|--------|--------------------------------------------------------------|--------|
| **(Dollars in thousands)**              |   | **Increase /  (Decrease)  Amount**                           |   | **%**                                                        |   | **Increase /  (Decrease)  Amount** |   | **%** |   |
| Salaries                                |   | $                                                            | 15,777 |                                                         | 16.0   |   | $ | 11,061 |   | 33.7 |   |
| Employee benefits                       |   | 3,815                                                        |   | 15.2                                                         |   | 1,668 |   | 19.7 |   |
| Net occupancy expense of bank  premises |   | 1,237                                                        |   | 10.1                                                         |   | 891 |   | 21.0 |   |
| Furniture and equipment expense         |   | 3,912                                                        |   | 21.7                                                         |   | 2,429 |   | 40.5 |   |
| Communication and supplies              |   | 492                                                          |   | 4.9                                                          |   | 538 |   | 16.1 |   |
| Other expenses                          |   | 10,028                                                       |   | 26.0                                                         |   | 5,965 |   | 43.4 |   |
| Total noninterest expenses              |   | $                                                            | 35,261 |                                                         | 17.4   |   | $ | 22,552 |   | 32.9 |   |

 

Noninterest expenses for thequarter ended September 30, 2003, increased by $22.6 million or 32.9% overthe third quarter of 2002.  Acquisitionsadded $11.4 million to noninterest expenses in the third quarter 2003.  With respect to the elements of noninterestexpenses, salaries increased approximately $11.1 million or 33.7%, primarily asa result of the Acquisitions ($5.5 million) and IWM severance expense ($3.6million).  Pre-operationalmerger-related staffing costs that are reflected in the third quarter expensesare expected to diminish in the fourth quarter as we begin to realize thecontemplated reductions in head-count relating to the integration ofF&M.  Bankshares is also on track torealize the other targeted cost-savings from the integration of F&M in thefourth quarter of 2003 and into early 2004.

 

18

----

 

The employee benefit increaseover the third quarter 2002 is primarily due to an increase of $1.4 million inpension and 401-K expenses. Acquisitions added $800 thousand of benefit expense in the third quarterof 2003.

 

The $2.4 million, or 40.5%,increase in furniture and equipment expenses is attributable to technologyimprovements that have been made in the IWM Division, expenses incurred as aresult of the Acquisitions and increased costs related to handling normalvolume growth by the main bank operating systems.

 

Other expenses for the thirdquarter increased by $6.0 million, or 43.4% over the prior year.  The increase includes $3.1 million relatedto the Acquisitions of which, $1.1 million is amortization of identifiableintangibles.  There were also $1.5million of merger-related professional fees and an additional $600 thousand forthe Directors’ Deferred Compensation plan expense in the third quarter of2003.  The cost of this plan fluctuateswith changes in the market value of Bankshares common stock.

 

Noninterest expenses for thenine months ended September 30, 2003 increased $35.3 million, or17.4%.  Acquisitions added $14.0 millionto noninterest expenses for the nine months ended September 30, 2003.  With respect to the elements of noninterestexpenses, salaries increased approximately $15.8 million or 16.0%, primarily asa result of the Acquisitions ($6.8 million) and IWM severance expense ($1.9million).  Pre-operationalmerger-related staffing costs are expected to diminish in the fourth quarter aswe begin to realize the contemplated reductions in head-count.

 

The $3.8 million employee benefitincrease over the nine months ended September 30, 2002 is largely due toan increase of $3.2 million in pension and 401-K expenses.  $346 thousand of the pension and 401-Kexpense increase was attributable to the Acquisitions.

 

The $3.9 million, or 21.7%,increase in furniture and equipment expenses for the nine months endedSeptember 30, 2003 over the same period one year ago, is primarilyattributable to technology improvements that have been made in the IWMDivision, expenses incurred as a result of the Acquisitions and increased costsrelated to handling normal volume growth by the main bank operating systems.

 

Other expenses for the ninemonths ended September 30, 2003 increased by $10.0 million, or 26.0% overthe nine months ended September 30, 2002. The increase includes $4.1 million related to the Acquisitions of which$1.5 million is due to amortization of identifiable intangibles, and $2.3million of merger-related professional fees. Also included in the increase is an additional $1.1 million for theDirectors’ Deferred Compensation plan. The cost of this plan fluctuates with changes in the market value ofBankshares common stock.

 

As a result of the increasedlevel of expenses, the operating efficiency ratio, a key measure of expensemanagement, was 48.95% for the nine months ended September 30, 2003 versus45.69% for the comparable period last year. The efficiency ratio is measured by dividing noninterest expenses by thesum of net interest income on a fully taxable-equivalent basis and noninterestincome.  When computing the efficiencyratio, management excludes the amortization of intangible assets,merger-related expenses and gains and losses from sales of investmentsecurities because of the uncertainty as to timing and amount of gain or lossto be recognized.  See page 23 for areconciliation of this measure to the GAAP basis calculation.

 

**Analysis of Financial Condition**

 

At September 30, 2003compared to December 31, 2002, total assets increased 28.6% or $3.1billion.  Total loans increased 23.3% or$1.7 billion.  The Acquisitionscontributed $2.1 billion in total assets and $1.3 billion in total loans.

 

At September 30, 2003,total assets increased 31.1% or $3.3 billion compared to one year earlier.  Total loans increased 25.2% or $1.8 billionat September 30, 2003, compared to one year earlier.

 

19

----

 

Total deposits atSeptember 30, 2003, were $10.3 billion, an increase of 24.6% or $2.0billion over December 31, 2002. Interest-bearing deposits were $7.6 billion, an increase of 23.1% or$1.4 billion from the end of last year. Noninterest-bearing deposits were $2.7billion, an increase of 29.3% or $611.5 million compared to December 31,2002. A large part of the growth in deposits was due to the Acquisitions.  The Acquisitions added $1.7 billion in totaldeposits, of which $1.4 billion were interest-bearing  and $310.5 million were noninterest-bearing deposits.  The additional growth in deposits was incore deposits from customers in the local markets. The affiliate bankingstructure positions Bankshares to compete not only with the large national andregional competition in the gathering of these funds, but also with localcommunity banks. Management believes the company is positioned to retain thesedeposits in a rising interest rate scenario. However, should the company experience an outflow of deposits, areversal of recent trends, the investment portfolio should provide adequateliquidity to fund such outflows.

 

Shareholders’ equity at September 30,2003 was $1.8 billion, an increase of 37.6% from December 31, 2002.  Bankshares has repurchased 5,500 shares yearto date, and has authorization enabling it to repurchase up to 1.5 million additionalshares.  There were no share repurchasesduring the quarter. Historically, shares repurchased have been open marketpurchases.  For more details see theStatement of Changes in Consolidated Shareholders’ Equity on page 5.  Since the share repurchase program began inthe mid-1990’s, Management has generally targeted 40% of net income for cashdividends to shareholders and 30% of net income for potential sharerepurchases.  At September 30, 2003and December 31, 2002 the cash dividend payout ratio was 46.38% and 43.07%respectively.

 

**AssetQuality**

 

**Nonperforming Assets**

 

Nonperforming assets consist ofnonaccrual loans, renegotiated loans and other real estate owned (i.e., realestate acquired in foreclosure or in lieu of foreclosure).  With respect to nonaccrual loans, Banksharespolicy is that, regardless of the value of the underlying collateral and/orguarantees, no interest is accrued on the entire balance once either principalor interest payments on any loan become 90 days past due at the end of acalendar quarter.  All accrued anduncollected interest on such loans is eliminated from the income statement andis recognized only as collected.  A loanmay be put on nonaccrual status sooner than this standard if, in management’sjudgment, such action is warranted.

 

During the three months endedSeptember 30, 2003, nonperforming assets increased $13.3 million to $51.4million.  Nonaccrual loans were $51.0million at September 30, 2003 and increased $17.6 million over year end.  Other real estate owned, the other componentof nonperforming assets, increased $265 thousand to $397 thousand from yearend.  Nonperforming assets as a percentof period-end loans and other real estate owned was .57% at September 30,2003 and .46% at December 31, 2002, respectively.  The increase in nonperforming loans was dueprimarily to a customer of Mercantile – Safe Deposit and Trust Company(“MSD&T”), the lead bank, engaged in the air pollution control systembusiness.   These loans were moved frommonitored to nonaccrual status.  Theloans to this customer totaled approximately $10.3 million.  The Acquisitions added $3.6 million tononperforming assets.

 

At September 30, 2003 andDecember 31, 2002, monitored loans, or loans with characteristicssuggesting that they could be classified as nonperforming in the near future,were $30.5 million and $24.9 million, respectively. Net additions to themonitored loan category were primarily attributable to several customers ofMSD&T.  The largest component ofmonitored loans continues to be the two commercial aircraft-related loans addedto this category during the fourth quarter of 2002.  These two loans are performing and current with a balance ofapproximately $18.7 million at September 30, 2003. They remain in themonitored category because of continuing pressure on the airline industryoverall.  The amount of loans past due30-89 days decreased from

 

20

----

 

 

$104.2 million at December 31,2002 to $40.7 million at September 30, 2003. The Acquisitions accounted forapproximately $9.1 million of loans past due 30-89 days. In general, creditquality indicators remain stable at the community banks with greaterfluctuations occurring at MSD&T.

 

The table below presents acomparison of nonperforming assets at September 30, 2003, June 30, 2003 andDecember 31, 2002.

 
| **Nonperforming Assets  (Dollars in thousands)**                                   |   | **September 30,  2003** |       | **June 30,  2003** |   | **December 31,  2002** |   |
|------------------------------------------------------------------------------------|--------|-------------------------|------------|--------------------|--------|------------------------|--------|
| Nonaccrual loans (1)                                                               |   |                    | ** ** |               |   |                   |   |
| Commercial                                                                         |   | **$**                   | **44,094** | ** **         | $      | 30,717                 |   | $ | 25,260 |   |
| Construction                                                                       |   | **935**                 | ** ** | 1,178              |   | 1,365                  |   |
| Residential real estate                                                            |   | **3,589**               | ** ** | 4,001              |   | 2,479                  |   |
| Consumer                                                                           |   | **818**                 | ** ** | 178                |   | 261                    |   |
| Lease financing                                                                    |   | **1,565**               | ** ** | 1,694              |   | 4,006                  |   |
| Total nonaccrual loans                                                             |   | **51,001**              | ** ** | 37,768             |   | 33,371                 |   |
| Renegotiated loans (1)                                                             |   | **—**              | ** ** | —             |   | —                 |   |
| Loans contractually past due 90  days or more and still accruing interest          |   | **—**              | ** ** | —             |   | —                 |   |
| Total nonperforming loans                                                          |   | **51,001**              | ** ** | 37,768             |   | 33,371                 |   |
| Other real estate owned                                                            |   | **397**                 | ** ** | 376                |   | 132                    |   |
| Total nonperforming assets                                                         |   | **$**                   | **51,398** | ** **         | $      | 38,144                 |   | $ | 33,503 |   |
|                                                                               |   |                    | ** ** |               |   |                   |   |
| Nonperforming assets as a  percent of period-end loans and other real estate owned |   | **.57**                 | %          | .50                | %      | .46                    | %      |

 

----

(1)          Aggregate gross interest income of $2.8million, $1.5 million and $2.8 million for the nine months ended September 30,2003, the first six months of 2003 and the year 2002, respectively, onnonaccrual and renegotiated loans, would have been recorded if these loans hadbeen accruing on their original terms throughout the period or sinceorigination if held for part of the period. The amount of interest income on the nonaccrual and renegotiated loansthat was recorded totaled $1.1 million, $648 thousand and $641 thousand for thenine months ended September 30, 2003, the first six months of 2003 and the year2002, respectively.

 

**Note:**Bankshares wasmonitoring loans estimated to aggregate $30.5 million at September 30, 2003,$34.5 million at June 30, 2003 and $24.9 million at December 31, 2002, notclassified as nonaccrual or renegotiated loans.  These loans had characteristics that indicated they might resultin such classification in the future.

 

**Allowance and Provision for Loan Losses**

 

Each Bankshares affiliate isrequired to maintain an allowance for loan losses adequate to absorb lossesinherent in the loan portfolio. Management at each affiliate, along with Bankshares management, conductsa regular review to assure that adequacy. On a periodic basis, significant credit exposures, nonperforming loans,impaired loans, historical losses by loan type and various statisticalmeasurements of asset quality are examined to assure the adequacy of theallowance for loan losses.

 

The allowance for loan losseshas been established through provisions for loan losses charged against income.Loans deemed uncollectible are charged against the allowance for loan lossesand any subsequent recoveries are credited to the allowance.  Intensive collection efforts continue aftercharge-off in order to maximize recovery amounts.  The provision for loan losses for the third quarter of 2003 was$3.0 million, a 7.4% decrease from the same period last year. Net charge-offswere $2.7 million, a 32.5% increase for the third quarter of 2003 compared tothe same period in 2002. The allowance for loans as a percent of period-endloans decreased to 1.73% at September 30, 2003 from 1.90% at the end of thethird quarter last year.

 

The provision for loan lossesfor the nine months ended September 30, 2003 was $9.1 million, a decrease of20.7% from last year’s provision.  Theprovision increased last year as credit quality issues were identified andaddressed within the leasing business. Nonperforming assets in the leasing business have declined from $4.5

 

21

----

 

million at September 30, 2002to $1.6 million at September 30, 2003. Net charge-offs for the nine months ended September 30, 2003 were $5.1million, a 68.6% decrease compared to the same period last year.

 

The following table presents asummary of the activity in the Allowance for Loan Losses.

 
| **Allowance for Loan Losses**                               |   | **For the 9 Months  Ended September 30,** |        | **For the 3 Months  Ended September 30,** |   |
|-------------------------------------------------------------|--------|-------------------------------------------|-------------|-------------------------------------------|--------|
| **(Dollars in thousands)**                                  |   | **2003**                                  |        | **2002**                                  |   | **2003** |   | **2002** |   |
| Allowance balance - beginning                               |   | **$**                                     | **138,601** | ** **                                | $      | 141,463 |   | **$** | **142,261** | ** ** | $ | 135,394 |   |
| Allowance of acquired bank                                  |   | **13,205**                                | ** **  |                                      |   | **13,205** | ** ** |   |   |
| Charge-offs:                                                |   |                                      | ** **  |                                      |   |   | ** ** |   |   |
| Commercial                                                  |   | **(3,362**                                | **)**       | (11,522                                   | )      | **(2,301** | **)** | (2,136 | ) |
| Construction                                                |   | **(160**                                  | **)**       | —                                    |   | **(160** | **)** | — |   |
| Residential real estate                                     |   | **(54**                                   | **)**       | (117                                      | )      | **(4** | **)** | (7 | ) |
| Consumer                                                    |   | **(2,860**                                | **)**       | (2,234                                    | )      | **(1,287** | **)** | (702 | ) |
| Lease financing                                             |   | **(1,188**                                | **)**       | (4,800                                    | )      | **—** | ** ** | — |   |
| Total                                                       |   | **(7,624**                                | **)**       | (18,673                                   | )      | **(3,752** | **)** | (2,845 | ) |
| Recoveries:                                                 |   |                                      | ** **  |                                      |   |   | ** ** |   |   |
| Commercial                                                  |   | **869**                                   | ** **  | 675                                       |   | **343** | ** ** | 158 |   |
| Construction                                                |   | **136**                                   | ** **  | 148                                       |   | **1** | ** ** | 11 |   |
| Residential real estate                                     |   | **111**                                   | ** **  | 77                                        |   | **72** | ** ** | 19 |   |
| Consumer                                                    |   | **1,379**                                 | ** **  | 1,244                                     |   | **614** | ** ** | 396 |   |
| Lease financing                                             |   | **5**                                     | ** **  | 210                                       |   | **5** | ** ** | 210 |   |
| Total                                                       |   | **2,500**                                 | ** **  | 2,354                                     |   | **1,035** | ** ** | 794 |   |
| Net charge-offs                                             |   | **(5,124**                                | **)**       | (16,319                                   | )      | **(2,717** | **)** | (2,051 | ) |
| Provision for loan losses                                   |   | **9,072**                                 | ** **  | 11,443                                    |   | **3,005** | ** ** | 3,244 |   |
| Allowance balance - ending                                  |   | **$**                                     | **155,754** | ** **                                | $      | 136,587 |   | **$** | **155,754** | ** ** | $ | 136,587 |   |
| Average loans                                               |   | **7,738,388**                             | ** **  | 7,041,412                                 |   | **8,331,265** | ** ** | 7,162,156 |   |
| Net charge-offs (annualized) as  a percent of average loans |   | **.08**                                   | %           | .30                                       | %      | **.12** | % | .11 | % |
| Period-end loans                                            |   | **9,015,082**                             |        | 7,200,790                                 |   |   | ** ** |   |   |
| Allowance for loan losses as a  percent of period-end loans |   | **1.73**                                  | %           | 1.90                                      | %      |   |   |   |   |

 

22

----

**Reconciliation ofNon-GAAP Measures**

*(Dollars in thousands, except per share data)*

* *
|   |   | **For the 9 Months Ended  September 30,** |   | **For the 3 Months Ended  September 30,** |   |
|--------|--------|------------------------------------------------|--------|------------------------------------------------|--------|
|   |   | **2003**                                       |   | **2002**                                       |   | **2003** |   | **2002** |   |
|        |        |                                                |        |                                                |        |  |  |  |  |

* *

(1) The net interest margin andefficiency ratios are presented on a fully taxable-equivalent (FTE) andannualized basis.  The FTE basis adjustsfor the tax-favored status of income from certain loans and investments.  Management believes this measure to be thepreferred industry measurement of net interest income and provides a relevantcomparison between taxable and non-taxable investments

 
| Net interest  income (GAAP basis)         |   | **$**     | **346,081** | ** ** | $      | 329,527   |       | **$** | **122,232** | ** ** | $ | 111,914 |   |
|-------------------------------------------|--------|-----------|-------------|------------|--------|-----------|------------|-------|-------------|------------|---|---------|--------|
| Taxable-equivalent  adjustment            |   | **4,879** | ** **  | 4,607      |   | **1,757** | ** ** | 1,568 |        |
| Net interest  income - taxable equivalent |   | **$**     | **350,960** | ** ** | $      | 334,134   |       | **$** | **123,989** | ** ** | $ | 113,482 |   |

 

(2) Bankshares presents return on averageassets, return on average tangible assets, return on average equity, and returnon average tangible equity. Management excludes intangible assets from itscalculation of average tangible assets and average tangible equity. Thisadjustment allows management to review the core operating results and corecapital position of the Company.  Thisis consistent with the treatment by bank regulatory agencies which excludegoodwill and other intangible assets from their calculation of risk-basedcapital ratios.

 
| Return on  average assets (GAAP basis)              |   | **1.71**  | %      | 1.89   | %      | **1.48**  | %      | 1.87   | %      |
|-----------------------------------------------------|--------|-----------|--------|--------|--------|-----------|--------|--------|--------|
| Impact of  excluding average intangible assets      |   | **.06**   |   | .04    |   | **.08**   |   | .03    |   |
| Return on  average tangible assets                  |   | **1.77**  | %      | 1.93   | %      | **1.56**  | %      | 1.90   | %      |
|                                                |   |      |   |   |   |      |   |   |   |
| Return on  average equity (GAAP basis)              |   | **14.05** | %      | 15.13  | %      | **12.07** | %      | 15.13  | %      |
| Impact of  excluding average intangible assets      |   | **2.52**  |   | 1.59   |   | **3.63**  |   | 1.54   |   |
| Return on  average tangible equity                  |   | **16.57** | %      | 16.72  | %      | **15.70** | %      | 16.67  | %      |
|                                                |   |      |   |   |   |      |   |   |   |
| Average equity  to average assets (GAAP basis)      |   | **12.20** | %      | 12.52  | %      | **12.29** | %      | 12.37  | %      |
| Impact of  excluding average intangible assets      |   | **(1.54** | **)**  | (.99   | )      | **(2.38** | **)**  | (.95   | )      |
| Average  tangible equity to average tangible assets |   | **10.66** | %      | 11.53  | %      | **9.91**  | %      | 11.42  | %      |

 

When computing the efficiency ratio and netoperating earnings, management excludes the amortization of intangible assets,merger-related expenses and gains and losses from sales of investmentsecurities because of the uncertainty as to timing and amount of gain or lossto be recognized.

 

(3) The efficiency ratio is measured bydividing noninterest expenses by the sum of net interest income on a FTE basisand noninterest income.

 
| Efficiency  ratio (GAAP basis) |                                 | **49.57** | %        | 45.96      | %      | **53.67** | %         | 46.11 | %      |
|--------------------------------|--------------------------------------|-----------|----------|------------|--------|-----------|-----------|-------|--------|
| Impact of  excluding:          | Securities (gains) and losses        |      | **.51**  | ** ** | .09    |      | **(.10**  | **)** | (.07   | ) |
|                           | Amortization  of deposit intangibles |      | **(.40** | **)**      | (.30   | )         | **(.69**  | **)** | (.28   | ) |
|                           | Amortization  of other intangibles   |      | **(.25** | **)**      | (.06   | )         | **(.30**  | **)** | (.06   | ) |
|                           | Merger-related  expenses             |      | **(.48** | **)**      | — |      | **(1.44** | **)** | — |   |
| Operating  efficiency ratio    |                                 | **48.95** | %        | 45.69      | %      | **51.14** | %         | 45.70 | %      |

 

(4)  Net operating earnings and diluted netoperating earnings per share

 
| Net income  (GAAP basis)                   |                                                 | **$**  | **146,169** | ** ** | $      | 141,735 |       | **$**      | **47,173** | ** ** | $ | 48,615 |   |
|--------------------------------------------|------------------------------------------------------|--------|-------------|------------|--------|---------|------------|------------|------------|------------|---|--------|--------|
| Less:                                      |  Securities (gains) and  losses, net of tax     |   | **(4,240**  | **)**      | (511   | )       | **203**    | ** ** | 123        |       |
| Plus:                                      | Amortization of core deposit intangibles, net of tax |   | **1,151**   | ** ** | 796    |    | **708**    | ** ** | 254        |       |
|                                       | Amortization  of other intangibles, net of tax       |   | **721**     | ** ** | 148    |    | **311**    | ** ** | 55         |       |
|                                       | Merger-related  expenses, net of tax                 |   | **1,998**   | ** ** | — |    | **1,481**  | ** ** | —     |       |
| Net operating  earnings                    |                                                 | **$**  | **145,799** | ** ** | $      | 142,168 |       | **$**      | **49,876** | ** ** | $ | 49,047 |   |
|                                       |                                                 |   |        |       |   |    |       |       |       |       |
| Diluted net  income per share (GAAP basis) |                                                 | **$**  | **2.05**    | ** ** | $      | 2.02    |       | **$**      | **.63**    | ** ** | $ | .69    |   |
| Less:                                      | Securities (gains) and losses, net of tax            |   | **(.06**    | **)**      | (.01   | )       | **—** | ** ** | —     |       |
| Plus:                                      | Amortization of core deposit intangible, net of tax  |   | **.02**     | ** ** | .01    |    | **.01**    | ** ** | .01        |       |
|                                       | Amortization of other intangibles, net of tax        |   | **.01**     | ** ** | — |    | **.01**    | ** ** | —     |       |
|                                       | Merger-related expenses, net of tax                  |   | **.03**     | ** ** | — |    | **.02**    | ** ** | —     |       |
| Diluted net  operating earnings per share  |                                                 | **$**  | **2.05**    | ** ** | $      | 2.02    |       | **$**      | **.67**    | ** ** | $ | .70    |   |

 

23

----

 

**Cautionary Statement**

 

This report contains financial information determined by methods otherthan in accordance with Generally Accepted Accounting Principles (“GAAP”).Bankshares’ management uses these non-GAAP measures in their analysis of theCompany’s performance. In, particular, net interest income, net interest marginand net operating efficiency are calculated on a fully tax-equivalent basis(“FTE”).  The FTE basis is determined byadjusting net interest income to reflect tax-exempt interest income on abefore-tax equivalent basis. These measures typically adjust GAAP performancemeasures to exclude goodwill and the amortization of goodwill related to theconsummation of mergers. These non-GAAP measures may also exclude othersignificant gains, losses or expenses that are unusual in nature. Since theseitems and their impact on Bankshares’ performance are difficult to predict,management believes presentations of financial measures excluding the impact ofthese items provide useful supplemental information that is essential to aproper understanding of the operating results and financial position ofBankshares core businesses. These disclosures should not be viewed as asubstitute for results determined in accordance with GAAP, nor are theynecessarily comparable to non-GAAP performance measures that may be presentedby other companies.

 

This report contains forward-looking statements within the meaning ofand pursuant to the safe harbor provisions of the Private Securities LitigationReform Act of 1995.  A forward-lookingstatement encompasses any estimate, prediction, opinion or statement of beliefcontained in this report, and the underlying management assumptions.  Such statements in this report includeidentification of trends, loan growth, comments on adequacy of the allowancefor loan losses, credit quality, changes in leasing activities, effects ofasset sensitivity and interest rate changes, and information concerning marketrisk referenced in Item 3. Forward-looking statements are based on current expectations andassessments of potential developments affecting market conditions, interestrates and other economic conditions, and results may ultimately vary from thestatements made in this report.

 

24

----

 

 

**ANALYSIS OF INTERESTRATES AND INTEREST DIFFERENTIALS**

 

The following table presents the distribution of the averageconsolidated balance sheet, interest income/expense and annualized yieldsearned and rates paid through the nine months ended September 30, 2003 and2002

 
|                                               |   | **For the 9 Months Ended  September 30, 2003** |           | **For the 9 Months Ended  September 30, 2002** |        |
|----------------------------------------------------|--------|-----------------------------------------------------|----------------|-----------------------------------------------------|-------------|
|                                               |   | **Average  Balance**                                |           | **Income*/  Expense**                               |        | **Yield*/  Rate** |   | **Average  Balance** |   | **Income*/  Expense** |   | **Yield*/  Rate** |   |
| Earning assets                                     |   |                                                | ** **     |                                                | ** **  |   | ** ** |   |   |   |   |   |   |
| Loans:**                                           |   |                                                | ** **     |                                                | ** **  |   | ** ** |   |   |   |   |   |   |
| Commercial                                         |   | **$**                                               | **4,627,564**  | ** **                                          | **$**       | **202,500** | ** ** | **5.85** | **%** | $ | 4,256,364 |   | $ | 209,810 |   | 6.59 | % |
| Construction                                       |   | **888,451**                                         | ** **     | **36,388**                                          | ** **  | **5.48** | ** ** | 714,563 |   | 33,139 |   | 6.20 |   |
| Residential  real estate                           |   | **1,124,637**                                       | ** **     | **55,426**                                          | ** **  | **6.59** | ** ** | 1,074,334 |   | 59,239 |   | 7.37 |   |
| Consumer                                           |   | **1,097,736**                                       | ** **     | **52,452**                                          | ** **  | **6.39** | ** ** | 996,151 |   | 53,603 |   | 7.19 |   |
| Total loans                                        |   | **7,738,388**                                       | ** **     | **346,766**                                         | ** **  | **5.99** | ** ** | 7,041,412 |   | 355,791 |   | 6.76 |   |
| Federal funds  sold, et al                         |   | **262,648**                                         | ** **     | **3,279**                                           | ** **  | **1.67** | ** ** | 152,041 |   | 4,028 |   | 3.54 |   |
| Securities:***                                     |   |                                                | ** **     |                                                | ** **  |   | ** ** |   |   |   |   |   |   |
| Taxable  securities                                |   |                                                | ** **     |                                                | ** **  |   | ** ** |   |   |   |   |   |   |
| U.S. Treasury  securities and government agencies  |   | **1,765,230**                                       | ** **     | **57,150**                                          | ** **  | **4.33** | ** ** | 2,078,629 |   | 73,902 |   | 4.75 |   |
| Mortgage-backed  securities                        |   | **809,744**                                         | ** **     | **23,957**                                          | ** **  | **3.96** | ** ** | 201,358 |   | 8,577 |   | 5.70 |   |
| Other stocks  and bonds                            |   | **105,663**                                         | ** **     | **5,091**                                           | ** **  | **6.44** | ** ** | 23,201 |   | 1,056 |   | 6.09 |   |
| Tax-exempt  securities                             |   |                                                | ** **     |                                                | ** **  |   | ** ** |   |   |   |   |   |   |
| States and  political subdivisions                 |   | **53,886**                                          | ** **     | **2,890**                                           | ** **  | **7.17** | ** ** | 38,888 |   | 2,364 |   | 8.13 |   |
| Total  securities                                  |   | **2,734,523**                                       | ** **     | **89,088**                                          | ** **  | **4.36** | ** ** | 2,342,076 |   | 85,899 |   | 4.90 |   |
| Interest-bearing  deposits in other banks          |   | **7,433**                                           | ** **     | **52**                                              | ** **  | **.94** | ** ** | 358 |   | 11 |   | 4.21 |   |
| Total earning  assets                              |   | **10,742,992**                                      | ** **     | **439,185**                                         | ** **  | **5.47** | ** ** | 9,535,887 |   | 445,729 |   | 6.25 |   |
| Cash and due  from banks                           |   | **255,251**                                         | ** **     |                                                | ** **  |   | ** ** | 224,488 |   |   |   |   |   |
| Bank premises and  equipment, net                  |   | **111,010**                                         | ** **     |                                                | ** **  |   | ** ** | 101,275 |   |   |   |   |   |
| Other assets                                       |   | **436,326**                                         | ** **     |                                                | ** **  |   | ** ** | 285,367 |   |   |   |   |   |
| Less:  allowance for loan losses                   |   | **(144,548**                                        | **)**          |                                                |        |   | ** ** | (141,826 | ) |   |   |   |   |
| Total assets                                       |   | **$**                                               | **11,401,031** | ** **                                          |        | ** ** |   | ** ** | $ | 10,005,191 |   |   |   |   |   |
| Interest-bearing  liabilities                      |   |                                                | ** **     |                                                | ** **  |   | ** ** |   |   |   |   |   |   |
| Deposits:                                          |   |                                                | ** **     |                                                | ** **  |   | ** ** |   |   |   |   |   |   |
| Savings                                            |   | **$**                                               | **1,109,563**  | ** **                                          | **3,679**   | ** ** | **.44** | ** ** | $ | 951,952 |   | 6,630 |   | .93 |   |
| Checking plus  interest accounts                   |   | **1,022,778**                                       | ** **     | **1,556**                                           | ** **  | **.20** | ** ** | 855,101 |   | 2,234 |   | .35 |   |
| Money market                                       |   | **1,273,361**                                       | ** **     | **7,262**                                           | ** **  | **.76** | ** ** | 1,065,126 |   | 10,913 |   | 1.37 |   |
| Time deposits  $100,000 and over                   |   | **1,257,288**                                       | ** **     | **22,549**                                          | ** **  | **2.40** | ** ** | 1,057,250 |   | 26,147 |   | 3.31 |   |
| Other time  deposits                               |   | **1,789,902**                                       | ** **     | **35,846**                                          | ** **  | **2.68** | ** ** | 1,768,526 |   | 48,344 |   | 3.65 |   |
| Total  interest-bearing deposits                   |   | **6,452,892**                                       | ** **     | **70,892**                                          | ** **  | **1.47** | ** ** | 5,697,955 |   | 94,268 |   | 2.21 |   |
| Short-term  borrowings                             |   | **832,631**                                         | ** **     | **4,317**                                           | ** **  | **.69** | ** ** | 852,070 |   | 9,074 |   | 1.42 |   |
| Long-term debt                                     |   | **472,859**                                         | ** **     | **13,016**                                          | ** **  | **3.68** | ** ** | 280,752 |   | 8,253 |   | 3.93 |   |
| Total  interest-bearing funds                      |   | **7,758,382**                                       | ** **     | **88,225**                                          | ** **  | **1.52** | ** ** | 6,830,777 |   | 111,595 |   | 2.18 |   |
| Noninterest-bearing  deposits                      |   | **2,142,529**                                       | ** **     |                                                | ** **  |   | ** ** | 1,815,090 |   |   |   |   |   |
| Other  liabilities and accrued expenses            |   | **108,999**                                         | ** **     |                                                | ** **  |   | ** ** | 106,817 |   |   |   |   |   |
| Total  liabilities                                 |   | **10,009,910**                                      | ** **     |                                                | ** **  |   | ** ** | 8,752,684 |   |   |   |   |   |
| Shareholders’  equity                         |   | **1,391,121**                                       | ** **     |                                                | ** **  |   | ** ** | 1,252,507 |   |   |   |   |   |
| Total  liabilities & shareholders’ equity |   | **$**                                               | **11,401,031** | ** **                                          |        | ** ** |   | ** ** | $ | 10,005,191 |   |   |   |   |   |
| Net interest  rate spread                          |   |                                                | ** **     | **$**                                               | **350,960** |   | **3.95** | **%** |   |   | $ | 334,134 |   | 4.07 | % |
| Effect of  noninterest-bearing funds               |   |                                                |           |                                                |        | **.42** | ** ** |   |   |   |   | .61 |   |
| Net interest  margin on earning assets             |   |                                                |           |                                                |        | **4.37** | **%** |   |   |   |   | 4.68 | % |
| Taxable-equivalent  adjustment included in:        |   |                                                | ** **     |                                                | ** **  |   | ** ** |   |   |   |   |   |   |
| Loan income                                        |   |                                                | ** **     | **$**                                               | **3,675**   | ** ** |   | ** ** |   |   | $ | 3,571 |   |   |   |
| Investment  securities income                      |   |                                                | ** **     | **1,204**                                           | ** **  |   | ** ** |   |   | 1,036 |   |   |   |
| Total                                              |   |                                                | ** **     | **$**                                               | **4,879**   | ** ** |   | ** ** |   |   | $ | 4,607 |   |   |   |

 

----

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

** Nonaccrual loans are included in average loans

*** Balances reported atamortized cost; excludes pretax unrealized gains (losses) on securitiesavailable-for-sale

 

25

----

 

The following table presents the distribution of the averageconsolidated balance sheet, interest income/expense and annualized yieldsearned and rates paid through the third quarter of 2003 and 2002

 
|                                               |   | **For the 3 Months Ended  September 30, 2003** |           | **For the 3 Months Ended  September 30, 2002** |        |
|----------------------------------------------------|--------|-----------------------------------------------------|----------------|-----------------------------------------------------|-------------|
|                                               |   | **Average  Balance**                                |           | **Income*/  Expense**                               |        | **Yield*/  Rate** |   | **Average  Balance** |   | **Income*/  Expense** |   | **Yield*/  Rate** |   |
| Earning assets                                     |   |                                                | ** **     |                                                | ** **  |   | ** ** |   |   |   |   |   |   |
| Loans:**                                           |   |                                                | ** **     |                                                | ** **  |   | ** ** |   |   |   |   |   |   |
| Commercial                                         |   | **$**                                               | **4,900,613**  | ** **                                          | **$**       | **69,660** | ** ** | **5.64** | **%** | $ | 4,309,714 |   | $ | 70,450 |   | 6.49 | % |
| Construction                                       |   | **969,251**                                         | ** **     | **13,047**                                          | ** **  | **5.34** | ** ** | 769,238 |   | 11,702 |   | 6.04 |   |
| Residential  real estate                           |   | **1,205,020**                                       | ** **     | **19,087**                                          | ** **  | **6.28** | ** ** | 1,076,355 |   | 19,518 |   | 7.19 |   |
| Consumer                                           |   | **1,256,381**                                       | ** **     | **19,582**                                          | ** **  | **6.18** | ** ** | 1,006,849 |   | 17,954 |   | 7.07 |   |
| Total loans                                        |   | **8,331,265**                                       | ** **     | **121,376**                                         | ** **  | **5.78** | ** ** | 7,162,156 |   | 119,624 |   | 6.63 |   |
| Federal funds  sold, et al                         |   | **413,675**                                         | ** **     | **1,245**                                           | ** **  | **1.19** | ** ** | 240,313 |   | 1,369 |   | 2.26 |   |
| Securities:***                                     |   |                                                | ** **     |                                                | ** **  |   | ** ** |   |   |   |   |   |   |
| Taxable  securities                                |   |                                                | ** **     |                                                | ** **  |   | ** ** |   |   |   |   |   |   |
| U.S. Treasury  securities and government agencies  |   | **1,629,544**                                       | ** **     | **17,192**                                          | ** **  | **4.19** | ** ** | 2,126,356 |   | 24,695 |   | 4.61 |   |
| Mortgage-backed  securities                        |   | **1,150,073**                                       | ** **     | **10,093**                                          | ** **  | **3.48** | ** ** | 197,654 |   | 2,793 |   | 5.61 |   |
| Other stocks  and bonds                            |   | **120,093**                                         | ** **     | **1,726**                                           | ** **  | **5.70** | ** ** | 23,763 |   | 343 |   | 5.73 |   |
| Tax-exempt  securities                             |   |                                                | ** **     |                                                | ** **  |   | ** ** |   |   |   |   |   |   |
| States and  political subdivisions                 |   | **84,944**                                          | ** **     | **1,295**                                           | ** **  | **6.05** | ** ** | 38,503 |   | 778 |   | 8.02 |   |
| Total  securities                                  |   | **2,984,654**                                       | ** **     | **30,306**                                          | ** **  | **4.03** | ** ** | 2,386,276 |   | 28,609 |   | 4.76 |   |
| Interest-bearing  deposits in other banks          |   | **21,372**                                          | ** **     | **46**                                              | ** **  | **.85** | ** ** | 358 |   | 3 |   | 3.84 |   |
| Total earning  assets                              |   | **11,750,966**                                      | ** **     | **152,973**                                         | ** **  | **5.16** | ** ** | 9,789,103 |   | 149,605 |   | 6.06 |   |
| Cash and due  from banks                           |   | **295,289**                                         | ** **     |                                                |        |   | ** ** | 234,441 |   |   |   |   |   |
| Bank premises  and equipment, net                  |   | **124,275**                                         | ** **     |                                                |        |   | ** ** | 101,131 |   |   |   |   |   |
| Other assets                                       |   | **602,614**                                         | ** **     |                                                |        |   | ** ** | 316,554 |   |   |   |   |   |
| Less:  allowance for loan losses                   |   | **(151,044**                                        | **)**          |                                                |        |   | ** ** | (137,249 | ) |   |   |   |   |
| Total assets                                       |   | **$**                                               | **12,622,100** | ** **                                          |        |   |   | ** ** | $ | 10,303,980 |   |   |   |   |   |
| Interest-bearing  liabilities                      |   |                                                | ** **     |                                                | ** **  |   | ** ** |   |   |   |   |   |   |
| Deposits:                                          |   |                                                | ** **     |                                                | ** **  |   | ** ** |   |   |   |   |   |   |
| Savings                                            |   | **$**                                               | **1,218,813**  | ** **                                          | **936**     | ** ** | **.30** | ** ** | $ | 983,806 |   | 2,228 |   | .90 |   |
| Checking plus  interest accounts                   |   | **1,119,989**                                       | ** **     | **451**                                             | ** **  | **.16** | ** ** | 872,322 |   | 754 |   | .34 |   |
| Money market                                       |   | **1,431,262**                                       | ** **     | **2,203**                                           | ** **  | **.61** | ** ** | 1,140,825 |   | 3,735 |   | 1.30 |   |
| Time deposits  $100,000 and over                   |   | **1,270,016**                                       | ** **     | **7,046**                                           | ** **  | **2.20** | ** ** | 1,138,356 |   | 8,881 |   | 3.10 |   |
| Other time  deposits                               |   | **1,942,113**                                       | ** **     | **11,677**                                          | ** **  | **2.39** | ** ** | 1,763,253 |   | 15,061 |   | 3.39 |   |
| Total  interest-bearing deposits                   |   | **6,982,193**                                       | ** **     | **22,313**                                          | ** **  | **1.27** | ** ** | 5,898,562 |   | 30,659 |   | 2.06 |   |
| Short-term  borrowings                             |   | **944,979**                                         | ** **     | **1,303**                                           | ** **  | **.55** | ** ** | 833,966 |   | 2,834 |   | 1.35 |   |
| Long-term debt                                     |   | **611,801**                                         | ** **     | **5,368**                                           | ** **  | **3.48** | ** ** | 275,677 |   | 2,630 |   | 3.78 |   |
| Total  interest-bearing funds                      |   | **8,538,973**                                       | ** **     | **28,984**                                          | ** **  | **1.35** | ** ** | 7,008,205 |   | 36,123 |   | 2.04 |   |
| Noninterest-bearing  deposits                      |   | **2,406,521**                                       | ** **     |                                                |        |   | ** ** | 1,917,680 |   |   |   |   |   |
| Other  liabilities and accrued expenses            |   | **125,669**                                         | ** **     |                                                |        |   | ** ** | 103,074 |   |   |   |   |   |
| Total  liabilities                                 |   | **11,071,163**                                      | ** **     |                                                |        |   | ** ** | 9,028,959 |   |   |   |   |   |
| Shareholders’  equity                         |   | **1,550,937**                                       | ** **     |                                                |        |   | ** ** | 1,275,021 |   |   |   |   |   |
| Total  liabilities & shareholders’ equity |   | **$**                                               | **12,622,100** | ** **                                          |        |   |   | ** ** | $ | 10,303,980 |   |   |   |   |   |
| Net interest rate  spread                          |   |                                                |           | **$**                                               | **123,989** | ** ** | **3.81** | **%** |   |   | $ | 113,482 |   | 4.02 | % |
| Effect of  noninterest-bearing funds               |   |                                                |           |                                                |        | **.38** | ** ** |   |   |   |   | .58 |   |
| Net interest  margin on earning assets             |   |                                                |           |                                                |        | **4.19** | **%** |   |   |   |   | 4.60 | % |
| Taxable-equivalent  adjustment included in:        |   |                                                | ** **     |                                                | ** **  |   | ** ** |   |   |   |   |   |   |
| Loan income                                        |   |                                                |           | **$**                                               | **1,239**   | ** ** |   | ** ** |   |   | $ | 1,226 |   |   |   |
| Investment  securities income                      |   |                                                |           | **518**                                             | ** **  |   | ** ** |   |   | 342 |   |   |   |
| Total                                              |   |                                                |           | **$**                                               | **1,757**   | ** ** |   | ** ** |   |   | $ | 1,568 |   |   |   |

 

----

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

** Nonaccrual loans are included in average loans

*** Balances reported atamortized cost; excludes pretax unrealized gains (losses) on securitiesavailable-for-sale

 

26

----

 

**RATE/VOLUME ANALYSIS**

 

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

 
|                                       |   | **For the 9 months  Ended September 30,  2003 vs. 2002  Due to variances in** | ** ** | **For the 3 months  Ended September 30,  2003 vs. 2002  Due to variances in** | ** ** |
|--------------------------------------------|--------|------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|
| **(Dollars in thousands)**                 |   | **Rates**                                                                          | ** ** | **Volumes**                                                                        | ** ** | **Total** | ** ** | **Rates** | ** ** | **Volumes** | ** ** | **Total** | ** ** |
| Interest  earned on:                       |   |                                                                               |       |                                                                               |       |   |   |   |   |   |   |   |   |
| Loans:                                     |   |                                                                               |       |                                                                               |       |   |   |   |   |   |   |   |   |
| Commercial (1)                             |   | $                                                                                  | (25,608    | )                                                                                  | $          | 18,298 |   | $ | (7,310 | ) | $ | (10,449 | ) | $ | 9,659 |   | $ | (790 | ) |
| Construction  (2)                          |   | (4,815                                                                             | )          | 8,064                                                                              |       | 3,249 |   | (1,698 | ) | 3,043 |   | 1,345 |   |
| Residential  real estate                   |   | (6,587                                                                             | )          | 2,774                                                                              |       | (3,813 | ) | (2,764 | ) | 2,333 |   | (431 | ) |
| Consumer                                   |   | (6,617                                                                             | )          | 5,466                                                                              |       | (1,151 | ) | (2,822 | ) | 4,450 |   | 1,628 |   |
| Total loans                                |   | (43,627                                                                            | )          | 34,602                                                                             |       | (9,025 | ) | (17,733 | ) | 19,485 |   | 1,752 |   |
| Taxable  securities (3)                    |   | (11,027                                                                            | )          | 13,690                                                                             |       | 2,663 |   | (1,112 | ) | 988 |   | (124 | ) |
| Tax-exempt  securities (3)                 |   | (386                                                                               | )          | 912                                                                                |       | 526 |   | (5,363 | ) | 6,543 |   | 1,180 |   |
| Federal funds  sold, et al                 |   | (3,679                                                                             | )          | 2,930                                                                              |       | (749 | ) | (421 | ) | 938 |   | 517 |   |
| Interest-bearing  deposits in other banks  |   | (176                                                                               | )          | 217                                                                                |       | 41 |   | (133 | ) | 176 |   | 43 |   |
| Total interest  income                     |   | (58,895                                                                            | )          | 52,351                                                                             |       | (6,544 | ) | (24,762 | ) | 28,130 |   | 3,368 |   |
|                                       |   |                                                                               |       |                                                                               |       |   |   |   |   |   |   |   |   |
| Interest paid  on:                         |   |                                                                               |       |                                                                               |       |   |   |   |   |   |   |   |   |
| Savings  deposits                          |   | (4,049                                                                             | )          | 1,098                                                                              |       | (2,951 | ) | (1,824 | ) | 532 |   | (1,292 | ) |
| Checking plus  interest deposits           |   | (1,116                                                                             | )          | 438                                                                                |       | (678 | ) | (517 | ) | 214 |   | (303 | ) |
| Money market  accounts                     |   | (5,785                                                                             | )          | 2,134                                                                              |       | (3,651 | ) | (2,483 | ) | 951 |   | (1,532 | ) |
| Certificates  of deposit $100,000 and over |   | (8,545                                                                             | )          | 4,947                                                                              |       | (3,598 | ) | (2,862 | ) | 1,027 |   | (1,835 | ) |
| Other time  deposits                       |   | (13,082                                                                            | )          | 584                                                                                |       | (12,498 | ) | (4,912 | ) | 1,528 |   | (3,384 | ) |
| Short-term  borrowings                     |   | (4,550                                                                             | )          | (207                                                                               | )          | (4,757 | ) | (1,908 | ) | 377 |   | (1,531 | ) |
| Long-term debt                             |   | (884                                                                               | )          | 5,647                                                                              |       | 4,763 |   | (469 | ) | 3,207 |   | 2,738 |   |
| Total interest  expense                    |   | (38,011                                                                            | )          | 14,641                                                                             |       | (23,370 | ) | (14,975 | ) | 7,836 |   | (7,139 | ) |
| Net interest  earned                       |   | $                                                                                  | (20,884    | )                                                                                  | $          | 37,710 |   | $ | 16,826 |   | $ | (9,787 | ) | $ | 20,294 |   | $ | 10,507 |   |

 

----

(1)          Interest Year-to-date tax-equivalent adjustment of $2,682,731 and$2,728,437 for 2003 and 2002, respectively, and quarter-to-date tax-equivalentadjustment of $927,323 and $906,830 for 2003 and 2002, respectively, areincluded in the commercial loan rate variances

(2)          Interest Year-to-date tax-equivalent adjustment of $993,597 and $842,687for 2003 and 2002, respectively, and quarter-to-date tax-equivalent adjustmentof $313,464 and $319,014 for 2003 and 2002, respectively, are included in thecommercial loan rate variances

(3)          Interest Year-to-date tax-equivalent adjustment of $1,203,998 and$1,035,161 for 2003 and 2002, respectively, and quarter-to-date tax-equivalentadjustment of $518,091 and $340,797 for 2003 and 2002, respectively, areincluded in the investment securities rate variances

 

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

# ** **

Information responsive to this item as of December 31, 2002appears under the captions “*Risk Management”, “Interest Rate Risk sensitivityAnalysis”* and*“Earnings Simulation Model Projection”* onpages 24-27 of the registrant’s 2002 Annual Report to Shareholders, filed asExhibit 13 to registrant’s Annual Report on Form 10-K for the year endedDecember 31, 2002. There was no material change in such information as ofSeptember 30, 2003.

 

27

----

 

**ITEM4. CONTROLS AND PROCEDURES**

# ** **

As of September 30, 2003, Bankshares’ management, under thesupervision and with the participation of the Company’s Chief Executive Officerand Chief Financial Officer, evaluated the effectiveness of the design andoperation of the Company’s disclosure controls and procedures. Based on theevaluation, the Chief Executive Officer and Chief Financial Officer concludedthat the Company’s disclosure controls and procedures were effective. Therewere no significant changes in the Company’s internal controls subsequent tothe date of the evaluation that could significantly affect those controls.

 

**PARTII – OTHER INFORMATION**

# ** **

**Item 5.****           OtherInformation**

 

The 2004 Annual Meeting of stockholders of the registrant is expectedto be held on April 28, 2004

 

**Item 6.****           Exhibitsand Reports on Form 8-K**

 

(a)                                  Exhibits

 

31.1 Section 302 Certification of Chief Executive Officer. Filedas an exhibit hereto and incorporated herein by reference

 

31.2 Section 302 Certification of Chief Financial Officer. Filedas an exhibit hereto and incorporated herein by reference

 

32.1 Section 906 Certification of Chief Executive Officer. Filedas an exhibit hereto and incorporated herein by reference

 

32.2 Section 906 Certification of Chief Financial Officer. Filedas an exhibit hereto and incorporated herein by reference

 

(b)                                 Reports on Form 8-K

 

Form 8-K filed, dated July 9, 2003, Item 5

Form 8-K filed, dated July 22, 2003, Item 7

Form 8-K filed, dated August 6, 2003, Item 5

Form 8-K filed, dated August 8, 2003, Item 5

Form 8-K filed, dated August 12, 2003, Item 5

Form 8-K filed, dated August 18, 2003, Item 5

Form 8-K filed, dated August 19, 2003, Item 5

Form 8-K filed, dated September 9, 2003 Item 5

Form 8-K filed, dated September 22, 2003 Item 5

 

28

----

 

**Signatures**

 

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

 
|                   |   |   | **BANKSHARES** |
|------------------------|--------|--------|----------------|
|                   |   |   | (Registrant)   |
|                   |   |   |           |
| November 10, 2003 |   |   |           | /s/ Edward J. Kelly, III |
| Date                   |   |   |           | By: Edward J. Kelly, III |
|                   |   |   |           | Chairman of the Board, |
|                   |   |   |           | President and  Chief Executive Officer |
|                   |   |   |           |   |
| November 10, 2003 |   |   |           | /s/ Terry L. Troupe |
| Date                   |   |   |           | By: Terry L. Troupe |
|                   |   |   |           | Chief Financial Officer |
|                   |   |   |           |   |
| November 10, 2003 |   |   |           | /s/ William T. Skinner, Jr. |
| Date                   |   |   |           | By: William T. Skinner, Jr. |
|                   |   |   |           | Controller |

 

29

----